The Volokh Conspiracy

A new study confirms what many had concluded about the “cash for clunkers” program: It failed.  Here’s the abstract:

A key rationale for fiscal stimulus is to boost consumption when aggregate demand is perceived to be inefficiently low. We examine the ability of the government to increase consumption by evaluating the impact of the 2009 “Cash for Clunkers” program on short and medium run auto purchases. Our empirical strategy exploits variation across U.S. cities in ex-ante exposure to the program as measured by the number of “clunkers” in the city as of the summer of 2008. We find that the program induced the purchase of an additional 360,000 cars in July and August of 2009. However, almost all of the additional purchases under the program were pulled forward from the very near future; the effect of the program on auto purchases is almost completely reversed by as early as March 2010 – only seven months after the program ended. The effect of the program on auto purchases was significantly more short-lived than previously suggested. We also find no evidence of an effect on employment, house prices, or household default rates in cities with higher exposure to the program.

(Hat tip: Tyler Cowen)

Predicting the stock market is either impossible or extraordinarily difficult, so I generally refrain from doing so — in print. Even apparently successful investors who trade daily or weekly are wrong nearly as often as they are right. So with the caveat that the chances of my being right are at best not appreciably better 50-50, I wanted to share an optimistic scenario for the stock market over the next 2-3 years.

Typically, a Democratic majority in the House of Representatives has been bad for the stock market and the economy and Republican control has been good (in the past, I have run, but not published, the numbers back to 1854). The reverse is generally true for the presidency.

There have been two switches from Democratic to Republican control of the House since 1950: in the 1994 election and in the 1952 election.

Cumulative returns in the S&P 500 over the two years following the 1994 Republican takeover (1995-96) were 69.8%. (The three-year returns for 1995-97 were a staggering 127.0% [+38%,+23%,+33%].)

Cumulative returns in the S&P 500 over the two years following the 1952 takeover (1953-54) were 54.7%. (The three year returns for 1953-55 were 98.4% [-1%,+56%,+28%], but the Democrats retook the House in the 1954 election.)

Indeed, the best year for the S&P 500 since World War II was 1954 (56.0%), the second year after a Republican takeover of the House. The best year since 1976 was 1995 (38.5%), the year after the last Republican takeover of the House.

So will we get a huge stock market increase this time, as we have the last two times that Republicans have taken the House? Maybe, maybe not.

If the Republicans take the House, why might we get a strong stock market?

(1) an end to disastrous new government efforts to stimulate the economy (or at least a significant slow down in such wealth-destroying efforts);

(2) a probable reduction in regulatory uncertainty; and

(3) a reduction in the odds for increased taxes (beyond the expiration of the Bush Tax cuts for those making over $250,000).

A strong stock market and a reduction in regulatory uncertainty would likely lead to robust economic growth — and eventually strong job growth. That would make the world a lot better for our students and our children.

I don’t expect that good economic policy will suddenly start coming out of Washington in 2011, but I do hope that the policies will not get increasingly worse, month by month. Though we will never know, I believe that, if the Federal Reserve and the Bush and Obama Administrations had done little else than lower interest rates, provide liquidity, and temporarily guarantee money market funds, we would have had a brief, sharp recession, followed already by robust GDP growth.

So why might this optimistic 2011-2013 scenario not happen?

(1) the Republicans might not retake the House (the number of pick-ups needed is exceedingly large);

(2) the Republicans might act like the Democrats once they regain control, as they mostly did the last time they held sway;

(3) significant tax rate increases are already scheduled for 2011;

(4) because of tax increases, economic activity may have already been shifted from 2011 to 2010;

(5) a new carbon cap or tax may be imposed either by a lame duck Congress or by the EPA;

(6) regulatory uncertainties persist, especially over health care;

(7) two events (1952, 1994) are not enough to define an effect, especially since if one goes back further in time, this effect is not present. (The two-year returns following prior Republican takeovers of the House averaged just 5.6%.); and

(8) there were special circumstances in the 1953-55 period (end of the Korean War, worldwide post-WW2 boom) and in the 1995-97 period (computer revolution; end of the Cold War and expansion of economic freedom).

Ironically, if the Republicans retake the House and the stock market booms as it did after the 1952 and 1994 takeovers, such a strong recovery would greatly increase President Obama’s chances of being re-elected.

So what do I think about the stock market? At the moment at least, I am fully invested in US and foreign stocks and mutual funds — and I hope to remain so over most of the next two years, at least if the Republicans take the House and there are no major new pieces of economy-destroying legislation or EPA regulations.

A few days ago I linked to a couple of articles on VAT tax proposals that have been circulating, including an attack by Daniel Mitchell at the Cato site, and a short blog post from Greg Mankiw explaining why, as a replacement for the rest of the tax system, he thought it was a better tax mechanism, as well as being the functional equivalent of certain versions of the flat tax.

I received several interesting emails from tax professors in response.  One pointed to a paper very much on the point of the post by Brian D. Galle, Hidden Taxes, upcoming in Washington University Law Journal; the SSRN abstract says:

The idea of hidden taxes is as old as John Stuart Mill, but convincing evidence of their existence is new. In this Article, I survey and critique recent studies that claim to show that there are some taxes that can go unnoticed by those who pay them. I also develop the array of unanswered theoretical questions and policy implications that potentially follow from the studies’ results.

Probably the central question for hidden taxes is whether they might enable government to raise revenue without also distorting the economy. If so, I argue, they have the potential to radically refashion the architecture of redistributive government. But, as I also show, whether that is true turns on the cognitive mechanisms that might permit taxes to go unnoticed. For example, if hidden taxes are caused not by rational ignorance but by cognitive shortcomings, then it is likely that the burden of a hidden tax will be borne disproportionately by poorer taxpayers, and vice-versa. Thus, I attempt to integrate with the tax literature some recent developments in our understanding of bounded rationality in consumers more generally.

But I also received an email from a friend and colleague on my own Washington College of Law faculty, tax professor Benjamin Leff.  (Ben is a junior – ie, untenured – professor, and he had some hesitation about putting out views on a blog.  I assured him that people understand that this is informal, first draft discussion, not a final academic or scholarly product, and moreover, it is a space to think about the political ramifications of various policy positions, in ways that one might not think appropriate for a scholarly paper.)  I’m delighted to say that Ben is letting me put up his remarks as an embedded guest post, and my thanks to him for taking this up:

Your post on why the “hiddeness” of a VAT tax is “a bug, not a feature” was very interesting. Basically, if I understand correctly, you’re dipping into an old argument about the relevance of tax “salience.” The argument you’re making is that a less salient tax (a more “hidden” one) creates a public choice problem, because it enables policy-makers to tax more with less protest from the taxed. The implication is that if the people fully felt the sting of the taxes they pay, they would do the hard work of cutting government spending down to optimal levels, rather than overspending as they currently do (if they do). Thus, if a VAT were passed, and if it had the benefit of being less salient than current taxes, it would permit additional spending by the government.

I think the most common answer given to your argument currently is that the discovery of limitless deficit spending put an end to plausibility of the “starve the beast” argument you’re making. In other words, the link between taxing, voting, and spending that you propose is broken by the option of neither taxing nor reducing expenditures. That seems convincing to me, but I have no special knowledge about it. In recent memory, tax cutting has not generally been accompanied by reduced government spending, but obviously that doesn’t really prove anything. At root, it’s an empirical question: if a VAT were introduced, would the government use the revenue generated to (1) reduce non-VAT federal taxes (keeping overall revenue neutral); (2) reduce the deficit; or (3) increase federal spending. That question may or may not have anything to do with how “hidden” a VAT is. It may have more to do with the public debate that supports the imposition of a VAT, the intentions of Congress in enacting it, and the continuing commitment in Congress to whatever choices made with regards to spending and deficits.

But, more important than whether the argument is convincing or not, I think, is some context for it. You describe “hiddeness” as a feature that makes a VAT “particularly special” among tax mechanisms, but that’s not really true. We currently have a broad range of “salience” in the federal taxes that are imposed. What is especially problematic from a public choice perspective in the current system is that the “hidden” taxes appear to be disproportionately borne by wage earners. Therefore, as wealth increases (generally), one’s sense of being taxed increases more sharply than one’s actual tax burden. That is, (again, generally) rich people think they’re more taxed than they are and working people think they’re less taxed than they are. That’s a distributional public choice problem, and I think it should be clear why a distributional public choice problem would do more damage to the political process than a general one.

The “hiddeness” of wage-earners’ taxes is generally caused by two phenomena. First, wage-earners pay flat payroll taxes (generally social security and medicare), which is 7.65 percent of their income right out of their paycheck. This largely invisible (as evidenced by the fact that some of your commenters said that the bottom half of the country pays no federal tax, when in fact the vast majority of that bottom half pay a relatively steep flat tax on their very first dollar earned). But it’s not completely invisible, because at least it shows up on their paychecks and decreases their stated wage. But payroll taxes are even more invisible than that because employers are paying an additional 7.65% on their employee’s wages that doesn’t even get reported to them. There may be some argument about what the incidence of that tax is, but the consensus is that it falls at least substantially on labor. In other words, every employee in the country pays a flat 15.3% tax on their first dollar earned. Commentators often ignore it or are confused about it (especially conservative commentators who want to claim, falsely, that working people don’t pay federal taxes). Oops, I forgot to mention that it’s not a flat tax. It’s a regressive tax, because (at least for the social security component) once you earn above a ceiling ($106,800) the tax disappears.

The second factor that “hides” the taxes paid by working people is withholding. Because of withholding, wage earners often experience taxes as a refund, rather than an expense. When it was introduced, the biggest argument against withholding was exactly the argument you are making – that it’s a public choice problem to hide taxes. Many would argue that the biggest reason why our tax system can work at all is because of the withholding system. So, if you’re afraid of hidden taxes, the game has already been played (at least for the vast majority of Americans who are employees). Then the question if you’re still committed to “visible” taxes is whether a VAT is more or less hidden that withheld wages.

Thus, there’s currently a distributional problem with the federal tax system, because high-income taxpayers generally pay visible taxes, while low/middle-income taxpayers generally pay invisible ones. Because a VAT taxes only consumption, and exempts income from capital, it is yet another “hidden” tax primarily on wage earners, exacerbating the distributional salience problem that already exists in our current system. But if you think that the point of an income tax is to roughly measure “ability to pay” (as I and other liberals generally do), then you will be unhappy with a VAT not primarily because it is more or less “hidden” than current federal taxes, but because it actually increases the tax burden on wage earners while decreasing the burden on the wealthy. My view is that because a VAT excludes from tax income from investments, an income tax does a better job of tracking “ability to pay,” which is the cornerstone of an equitable tax system. But that discussion is well beyond the scope of your post.

All that to one side, though, what I think makes your post interesting to think about has to be the sharpness of the opposition of the “public choice” argument to the “economic” one, because your readers may be drawn to both. The way you cast it, the public choice argument seems infuriating to economists (or anyone who cares at all about economics), as you point out, because (generally) everything that makes a tax “efficient” also makes it less visible. And so, under the public choice argument – assuming that you thought that government spending is bad – the best tax would be the least efficient one. The more a tax changed market choices, the more it would “sting” (by thwarting one’s desires) and therefore, the more likely it would be to encourage the populace to reduce taxes. That should be true of spending programs too, by the way. If you’re opposed to government spending, then the worst possible thing is efficient government spending that really makes people’s lives better. You should be promoting wasteful spending that messes people up as much as possible. That is to say, if you’re looking for a revolution, make the current system work as badly as possible.

But on reflection, the economic argument and the public choice argument are not actually so opposed. Because, according to the economic argument (at least the welfarist economic argument), the government should do what it is most efficient for it to do to provide for the greatest happiness. So, if many things are public goods, for example, which are likely to be undersupplied by the market, then as an economist, you should not be for reduced government spending, but for spending sufficient to supply those public goods. You should be for exactly the right amount of government spending. It’s not a foregone conclusion, then, that we have excessive government spending, though we may be spending on the wrong things. Then you have a much more nuanced “salience” question. Taxes should be exactly “hidden” enough to permit people to make the right choices about how much government spending there ought to be. You have a problem of baseline, though. What is “the right” amount of hiddeness?

(Corrected, and thanks to commenter for pointing it out, to shift the last paragraph from Galle’s abstract from Ben’s discussion, where it wound up accidentally, back to Galle’s abstract.)

With an eye to Ben Bernanke’s upcoming testimony to the Financial Crisis Inquiry Commission during the two days of hearings on “too big to fail” – in other words, systemic risk – the WSJ has an editorial in today’s paper raising various questions about the basis on which the Fed, the FDIC, and other agencies concluded that AIG, Bear Stearns, Wachovia, and others qualified as “systemic risk” exceptions allowing for extraordinary actions – i.e., bailouts.

I follow the systemic risk discussions pretty closely, as part of a current writing project, but I realized that I had not been tracking the FOIA requests surrounding some of the US government actions – in part because the government doesn’t seem to be much interested in responding to them.  The general point of the FOIAs is to try and get an understanding of what particular government agencies, and the Fed and FDIC in particular, believed constituted systemic risk, along with an account of how the concept was applied in practice in 2007-2009.  The conclusion of the editorial is, I think, right in the question it poses:

Two years after the bailouts and more than a month after President Obama signed into law new authority for the government to prevent “systemic risk,” Washington still won’t tell us what this term means. Releasing the history of 2008 would at least allow us to know what regulators thought it meant at the time, with lessons for the future.

I agree that the question takes on more importance given the new legislation that confers even more discretionary authority on the Fed to address questions of systemic risk.  What the Fed understands by that term as applied in particular circumstances – which is to say, as a concrete regulatory term, and not just as a matter of a conceptual economic term – is far from irrelevant.  Call it (maybe!) the ‘regulatory casuistry’ of systemic risk, how it gets worked out as a practical term in a run of particular circumstances.

(A useful discussion of the term as a regulatory concept is in Steve Schwarcz’s Georgetown law journal article from midway through the financial crisis, “Systemic Risk,” parts of which are being incorporated into a book Steve and I are doing on financial regulatory reform; the FOIA requests remind me that the concrete ways in which agencies interpret an abstract term that grants them a great deal of discretionary authority matters a lot, and not just the abstract concept denoted by the term.)

My Case Western colleague, Scott Shane, has a brief item linking the lack of hiring by small businesses to the collapse in home prices.  Specifically, he identifies five reasons the “residential real-estate mess” is holding back small business job creation:

1. Declining house prices have softened demand for small businesses’ products and services.
2. Small businesses are overrepresented in the real estate-related industries that have been decimated by the residential housing market collapse.
3. Small business owners use their homes to obtain business credit.
4. Banks have tightened lending standards in response to a rising share of non-performing real estate loans.
5. Small business owners were major customers of residential real estate loans during the boom, making them among the consumers hardest hit from the collapse in home prices.

He concludes:

Waiting for small business owners to begin hiring in this economic recovery has become like waiting for Godot. Rather than continuing to wait (while chanting the mantra that “small businesses are the major job creators in economic recoveries”), we should acknowledge why small businesses aren’t leading job creation this time around and come up with solutions to the residential real estate problems that are holding them back.

Doing this is imperative. Slightly more than half (50.2 percent) the private sector works in small companies. If the residential real estate mess keeps the small business sector from hiring, it will be awfully difficult to reduce our unemployment rate to a reasonable level.

The New York Times Bucks Blog (of August 6, 2010) has a fascinating article by Jennifer Saranow Schultz on the first-ever offering in the United States of divorce insurance, the WedLock policy issued by a start up insurance company in North Carolina, Safeguard Guaranty Corp.  Markets in everything, etc.

The casualty insurance is designed to provide financial assistance in the form of cash to cover the costs of a divorce, such as legal proceedings or setting up a new apartment or house. It is sold in “units of protection.” Each unit costs $15.99 per month and provides $1,250 in coverage. So, if you bought 10 units, your initial coverage would be $12,500 and you’d be paying $15.99 per month for each of those units. In addition, every year, the company adds $250 in coverage for each unit.

Then, if you get divorced and your policy has matured (see below for the maturation rules), you would send WedLock proof of your divorce. In return, you’d receive a lump sum of cash equivalent to the amount of coverage you had purchased.

There are a couple of classic insurance questions explored in the NYT article.  One is how to prevent people who know they are going to get divorced from signing up; the key element is a maturation clause (a little bit like suicide riders in life insurance policies) that requires 48 months (reducible to 36 if you buy an additional rider) before the policy will pay off.  A second is how the company sets its rates – it does so based around the factors summarized,  more or less, in its “divorce probability calculator,” for which it claims a 13% margin of error (curiously, I thought, it does not ask how many years a married person has already been married, but maybe I err in thinking that is especially relevant).  A third is moral hazard, in the sense of inducing riskier behavior, in this case presumably lowering the inhibitions on behaviors that might lead to divorce; the approach of the policy seems to be to treat it like any other accident insurance, as an independently bad enough thing (even if monetarily compensated) so that in effect moral hazard doesn’t really operate.

The article finally explores the question of whether, at the premiums charged, it is such a good deal for a consumer couple; Schultz suggests it is not.  Will this kind of policy catch on?  My guess is not too widely, for the same reasons that prenup agreements haven’t become a standard part of marriages.  I myself would probably try to market this insurance not to couples as such, but as the “responsible” thing to take out with the children as beneficiaries – the economic effects might be exactly the same, but were I marketing it, I’d market it as the right thing to do in advance for the kids.

But the policy is a new kind of insurance, and it is hard to say what will happen.  Might such policies – this one really is modeled closely on standard casualty insurance – evolve into something quite different, something closer to a system of side-bets?  A swap market in divorce annuities, anyone?  How might we securitize marriage – or divorce?  Not to mention the problems of insurable interests and empty creditors.  (I wonder what the newly-wed Megan McArdle thinks, actually.)

(I’ll have more to say about this in another post about ‘theatre for a post-credit society’, but I will add that in some ways, this resembles a bit that very great play from the 1950s, Friedrich Durrenmatt’s somewhat forgotten The Visit of the Old Lady.  I will leave this as a cryptic teaser for the moment, however.)

Update: Folks, I have a worry that the comment thread is going to slide into various proposals for how to scam the policy, based on my summary above. I’d suggest people read the NYT article, and then if you want to propose ways to game the system, go to the company site and read the policy before proposing something. I think you’ll find that the insurance lawyers who drafted the policy are not quite as dumb as one might think based on a two graf summary above.

As a law professor who lives and works in DC, and frequently interacts with folks in various parts of the federal government, I should probably know the bureaucratic structure and process for executive-branch policy making than I do.  But I’ve never actually worked in the federal government, and I found this discussion by Keith Hennessey (H/T Greg Mankiw) to be a helpful primer.  It walks through the basics of how questions go to one policy council or another within the White House structure, and then talks specifically about the process for formulating economic policy in the White House.

Michael P. Fleischer, President of Bogen Communications, offers a business owner’s perspective on the costs of hiring new employees in the current economic environment.  He walks through the costs of hiring a hypothetical employee (Sally), explaining why it costs his business $74,000 to pay someone a $59,000 salary, of which they will only keep $44,000, with $12,000 in benefits).  Where does the extra money go?  Various taxes and insurance premiums, including unemployment and disability, workers’ comp, and so on.  Each item may be reasonable in itself, and some are quite small, but they add up.

In Fleischer’s view, these added costs increase his firm’s vulnerability to government decisions — and not just those made in Washington, D.C. While not all of the non-salary costs are due to government policy — Bogen could offer less generous benefits — many are, and this means firms like Bogen “have lost control of a big chunk of our cost structure,” and this makes Bogen reluctant to hire more.  Fleischer concludes:

even if the economic outlook were more encouraging, increasing revenues is always uncertain and expensive. As much as I might want to hire new salespeople, engineers and marketing staff in an effort to grow, I would be increasing my company’s vulnerability to government decisions to raise taxes, to policies that make health insurance more expensive, and to the difficulties of this economic environment.

A life in business is filled with uncertainties, but I can be quite sure that every time I hire someone my obligations to the government go up.  From where I sit, the government’s message is unmistakable: Creating a new job carries a punishing price.

UPDATE: More here.  (Hat tip: Professor Bainbridge)

The NYT‘s “Your Money” columnist, Ron Lieber, had a sobering column this week on the looming conflict over public pension obligations.

There’s a class war coming to the world of government pensions.

The haves are retirees who were once state or municipal workers. Their seemingly guaranteed and ever-escalating monthly pension benefits are breaking budgets nationwide.

The have-nots are taxpayers who don’t have generous pensions. Their 401(k)s or individual retirement accounts have taken a real beating in recent years and are not guaranteed. And soon, many of those people will be paying higher taxes or getting fewer state services as their states put more money aside to cover those pension checks.

At stake is at least $1 trillion. That’s trillion, with a “t,” as in titanic and terrifying.

Colorado, Lieber reports, is one of the few states that has tried to tackle this problem, enacting a bipartisan pension overhaul bill that, among other things, cuts back on cost-of-living increases for public pension payments.  “This sort of thing just isn’t done,” Lieber notes.  Some Colorado retirees have filed suit arguing Colorado can’t void its public pension obligations, while the state claims it’s an “actuarial necessity” because the money isn’t there.  Barring this sort of reform, states are required to raise taxes or cut other programs.

The money quote from the article comes from former Colorado governor Richard Lamm (D): “The New Deal is demographically obsolete. You can’t fund the dream of the 1960s on the economy of 2010.”

Mario Rizzo and Gerald O’Driscoll point to dueling letters to the editor from 1932 in The London Times by John Maynard Keynes and F. A. Hayek on whether government spending can help cure contemporary economic woes.  The letters, unearthed by Richard Ebeling, show that today’s debates over economic policy are, in many respects, a rerun of the debates of the 1930s.  O’Driscoll writes:

Prof. Ebeling’s rediscovery of these letters has unleashed a torrent of comments on blog sites. As New York University economist Mario Rizzo put it, “The great debate is still Keynes versus Hayek. All else is footnote.” Economists have clothed the debate with ever greater mathematical complexity, but the underlying issues remain the same.

Was Keynes correct that savings become idle money and depress economic activity? Or was the Hayek view, first articulated by Adam Smith in the “Wealth of Nations” in 1776, correct? (Smith: “What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too.”)

Is all spending equally productive, or should government policies aim to simulate private investment? If the latter, then Mr. Obama is following in FDR’s footsteps and impeding recovery. He does so by demonizing business and creating regime uncertainty through new regulations and costly programs. In this he follows neither Hayek nor Keynes, since creating a lack of confidence is considered destructive by both.

Finally, is creating new public debt in a weakened economy the path to recovery? Or is “economy” (austerity in today’s debate) and thrift the path to prosperity now, as it has usually been considered before?

Economist Russ Roberts has a good column in today’s Wall Street Journal outlining the continuing relevance of F.A. Hayek’s work to our own time:

He was born in the 19th century, wrote his most influential book more than 65 years ago, and he’s not quite as well known or beloved as the sexy Mexican actress who shares his last name. Yet somehow, Friedrich Hayek is on the rise….

Hayek is not the only dead economist to have garnered new attention. Most of the living ones lost credibility when the Great Recession ended the much-hyped Great Moderation. And fears of another Great Depression caused a natural look to the past. When Federal Reserve Chairman Ben Bernanke zealously expanded the Fed’s balance sheet, he was surely remembering Milton Friedman’s indictment of the Fed’s inaction in the 1930s. On the fiscal side, Keynes was also suddenly in vogue again…

But now that the stimulus has barely dented the unemployment rate, and with government spending and deficits soaring, it’s natural to turn to Hayek. He championed four important ideas worth thinking about in these troubled times.

First, he and fellow Austrian School economists such as Ludwig Von Mises argued that the economy is more complicated than the simple Keynesian story….

Second, Hayek highlighted the Fed’s role in the business cycle. Former Fed Chairman Alan Greenspan’s artificially low rates of 2002-2004 played a crucial role in inflating the housing bubble and distorting other investment decisions. Current monetary policy postpones the adjustments needed to heal the housing market.

Third, as Hayek contended in “The Road to Serfdom,” political freedom and economic freedom are inextricably intertwined. In a centrally planned economy, the state inevitably infringes on what we do, what we enjoy, and where we live. When the state has the final say on the economy, the political opposition needs the permission of the state to act, speak and write. Economic control becomes political control….

Even when the state tries to steer only part of the economy in the name of the “public good,” the power of the state corrupts those who wield that power. Hayek pointed out that powerful bureaucracies don’t attract angels—they attract people who enjoy running the lives of others. They tend to take care of their friends before taking care of others. And they find increasing that power attractive. Crony capitalism shouldn’t be confused with the real thing.

The fourth timely idea of Hayek’s is that order can emerge not just from the top down but from the bottom up. The American people are suffering from top-down fatigue. President Obama has expanded federal control of health care. He’d like to do the same with the energy market. Through Fannie and Freddie, the government is running the mortgage market. It now also owns shares in flagship American companies. The president flouts the rule of law by extracting promises from BP rather than letting the courts do their job. By increasing the size of government, he has left fewer resources for the rest of us to direct through our own decisions…..

I gave my own thoughts on Hayek’s continuing relevance here. In this post, I analyzed the continuing relevance of Hayek’s critique of conservatism. In a March post, I considered Hayek’s influence on academic thought and made the case for including his most important ideas in high school curricula.

The Atlantic is running an excerpt from Sebastian Mallaby’s new book, More Money Than God: Hedge Funds and the Making of  New Elite, which is out on June 14.  The excerpt covers the famous moment when George Soros broke the pound in 1992.  (It was then that I went to work for him, as general counsel to his charities, but mostly I remember people running in and out of rooms bringing him faxes while he was holding simultaneous meetings on assisting Eastern Europe.)  Mallaby is a terrific writer, and if you have any interest at all in the topic – and Mallaby is outstanding at bringing together the matters of finance and money with politics and power – you are likely to be interested in this book.  It is definitely on my summer reading list, although I am desperately hoping for a Kindle version, as I will be traveling and can’t haul around a lot of stuff.

On hedge funds and private equity in a different direction, I received an examination copy of a new textbook, An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm, by David P. Stowell.  It is excellent – clear, informative, well-written.  It is aimed at an undergraduate course audience, perhaps in the upper classes, but would also be perfectly useable in business school as an intro text, as well as in law school as an introductory class in these topics, if the professor were able to supplement it with legal materials.  (In fact, that might make an easy way to create something that does not now seem to exist for law school – a private equity-hedge fund text that covers both the business and legal aspects.  A fix for that might be to use this book, with a detailed supplement with examples and legal documents to illustrate the business descriptions in the text.)

I decided to stop teaching my introductory law school course on venture capital, private equity, and hedge funds, and instead return to the basic Business Associations class in the fall, after 7 or 8 years away from it.  I did so for two reasons – one, I find the whole private equity-hedge funds field too unsettled at the moment to teach with a lot of confidence that what I say now will reflect the industry in even just a couple of years, and I also think that at this moment, it has become so much just part of the deal industry that I can safely leave most of it to the M&A class, at least for now.  Second, though, I also wanted to return to BA, because my interests in business and finance law are shifting back towards the deeply embedded concepts of trust, agency, fiduciary duty, duty of care and duty of loyalty, and away from my long time focus on financial instruments and derivatives.

The latter goes to my scholarly interest in what I have called the “moral psychology of finance,” and somtimes called “virtue economics” – not in the sense of distributional justice in the economy, but instead the Aristotlean sense of “virtue ethics” and its intersection among practical reason, attitudes and rationality, and affective behavior and rational choice.  I am slowly re-reading Theory of Moral Sentiments, alongside Ian Simpson Ross’s exemplary Life of Adam Smith, a book I read with insufficient attention when it first appeared, but which I am re-reading with a great deal of care.

And finally, in this same broad area, I am also re-reading with intense care and considerable respect the papers in Ruth Chang’s 1997 volume, Incommensurability, Incomparability, and Practical Reason – with particular attention to Chang’s excellent introductory paper, and then Elizabeth Anderson’s contribution on practical reason (I’ll let the library locate me her later 2001 book, Making Comparisons Count, at over $100).  Partly this has to do with how this notion of virtue ethics intersects with practical reason – with every passing week, especially as I acquire and mostly skim an ever growing pile of books on the roots and solutions to the financial crisis and regulation, I am convinced that there is a lot more work to be done on the philosophy of economics, the philosophy of value and even the philosophy of valuation.  If I were advising a young person where to make a mark today, that would be a good starting point – where philosophy, economics, and intellectual history come together on these topics.

But, interestingly, the whole question of incommensurability and incomparability is at the center of a new paper I am completing on the vexed issue of proportionality in the laws of war.  Reading the examples in Chang’s book, I am much struck that the question of incommensurability and proportionality are far more real and unavoidable, as far as I can tell, in the ethics of war, and the classic calculation in the ethics of war between the demands of military necessity, on the one hand, and civilian harm, on the other.

A new grassroots organization started by my Independence Institute colleague Amy Oliver. This short video shows the growth in per-person national debt in the United States. Even when you take into account the fact that some of the increase in nominal debt is due to inflation, the tremendous increase in debt in the 21st century is frightening.

I want to return again briefly to how the traditional distinction of liquidity and insolvency in a crisis applies to sovereign states such as Greece.  Liquidity is usually thought of as a gap in information that causes investors, creditors, depositors or others to suddenly question an institution’s financial position. In the classic bank run, the information gap becomes a self-fulfilling prophecy of insolvency; in other cases, insolvency is discovered, not made, as information becomes available and indicates that the institution is genuinely not solvent. But in either case, insolvency is a condition of an institution, such as a bank or financial institution, discovered or made in the present.

In the case of sovereign states, the analogy is apt, but not entirely so. Sovereign states, even when they default on their obligations, do not simply disappear “into” (much less “in”) bankruptcy the way a private firm would, unless the firm had the deus ex machina of a government bailout.  States don’t just go away, their assets sold off and distributed out to the creditors.  The question of solvency or insolvency – the urgent information gap that has driven much of the recent Greek debt crisis – is not so much a question of solvency today, as whether a state can muster the political will to be solvent into the future.

Questions of political will across a long time horizon are by their nature deeply uncertain, not least from an investor’s point of view.  So it seems likely that in the absence of a flat out guarantee from a trusted party – the EU or its leading members – liquidity issues (including not just risk premiums, but much volatility in debt pricing, reflecting genuine uncertainties) will trouble Greece, and other shaky euro economies.  The special sovereign uncertainties arise as investors seek to bridge an information gap that is fundamentally about the special solvency issue for a sovereign state – long term political will.  Can a trillion-dollar euro fund allay the uncertainties, not just today, but over the required time horizon?

(Whatever the answer to that question, it seems to me that Professor Anna Gelpern, whose Roubini blog post I earlier referenced, is right in saying that Greece does not have much reason to seek a restructuring at this point in time.)

Anna Gelpern’s post on the Roubini blog (that I posted on earlier) had an interesting point I wanted to follow up.   She remarks in passing, “apropos commitment, isn’t it interesting that the European Commission will issue collateralized debt (secured by its €141bn budget)?”  Indeed, and even more interesting that the bulk of the bailout fund will come via a vast intergovernmental SPV.  If you follow her link, it takes you to a Financial Times article discussing the legal-financial structure of the EU bailout, which describes the bailout fund:

The so-called European stabilisation mechanism will consist of two parts with separate legal bases.

The €60bn extension of the EU’s existing balance of payments facility – used to help Hungary, Latvia and Romania – to members of the eurozone will be based on Article 122.2 of the EU treaty which allows for support for governments during “exceptional circumstances”. It thus circumvents the eurozone’s no-bailout principle.

The €440bn loan guarantee mechanism will be organised on an intergovernmental basis between the 16 eurozone member states.

Why the intergovernmental structure for the overwhelming bulk of it?  For political and legal reasons – first, to deal with German constitutional legal concerns and, second, to deal with British political concerns that it could be dragged into indirect liability if the fund were handled through Brussels institutions.  The governments will provide credit guarantees; the intergovernmental SPV will use the guarantees to raise money on the capital markets.  The 60 bn euro piece from the EU directly will come in the form of debt collateralized by the EU’s own budget.

My colleague and a rising star in sovereign debt studies, Anna Gelpern, has a new and important post at the Roubini blog, on the question of where Greece goes with the new announcement of a trillion-dollar fund.    The opening:

Leading economists and editorialists say Greece will restructure its debt (here, here, here, here and here are just a few examples).  Many say so because they see so much in common between the spiraling European crisis and past crises in the emerging markets.  The analogy has merit, and until recently, I too subscribed to it.  Now I am not so sure.  This is because the benefits of restructuring now are oddly remote, because Greece has the legal leverage to extract a deep debt haircut if and when it can maximize its benefits, because the EU needs time to get its act together and seems willing to pay for it—and because, as a descriptive matter, the global political commitment behind the no-restructuring option is without precedent.  And sovereign debt is nothing but political commitment.

The post goes on to offer six reasons why restructuring is not likely for now.  Trenchant analysis, highly recommended.

Clemens Kownatzki at Business Insider talks today about the effects of demography on public pension liabilities in different countries.  The article has great OECD data organized as charts by 5 year age groups, showing population distribution today and projected for 2050 – for Greece, the US, and Japan.  Excellent graphics and sobering reading.

The current government budget deficits and the overall debt burden may be frightening but they pale in comparison to the scale of unfunded liabilities for pensions and healthcare.  Temporary measures for bailouts and economic stimulus packages are one thing but without drastic measures, ongoing government deficits are simply not sustainable for the simple fact that people live longer and there are not nearly enough young people joining the work force to generate sufficient government revenues and to support the growing unfunded liabilities.

In my view, the root of the problem (in addition to the obvious irresponsible spending habits of most government officials) is demographic in nature; the easiest way to hint at the scale of the predicament is to look at projected population charts ….

This is not news, of course; as demographer Nicholas Eberstadt has occasionally pointed out, demographics involves long time lines, and if you are able to get reasonably accurate population figures at the front end, you will know an awful lot about what things will be like decades down the road.

However, though we talk a lot about the effects of demography and aging populations, etc., there is a curious sense in which we suddenly stop thinking about them when assuming things like long term regression to the mean of economic growth, and many other things.  Indeed, an eminent demographer once mentioned to me – clear back in the late 1990s, before the current housing crisis – that he did not understand the apparent assumption among many baby boomers that they would fund their retirements through houses as investments.  He asked, clear back in the 1990s, whether either ordinary people or public policy types had taken into account the singularity of the baby boom bulge, and its effects on supply and demand for housing and many other things.  I asked, half-jokingly, what he thought the market would be for boomer “antiques,” and he simply laughed.

Yet factoring in these demographic patterns, while easy in principle, seems not to happen, for example, in the undergraduate economics texts or other places that form many educated people’s basic intuitions about this.  The models are relatively static, which befits the purely abstract principle – but tends to convey an impression about the real economy that is not true, and will become less true over the next few decades.

I guess a better title would be “California’s Woes and Prop 13, Not.”  Also, never let it be said that Our Volokh Conspiracy – and its commenters – do not drive the intellectual agenda.

William Voegeli, a couple of whose articles on California’s finances have been linked here (see California tag), and who also provided a nice short commentary for VC on the topic, has a new piece in CityJournal on the legacy of Prop 13.  He told me in an email that it got started on account of being struck by how many VC commenters on his earlier post attributed California’s parlous fiscal state to Prop 13.  Hence the new article, “Don’t Blame Proposition 13.” Likewise I’m pleased to announce the publication of his new book, Never Enough: America’s Limitless Welfare State. Here is a bit from the California Prop 13 article :

According to liberals in politics, journalism, and academia, Proposition 13 is the reason for California’s worsening fiscal nightmare and the declining quality of the state’s public services, and the motives behind it were deplorable. And because Prop. 13 ignited a national tax revolt that remains potent, the Left also blames the measure for much of what it thinks has gone wrong in American political life generally over the past three decades.

Yet no matter how often their moral and intellectual “superiors” denounce them, California taxpayers continue to insist that the problem isn’t their purported stinginess but their government, which makes lousy use of the considerable funds that it continues to receive. On this point, the voters aren’t being stubborn, greedy, or stupid. The voters are right.

The first thing to recognize is that Proposition 13 did not destroy the tax base of California’s local governments. True, the average property-tax rate has fallen from 2.67 percent in 1977 to 1.1 percent today, observes David Doerr of the California Taxpayers’ Association. But the state still brings in a lot in property taxes. By 2007, the year of the most recent Census Bureau data comparing state finances, California’s state and local governments levied $1,141 in property taxes per capita, less—but only 11 percent less—than the corresponding average, $1,288, for the other 49 states and the District of Columbia. Property-tax revenues in the state have increased from $4.9 billion to $47 billion in the 30 years since Proposition 13. Adjust those figures for inflation and population growth, and property-tax revenues in California were 87 percent higher in 2009 than they were in 1979, chiefly because of rising property values.

And even if one tax is limited, others can rise. A recent article in the California Journal of Politics and Policy by Colin McCubbins and Mathew McCubbins shows that, adjusted again for population growth and inflation, total state and local tax revenues in California were higher ten years after Proposition 13’s enactment than they were just before—and that they were half again as high in 2000 as in 1978. Census Bureau data show that California ranked tenth in the nation in 2007 in terms of per-capita receipts from all state and local taxes (property, income, sales, and excise taxes) paid by individuals and corporations. Per-capita receipts from individual and corporate income taxes were 64 percent higher in California than they were in the rest of the country: $1,764 in California, $1,077 elsewhere. All told, California’s governments received $4,731 per resident from all taxes, 14 percent more than the $4,160 average outside California.

Ah, comes the objection: these numbers unfairly compare California with an aggregate that includes many rural states with low taxes and limited public services. But even if we confine our discussion to the ten most populous states in the nation, home to 54 percent of all Americans in 2009, California remains a high-tax jurisdiction. Its per-capita taxes exceed not only the national average but those of every other high-population state except New York ….

The Californians who refuse to jettison Proposition 13 have a well-founded suspicion: that the state’s public sector is starving on its high-calorie diet because of mismanagement and capitulations to public-employee unions ….

Update:  The Lincoln version of the derivatives legislation clears the Senate Agriculture Committee today (which raises another set of issues, different from the ones under discussion below):

Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.  The backing from Sen. Charles Grassley (R., Iowa) is the first sign of what Democrats hope will be an eventual wave of Republican support …  The move was also significant because Mr. Grassley said he favored one of the bill’s most controversial elements, a provision that could force Wall Street banks to spin off their derivatives trading desks.   The 13-8 vote in the Senate Agriculture Committee came as Senate lawmakers appeared to be inching closer to a deal on a broader remake of market rules.

The New York Times reported yesterday on negotiations over financial regulation legislation, and included this comment on derivatives regulation and Wall Street:

The derivatives bill, which is expected to be folded into the sweeping overhaul of the nation’s banking system, would also require most derivatives trades to be routed through a third party, known as a clearing agent. That would provide each of the parties a guarantee that they would be paid if the other party defaulted or went out of business. The bill would also require most derivatives to be traded on an open exchange.

Currently, the only way to trade many derivatives is to call up various dealers and ask for the price at which they are willing to buy or sell. The securities dealer profits from the difference between the prices at which it buys from one party and sells to another. Investors rarely, if ever, see details on the other side of the trade. Wall Street has signaled that it can live with a clearinghouse approach, but it is strongly opposed to exchange trading of derivatives, which would introduce price competition and lower the profits.

I think it’s fair to quote those two grafs from the lengthy article, which covers many aspects of the bill negotiations.  Here is my question – and it’s a genuine question, I’m not sure exactly what to think.

I had more or less assumed that Wall Street would be bothered more by a clearinghouse than an exchange, if it were one or the other and not both.  Why?  I assumed Wall Street would be concerned that a clearinghouse serving as a centralized counterparty would be motivated to contain its risk, by limiting margin and generally limiting leverage on the contracts for which it ultimately was responsible to clear.  The exchange seemed much weaker as a regulatory device because it would not have the ability, or at least the same incentives, to limit margin.  The exchange would help matters by making public the prices and counterparties, but not act to clear and, so, have to think about its own risk.  (If you had both, however, you would have the advantages of an entity motivated to limit risk and with public information on prices by which to help the determination of regulatory margin.  But we’re assuming here it is one or the other, although I myself strongly would like to see both.)

So I was surprised to read this passage and see my assumptions turned on their head.  And maybe I should never have been surprised, and this ordering preference should have been obvious.  But it did surprise me.  Which then leads me to the further thought, what is Wall Street’s assumption on the NYT’s description of its ordering preferences?  Wall Street prefers a clearinghouse that takes central counterparty risk but which should then address attendant risks?  Why?  Is it because of an assumption that – in a market that does not publicly post prices for everyone to see – if leverage gets out of control, the central clearinghouse will serve as the clearer of last resort?

In other words, does a clearinghouse without a public posting of exchange prices increase or decrease the likelihood that the central clearinghouse (in practical effect backed by the Federal government, which blessed the system through legislation after all) run the serious risk of serving as the next Wall Street bailout mechanism?  The New Fed-Market Put Option?

I don’t know the answer to this; this reporting surprised me, so I put the proposition to you.  Or have I misconceived Wall Street’s motivations or misunderstood what this ordering preference is all about?  Please stay on topic here and directly address these issues.

(Update 2.  Also see Gary Gensler urging a clearinghouse in the Wall Street Journal today, and Thomas Jackson and David Skeel, also in today’s WSJ, urging that derivatives be treated like other contracts in bankruptcy as a mechanism by which failed parties could have the regular bankruptcy protection against contract enforcement and so avoid cascading risk – and financial firms would not have to put (or give up) their customized derivatives onto exchanges (i.e., make everything into a uniform plain vanilla derivative).)

I’m sure many VC readers have been looking at the papers today, trying to sort out facts versus allegations, in the SEC suit against Goldman Sachs for fraud involving CDOs.  The Wall Street Journal, New York Times, Washington Post, and Financial Times all have good stories, to take the papers from my front lawn.

One of those stories (they have all, ahem, melded together in my mind) remarked that if sustained in court, and quite possibly even if not, the fraud suit and the narrative it tells, has the possibility of significantly altering the perception of the financial crisis, or at least its relationship to complex derivatives.  Away from a (possible, anyway one I share) perception of banks that didn’t much care about the down-stream performance of their products because they would get paid up-stream anyway – a perception of a systemically driven indifference, but not necessarily fraudulent, toward knowing, deliberately constructed malfeasance, understanding pretty well that these CDOs were headed to the dust-bin of history.

Such a shift in perception might come about regardless of whether this narrative is established as factually correct or not.  Another version might be that most of Wall Street was complacent and badly incentivized, so as to not care about credit quality – whereas Goldman Sachs, being the Masters of the Universe and Smarter Than the Average Bear (Stearns -ed.), uniquely saw it coming  and, in this case at least, protected itself and even figured out how to profit, but alas through fraud.

One of the problems with trying to say much at this stage about the legal analysis is that it is so factually driven.  If the facts are as the SEC alleges, well, then, bad, bad Goldman!!  But  on these allegations, there’s not a lot of room for legal nuance, although I am happy to be corrected on that in the comments, not being a securities litigator.  So, here’s my question for the comments.  Assume that the facts are as alleged.  In that case, is there an important legal issue, or is it the application of straight securities fraud principles?  Is there an alternative, plausible reading of the facts?  And is there an alternative, plausible factual reading that creates an important legal question?

That’s with respect to the fraud case on its own.  Assume the facts as alleged by the SEC.  What would that argue as a matter of long term regulatory reform in financial markets and institutions and regulation?  Although, frankly, at this stage, I’m more interested in the comments in trying to see whether there’s an important legal issue in the case at hand, as a legal issue.  As the New York Times Room for Debate blog exchange seemed to show, at this stage the systemic lessons people seem to be drawing out of the suit against Goldman are pretty much whatever they thought before the suit against Goldman.

A reader sends me the following comment, further to the several VC posts on behavioral economics (initially occasioned by Andy Ferguson’s Weekly Standard essay):

One basic issue that this whole-”behavioral econ– good-or-bad?”
discussion seems to have neglected the following simple point: welfare
evaluation is much harder with “behavioral agents” than “rational
agents.”

With “rational” agents we know that subject to tons and tons of
asumptions markets are great (first welfare theorem).  And we have a
pretty good idea of what constitutes a market failure (externalities)
and when a “social planner” can help.  Thus, there is a principled
econ case for certain forms of “social planner” intervention that we
know will raise welfare (whether a government can act as an optimal
social planner is another question).

With “behavioral” agents, the basic issue is that people’s preferences
are at some level time-inconsistent.  My self of today wishes that my
self of tomorrow would put money in to a 401(K) but my self of
tomorrow wishes it to be the next period’s self and etc.  Thus, the
person sitting at today does *not* have the same preferences as the
person sitting at tomorrow.   If you make the person of today put
money into a 401(k) *today* you make them worse off (since they wanted
to put money in a 401(k) tomorrow), but you make their yesterday’s
self happy.   As a social planner, whose utility do you maximize?

It’s not obvious how you do this.  There are some attempts to work
this out in the literature (e.g. http://www.nber.org/papers/w13737)
but it’s not settled.

I guess the main take-away is that claiming policy implications from
behavioral research is *much* harder than from other kinds of econ
research, so at some level behavioral people are jumping the gun a bit
in claiming that they have a new way to do policy; and this objection
is totally independent of worries about slippery slopes and whatnot.
That said, much of the actual-existing behavioral influenced policy
moves (e.g. doing stimulus through withholding rather than lump sum)
seems like a good idea since it is formally identical to what would
have been the status quo.

The paper cited at NBER is interesting, but I would add that this seems to me an area in which philosophy does have something to say.  The problems of the self over time have been much discussed, and at least some of the leading arguments about “whose” utility you maximize have been formally adduced, including the proposition that this present-self, future-self, successive-selves way of thinking about things is appealing in part because it matches up to marginality analysis, but is not coherent as an account of identity.  This is not an argument about values or an argument from moral philosophy; it is an argument about the nature of identity and self, and I think the philosophers of mind, identity, and such fields do indeed have something to say as to the conceptually valid and invalid ways of framing the issue of the self.

(In a quite different approach to the time-identity problem, framed as a matter of constitutional law and politics, I recommend highly Jed Rubenfeld’s short, compelling book, Freedom and Time: A Theory of Constitutional Self-Government.  When it first appeared, I found it – with apologies to Jed – very smart but frankly weird.  It has grown on me since then – grown on me a lot.)

Thanks to the VC reader for this thoughtful comment.

I finally had a chance to read the Cato Unbound symposium that Todd Z mentioned below.  It’s well worth the read.

I should add to my earlier post on this that I am not, as it happens, hostile to the pursuit of behavioral economics; far from it.  But I do share some of the skepticism about how it goes about the intellectual enterprise – for example, the way in which concepts in moral psychology that I would regard as unavoidably “deep,” such as trust, get operationalized, in order to fit into a certain form of testable experimental design, into concepts that are much flatter and on the surface, such as “confidence,” to quote a recent conversation with a psychologist friend in the field.

Indeed, as I’ve occasionally observed here at VC, if rationalist economics and behavioral economics are in some sense at odds and competing, or at least complementary, in another sense, they are much more deeply linked.  They are linked in being “surface” theories of human nature.  Neither of them embraces a deep view of human psychology or human nature – they are each minimalist and reductive, each in its own way.

There are contrasting approaches in economics that do embrace deeper views of people, more precisely, more “committed” views of human psychology.  One category would be institutional economics insofar as it embraces one or another form of sociological theory of institutions.  A theory of institutions that matters to economics, however, in a social sense will almost always be one that concerns legitimacy.

The other category would be theories of value based around deep commitments about human nature – moral psychology – and the defining work would be the Theory of Moral Sentiments.  But all that stuff that Akerloff and Schiller and other people today want to say about animal sentiments, etc., is all essentially founded in what might as well be called the moral psychology school of economics – and yet does not want quite to speak its name.  It hides behind Keynes, in a peculiar feat of intellectual history, when really it is Smith, the moral psychologist.

It’s not to say that one or another is right or wrong.  They describe different kinds of things and are better seen as complementary.  Confidence, in the sense that some behavioralists assert it as a conceptual proxy for trust, isn’t quite that – it is a stronger concept that confidence as its operationalization, for example.  And legitimacy is far more than the artifact of an observed tendency of people to obey institutional precepts; even the term precepts is conceptually slightly different from commands or orders.

There are plenty of reasons why one would want to design experiments around minimal commitments; there are plenty of reasons why minimal commitments are not enough to explain things.  The problem with surface theories of human nature is that they describe the ‘man without qualities’.  The problem with deep theories of human nature is that they eventually wind up with Dr Freud or something equally non-falsifiable – the ‘man with too many qualities’.

That is at the level of intellectual inquiry.  But the Cato Unbound discussion – and the end of the Ferguson piece, as well as my comment on the move that a certain application of behavioral economics makes, parallel to a move concerning rationality and deliberative democracy – is about its political and moral application.  That’s a separate discussion from the intellectual qualities of behavioral economics.  However, I found myself interested by a side issue, which is the final thing I want to raise here.  It is that the Cato symposium regarded the moral and political issue as being one of paternalism – whether that is true or not, that was the framing moral question in the discussion.

I would have thought, however, that rather than “paternalistic” policy, the phenomenon that the Cato critics were raising was much more a question of “therapeutic” social policy.  There are reasons, of course, to be concerned about them both if one is a libertarian – and even if one is not, quite possibly.  But they are not precisely the same thing.  Paternalistic or therapeutic?  Culture of paternalism or culture of therapy?  Discuss.  (Update:  I woke up this morning thinking that maybe the Cato Unbound discussion really is about paternalism; I’m still interested in the distinction, though.  Also, responding to one of the comments, I don’t think that falsifiability or non-falsifiability is the only relevant criterion; falsifiability on examination turns out to be more complicated than usually expressed.)

Treat liquidity risk and runs on institutions as fundamentally a question of lack of information – the lack of information on the underlying financial solvency prompting flight from uncertainty.  In that case, the question following the announcement in the press yesterday of the Greek-EU bailout is not so much what it signals about liquidity, as instead what contribution it will make toward the forward discovery of Greek solvency – if any.

As many observed, this announced deal consists of a fixed amount of money committed, rather than vague political promises.  At some 30 billion euros, plus additional commitments from the IMF, yes, of course, the effect of the announcement eases immediate liquidity fears.  (Although perhaps the issue of the signoff of seemingly everyone in the EU with a pen in order to release the funds raises some hold-up questions in theory, but probably not in reality.)  What remains is whether this breathing space will do much to fill in the missing information about Greece’s underlying solvency.  As the WSJ’s Richard Barley says in today’s Heard on the Street:

Even the clearest, most credible part of the deal—the interest-rate mechanism—raises questions. On one level, a 5% rate for a three-year fixed-rate loan represents a concession relative to last week’s market levels. But this is still 3.7 percentage points over three-year German debt—a long way north of where the Greeks would like to be able to borrow. Indeed, if Greece were to take a 10-year loan under the package, it would be at a rate of well over 7%—the rate the market would have charged last week.

In a curious way, this may act as a floor to private-market rates. Why should a bond investor lend money more cheaply than other euro-zone governments are willing to do? After all, two-year yields on Greek debt, while down sharply from last week, are still 5.47%.

The level of interest rate demanded as the bailout puts the EU in the position of setting it low enough to bring down private rates, but high enough to meet Bagehot’s condition for avoiding moral hazard in bank runs (lend freely, but at punitive rates, etc.)  But the uncertainties over solvency in the longer term remain broadly political.  Barley goes on to discuss the political issues of contributions by EU governments – including Spain, Ireland, and others also under pressure.  Questions of the behavior of outside guarantors, including EU states, is one set of uncertainties.

But perhaps the greatest solvency uncertainty, and one which is not necessarily helped toward price discovery by means of the liquidity breathing space offered by the current funds, is whether Greece will be able to do anything near to what it has promised in the way of internal fiscal reform.  One can always frame that question merely as whether investors will roll over existing Greek debt and at what price.  But that question depends on their assessment of uncertainties related to the fundamentals of the Greek economy, its competitiveness, and its fiscal policies.  Is the Greek economy capable of servicing its debt load?

It is not a matter of an injection of liquidity, in other words, for the purpose of allowing for outsiders time to find out the “true condition” of the balance sheet of an institution.  It is far more for the purpose of allowing outsiders to assess the ability of the government to reform that already whacked-out balance sheet.  The immediate bailout funds will not last long enough to see a convincing answer to that question over the future which it necessarily entails.  So outsiders will be making an assessment of political risk into the future.  Will they believe the Greek government and Greek society that, for example, its current austerity measures and fiscal reforms will stick?  Should anyone believe that?  Beyond austerity measures, is Greece capable of taking measures that would improve its productivity, competitive position, on economic fundamentals?  I don’t merely mean the devaluation that would inevitably result if there were still a drachma, but improvements to its competitive position through changes in its economic fundamentals.  Those are the uncertainties that matter, internal to Greece – uncertainties that are about the fundamental solvency of Greek society, and not just its sovereign debt position.

Outside investors have two bets to make as this new liquidity facility winds through the system.  One is on the EU and how long and how much it is willing to extend liquidity.  The other on Greece, the Greek government but also Greek society, and it is fundamentally about, not liquidity, but solvency.  The wonder, frankly, is that news stories over the weekend were suddenly talking about Greek solvency, as though it had ever been anything other than the fundamental question.

Todd’s right, Andy Ferguson’s Weekly Standard piece is excellent – whether one agrees with his ultimate take on it or not.  The bottom line of the piece, however, is not simply a skepticism about the powers of social science – behavioral economics as the New Social Engineering.  It is, rather, a broadly libertarian point, going to a crucial apparently methodological, but ultimately moral, difference between traditional economics and behavioral economics:

You can see how useful the notion of irrational man is to a would-be regulator. It is less helpful to the rest of us, because it runs counter to every intuition a person has about himself. Nobody sees himself always as a boob, constantly misunderstanding his place in the world and the effect he has upon it. Surely the behavioral economists don’t see themselves that way. Only rational people can police the irrationality of others according to the principles of an advanced scientific discipline. If the behavioralists were boobs too, their entire edifice would collapse from its own contradictions. Somebody’s got to be smart enough to see how silly the rest of us are.

Traditional economics has always been more modest. Assuming the rationality of man was a device that made the discipline possible. The alternative—irrational people behaving in irrational ways—would complicate the world beyond the possibility of understanding. But the modesty wasn’t just epistemological. It was also a democratic impulse, a sign of neighborly deference. A regulator who always assumed that man was other than rational was inviting himself into a position where he could exert a control over his fellow citizens that wasn’t proper for a true democrat. Self-government demands this deference. It won’t work otherwise.

“Ultimately,” the economist Brian Mannix wrote not long ago, “we insist that our regulators start from a presumption of rationality for the same reason that we insist that our criminal courts start from a presumption of innocence: not because the assumption is necessarily true, but because a government that proceeds from the opposite assumption is inevitably tyrannical.”

Long before reading Cass Sunstein as a risk-expert, I read him as a jurisprudential philosophe.  I mean, going back to his writing on “deliberative democracy,” going way back.  It seems to me that the move from traditional economics here to behavioral economics is precisely the same move in moral philosophy that he, and others of the same tendency, made in the deliberative democracy literature.  What was it, after all, that characterized “deliberative democracy” as an intellectual move, in the hands of Amy Gutmann, Sunstein, and others?  A theory of meta-deliberation, a theory of how people would ideally discuss all the deeply divisive issues of the day – abortion, affirmative action, on and on.

And yet somehow, some way, the conclusion was always that the right process of thinking must ineluctably lead one to think they way Gutmann, Sunstein, all good and  honorable liberal thinkers thought about these hot button issues.  Not just good people – but rational people -would all think affirmative action a good thing, abortion okay, etc., etc.  The most stunning intellectual move was not merely the claim that these were the right moral conclusions, but that to reach some other conclusion meant that you hadn’t deliberated enough, or deliberated in the right way.

It is the same move that Ferguson’s article describes because it presumes to know what you don’t – viz., the set of rational outcomes.  As an exercise in paternalism, it reminds me of conversations as a child with my mother – viz., it wasn’t a conversation in which we had come to reason together to conclusions that we each might reach, even to agree to disagree.  No, the conversation wasn’t over until I had come to agree with her.  That’s deliberative democracy in a nutshell – and Ferguson describes the same move recapitulated as social science, in the form of behavioral economics.

Has the distribution of simulus funds been influenced by political factors?  A study by Veronique de Rugy suggested a partisan tilt in the disbursement of stimulus funds; she found a strong correlation, but no definitive evidence of causation.  This prompted a response from Nate Silver at FiveThirtyEight.  de Rugy replied here, prompting a surreply from Silver. And here’s a comment from Nick Gillespie.

Here is de Rugy’s bottom line:

my take on the data has always been the following: The regression analysis shows that district’s party representation matters. However, I cannot say how much it matters compared to other factors (such as the formula used by different agencies). I said it loud and clear each time I presented my findings. . .

If it is not possible to nail down the precise amount that party affiliation matters, does anyone truly want to argue that there are no political factors influencing this stimulus or stimuli in the past (whether put into place by Republicans or Democrats)? There is a lot of literature in economic-history journals on similar patterns in New Deal spending, and it consistently shows that New Deal spending correlated rather strongly and negatively with the margin of votes in the previous election. Areas where Roosevelt won by a little got more New Deal bucks than ones where he won by a lot. (I was directed to one article in particular by a reader this morning, and it is worth looking into: Price V. Fishback, Shawn Kantor, and John Joseph Wallis’s “Can the New Deal’s Three Rs Be Rehabilitated?: A program-by-program, county-by-county analysis.” Explorations in Economic History 40 (2003), pp. 278-307.)

I am confident that a similar pattern can be found with President Bush’s stimuli, which, by the way, I was publicly and consistently against. . . .

my predisposition toward limited government and sound fiscal policy hardly means that I rig my data or designs. Rather, it simply means that I am particularly skeptical when anyone claims that politicians (of all parties) do not programmatically seek to advantage their allies while punishing their adversaries. That was a useful guiding assumption under George W. Bush and, under the current administration, no less so.

And Silver, who is skeptical, summarizes his view:

For me, personally, the notion that the allocation of stimulus funds could have reflected a broad-based and widespread effort to benefit districts represented by Democrats seems implausible — something which is well worth examining but something which should have received especially rigorous scrutiny. This is particularly so given that many of the funds were intermediated by state governments, not all of which are controlled by Democrats, as well as federal agencies that were constrained by formula rules.

There are two other variations that I find less impluasible:

I find it less impausible that the funds could have been directed toward those sorts of districts which tend to vote Democratic (e.g. as measured by PVI or by Obama vote share) — even after controlling for other demographic variabes — a possibility that de Rugy raises in her response but which was not the focus of her hypothesis. The difference is that that this could have resulted from a sort of unconscious bias in the design of the stimulus rather than a deliberate conspiracy.

I also find it less implausible that some *particular* projects could have been directed toward those districts that had a Democratic representative who was either especially influential or who a key swing vote in the House. (This is what we call pork.) However, de Rugy ran various tests on the types of Democratic districts that benefited from the stimulus and did not find any relationships with the characteristics of the Democratic members of Congress that tended to represent them.

One point on which they both agree is that the quality and comprehensiveness of the data on Recovery.gov is quite poor — we’re not getting our $18 million worth here.  As Silver notes:

I share de Rugy’s disappointment with the quality of the data available at recovery.gov. Frankly, I am not sure that testing her hypothesis to a peer-reviewable level of robustness is possible given the middling quality of data and the inherent ambiguity with how particular projects must be assigned to particular congressional districts.