This post is an introduction to the Academy Award winning documentary, ‘Inside Job’ for introductory Economics students

What do Wall Street investment bankers and used car salesmen have in common? Sometimes, the less their customers know about the products they’re selling, the more profits they both stand to earn. Imperfect information in markets can lead to market failure, and at its core, the failures of global financial markets during 2008 – 2009 was a result of imperfect information.

Last night, the film ‘Inside Job’ won the Academy Award for Best Documentary of 2010. The film focuses on the changes in the financial industry in between 2000 and 2007 that led to an overall increase in the level of risk undertaken by home mortgage lenders, investment banks, and ultimately the broader investment community the banking system serves.

The mis-aligned incentives motivating Wall Street banks and the asymmetry of information between the buyers and sellers of financial products, as well as the creation of new, complex derivative markets that allowed investment banks to bet against the very assets they were assembling and selling off to investors, contributed to the collapse of credit markets in 2007 and 2008 and ultimately a contraction of the level of economic activity worldwide during the “Great Recession” of 2008 and 2009.

The article below is an attempt to introduce the seemingly incomprehensible nature of global financial markets and understand what occurred in them between 2000 and 2007 in the context of an introductory Economics unit on Market Failure.

Imperfect Information as a Market Failure:

Imagine this. You’re in the market for a used car. You go to the used car dealership, speak with a salesman, and he takes you through rows of automobiles, telling you the features of each one and assuring you that each of his cars has been inspected by a third party garage for reliability. You find this re-assuring; after all you wouldn’t want to buy a car that hasn’t passed a basic inspection, since you don’t want it to break down once you’ve driven it off the lot.

After an hour or so of poking around the lot, you pick out the perfect car. A silver 2006 Audi, a great year for Audis, says the dealer. You have his word that it has been closely inspected and is in top notch shape. So you hand over $20,000 for the Audi and drive it off the lot, satisfied with your purchase.

What would you say, however, if you knew that soon after driving off the lot, the very salesman who convinced you to buy that Audi purchased an insurance policy that would pay the salesman $20,000  in the case that it broke down. Would that knowledge have made you question your purchase?

What would you say if you found out that the “third party garage” the salesman used to inspect the car actually followed orders from the dealer himself, and was 100% dependent on that dealer’s business. Therefore, the mechanic was under significant pressure to give each of the cars sent to him a high mark in its inspection. By doing so, the garage mechanic assures that the dealer is able to easily sell cars to the buyers who trust that the mechanic has given an honest appraisal of the car’s mechanical reliability. Since the dealer can sell cars given high inspection marks  for higher prices, the dealer is then able take out insurance policies that pay a greater amount when the car ultimately breaks down.

Would all of this knowledge have made you questions your purchase and the price you paid for your Audi? Chances are, if there had been perfect information in the market for used cars, you, and countless other people, would not have been willing to pay the price you paid for your Audi. Fewer used cars would have been sold, and they would have sold for lower prices. The existence of asymmetric information results in an over allocation of resources towards the market for mechanically unsound used cars.

So what does the story above have to do with the global financial crisis? Believe it or not, the fundamental cause of the near collapse of the global financial system in recent years is almost identical to our story about the used-car salesman, the corrupt garage mechanic, the dubious insurance policies and the sucker buyer, who was stuck driving a crappy car that broke down within days of driving it off the lot.

Financial Market Failure:

Between 2000 and 2007, financial innovation led to unprecedented increases in the availability of low interest loans to millions of low income American households for whom home mortgages traditionally would have been unobtainable. Banks which issued these “sub-prime” loans to households with very poor credit were able to sell them to Wall Street investment banks, which were re-packaging individual home mortgages with  thousands of similar loans from all over the United States into asset-backed securities, a form of bond that could then be sold to an investor to whom the interest payments made by the homeowners would accrue over the lifespans of the mortgages included in the bond.

Investment banks turned to the big credit rating agencies (Standard and Poors, Moody’s), who inspected the make-up of these asset backed securities, declared them investment grade and gave them AAA ratings, essentially giving a thumbs up to the institutional investors who ultimately bought these bonds from the investment banks. An AAA rating assured investors who bought the bonds that they were very safe investments, in essence that they were in “good mechanical order”, just like the Audi you drove off the lot after being told it was in good mechanical order.

The investors who ultimately bought these bonds were not small time investors like you and me, rather they were institutions, such as state pension funds, hedge funds, money market funds, sovereign wealth funds, and so on, who often times used taxpayers money to buy bonds from big investment banks on Wall Street (such as Morgan Stanley, Goldman Sachs and Bear Stearns). These investors were assured by the banks that the bonds were of the highest quality and would therefore earn the investors interest payments for years, even decades. In addition, because of the high ratings given to these bonds by the rating agencies, the investors believed they would always be able to sell the bond if they needed the money back they had originally used to buy it.

The information given to investors was not always correct, however, it turned out that many of Wall Street banks assembling and selling these bonds were also betting against them in a parallel market for derivatives known as credit default swaps.

Here’s the catch… the Wall Street banks that bought millions of low-income Americans’ mortgages (the “sub-prime” type) were just like that used car salesman. They knew the bonds of their creation were of poor quality, but just had to get the investors to believe they were in good mechanical order to “get them off the lot” into the hands of an investor.

And just like the sleazy car salesman, as soon as the banks started selling these bonds to investors, they began taking out insurance policies against them in the case that they should lose their value. An insurance policy that pays out when the value of a bond collapses is called a “credit default swap” (CDS), and the market for these  became a multi-billion dollar industry in which big Wall Street banks bought insurance on the very bonds they created and sold to institutional investors, essentially betting that their own bonds would collapse in value. Of course, none of the investors knew the banks were betting against their own bonds, because this knowledge would have surely wiped out demand for them and led to collapse in business for the Wall Street banks.

The rating agencies inspecting the asset backed securities assembled from bad mortgages were just like the corrupt garage mechanic giving all the 2006 Audis a “thumbs up” to make them easier for the car dealership to sell. By giving sub-prime mortgage backed securities “investment grade” AAA ratings, the rating agencies made it easier for investment banks to sell them to sucker investors for high prices, which in turn enabled investment banks to take out insurance policies (CDSs) against them. And since the rating agencies knew the banks wanted AAA ratings for bonds that should have been given “junk bond” status, the agencies continued to give them the highest rating, since they were dependent on the Wall Street banks for their business.

In the end, just like the 2006 Audi you drove off the lot was of poor mechanical integrity and broke down just days after you dropped $20,000 on it, most of the bonds assembled and sold on to investors by Wall Street banks were themselves of very poor quality. The underlying assets, the sub-prime mortgages themselves, were made to American households who could not possibly pay them back, Americans whose incomes were so low that the monthly payment for the home loan often exceeded the income of the borrower himself.

Ultimately, when sub-prime mortgage borrowers began defaulting on their loans, the Wall Street investment banks that had assembled them into asset backed securities and the institutional investors who bought these bonds found themselves holding trillions of dollars worth of loans that were no longer being repaid. For the banks, however, things weren’t all that bad, because just like the corrupt car salesman, they had taken out hundreds of billions of dollars in insurance on the bonds, which assured that when they finally went bad, the banks, which had passed on most of the bonds to investors, could simply collect the insurance payouts from the issuers of credit default swaps.

Who were the insurance companies stupid enough to insure crappy bonds, you ask? You may have heard of AIG (American Insurance Group). This was the insurance company insuring most of the sub-prime mortgage backed bonds. When all the bonds started to go bad AIG quickly ran out of money as it paid the investment banks out the insurance they owed. When AIG ran out of cash, the US government stepped in and gave AIG $85 billion of taxpayer money in September 0f 2008, assuring that the Wall Street banks with insurance through AIG collected 100% of their insurance money.

Show Me the Market Failure:

So what makes this a “market failure” in the economic sense of the term? Well, the existence of imperfect information in the automobile market led to an over allocation of resources towards the market for used cars. Because the buyers were being duped by the sellers and the corrupt garage mechanics, demand for used cars was too high and the price they were being sold for was too high. With more perfect information, consumers would have demanded fewer cars and they would have been sold for a lower price.

With more perfect information in the financial markets, far fewer investors would have been willing to pay the prices they did for the bonds the Wall Street banks assembled from sub-prime mortgages. Far less credit would have been made available to low income American home buyers. Far fewer sub-prime mortgage loans would have been made, and fewer Americans would have purchased homes that they could not afford in the first place.

In addition, if the institutional investors who were ultimately stuck holding these bonds had known that the investment banks selling them were simultaneously buying insurance policies against them, the investors would have been much more wary about investing in them. Also, if the investors had known that the rating agencies giving the bonds AAA, investment grade ratings were essentially following orders from the investment banks, giving the bonds the high ratings the Wall Street bosses wanted them to get, then the investors would have  been less willing to buy the bonds and less credit would have ended up in the hands of low-income American home buyers.

The market for financial services failed because too many resources were allocated towards the provision of loans to low-income American households. With more perfect information about the value of the under-lying assets included in the bonds being sold by Wall Street banks (the sub-prime mortgages), and with the knowledge that the banks themselves were betting against the bonds they assembled and sold, far fewer investors would have been willing to buy the bonds and far less credit would have been made available to American home buyers.

A market failure exists anytime the free market produces at a level of output greater or less than that which is deemed socially optimal. Given the huge surplus of unsold homes in the United States right now, and the collapse of many institutional investors’ portfolios on whose financial strength hundreds of millions of real people around the world depend for their very livelihoods, it can be safely argued that the imperfect information in the market for mortgage-backed securities (bonds) led to an over allocation of resources towards homes for low income Americans.

Discussion Questions:

1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?
2. In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?
3. Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000′s?
4. Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?
5. Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

BACKGROUND & FRAMING OF THE ISSUES
One of the most widely discussed and often misunderstood areas of the U.S. economy is the current amount of the United States’ national debt, which currently totals $14.1T. Yes, currently the U.S. Government owes a collective $14.1T to both American & foreign households & institutions. This borrowing was necessary since the U.S. government has spent in excess of its tax revenue over the years, which, in economic speak, is called “deficit spending”. In short, the U.S. government must borrow when its spending exceeds its tax revenue. Over the past 10 years especially, government spending has well exceeded tax revenue almost tripling during that period. A combination of two wars, two recessions, and two political parties that have not yet made deficit fighting an urgent priority accounts for this surge in debt over the past 10 years.

The shear magnitude of the U.S. national debt ($14.1T), coupled with alarmist comments by the U.S. Congress and the American press lead most Americans to conclude that our country is in a very precarious position and is perhaps on the verge of bankruptcy. Moreover, many Americans are aware that future Federal payouts for social security and Medicare alone, assuming no benefit changes, will rise at a much faster rate than the current tax revenues for those same social programs further increasing the national debt.

THE IMPORTANCE OF DEBT TO A COUNTRY
Contrary to what many Americans believe to be conventional wisdom, debt is actually a beneficial and recommended pursuit, if used correctly, since it enables a nation or an individual to equalize income and expenditures over time, and improve standards of living earlier than what would otherwise be attainable. It is easier to accept this premise on the personal front as millions of Americans have been able to improve their standard of living currently by pulling their future incomes forward via borrowing to purchase homes, cars, and education. Of course, we all know that debt, like a car, can cause damage if it is not used and managed wisely, and that is where many alarmists focus and even some go so far as saying that all debt is bad and should be avoided. Many nations, with Russia being a prime example, have been criticized by economists for not utilizing enough national debt to improve their economy and their citizens’ standards of living. Thus, hopefully, with a conclusion that debt is actually a “good thing”, if used for productive purposes, one can then proceed to the next section as to what are acceptable levels of national debt.

$14.1T: AN AFFORDABLE LEVEL OF NATIONAL DEBT?
The United States’ current level of national debt is still affordable and consistent with several other nations. The problem, however, is that with the continued rate of growth in the debt experienced over the last 10 years it will not be affordable forever. National accounting statistics show clearly that the U.S.’s 96% national debt/GDP percentage is, in fact, above average compared with most other modern economies, but it is certainly not the highest as economies like Japan and Italy currently have debt/GDP levels at 204% and 130%, respectively. Moreover, the level of U.S. national debt as a percentage of GDP (96%) is relatively close to where it was back in 1950 after having financed World War II. Our nation’s highest level of debt relative to GDP was 121% back in 1945. The key point is that debt must be benchmarked to our nation’s income which is GDP. I find it interesting that if I tell someone that Bill Gates owes someone $10M they quickly can figure out that he’s probably fine, but if I tell the guy at Starbucks that the U.S. owes $14.1T they think the country must be ready to go bankrupt. Big numbers really scare people, so one needs a perspective.

WHO IS THE NATIONAL DEBT OWED TO?
Much has also been made of the fact that $4.3T of the U.S. national debt, or 30%, is owed to foreigners. The fact that a good chunk of the debt is owed to foreigners is not nearly as much of a concern as the growth of the national debt in general. Foreign debt is nothing more than foreigners temporarily saving their U.S. dollars, the same dollars sent to them for their products imported into our country. Some foreigners elect to temporarily save these dollars and earn interest by lending them back to the U.S. Government by purchasing bonds. I don’t consider the fact that debt is “foreign” to be a problem, as these dollars will eventually be paid back to the foreigners with interest and these same dollars will, in turn, be spent back into our U.S. economy. Debt held by foreigners is “dollar savings” just like debt held by American citizens is “dollar savings”, so, in other words, it is really not that important whether the debt is held by foreigners or US citizens since eventually those dollars will be spent back into the U.S. economy since they can’t be spent in another economy!

SO IT MIGHT BE AN AFFORDABLE LEVEL OF U.S. NATIONAL DEBT NOW, BUT WHAT ABOUT THE FUTURE?
Many have argued that the U.S. aging population coupled with the flood of “baby boomers” moving into their retirement years will cause social security and Medicare alone to “shoot through the roof” and cause the U.S. national debt to reach unacceptable and unmanageable levels, potentially, some say, even bankrupting the U.S. Government. Many use extrapolations of future social security and Medicare payments out into varying distant futures based on the number of retiring baby boomers and increasing life spans concluding that there are trillions of unfunded government obligations ($10T, $25T, $80T, etc.) which are insurmountable. The problem with most all of these analyses are that they fail to address how simple and relatively small adjustments make these problems disappear. For example, on social security, an increase in the social security tax rate from its current rate of 12.4% (6.2% for employees matched by employer) to 15.9% is deemed by one source to fully fund social security at today’s benefit structure out into perpetuity (i.e., forever). Similar analyses are out there for other actions such as updating social security retirement ages to be more consistent with longer life spans. Now granted, few would be happy with a 28% increase in their social security taxes paid or later retirement ages, but what will likely happen will be a combination of different types of changes including reduced benefits, higher taxes, later retirement ages, and reallocations of the overall federal budget.

CONCLUSION
Today’s $14.1T U.S. national debt, although currently affordable, is rising at too fast a rate. In just 10 years, the U.S. debt level has gone from 58% of GDP in 2000 to 96% today. At current rates of spending and tax revenues, our country will exceed 100% of GDP by the end 2011.

The U.S. economy has some sizable challenges ahead in terms of keeping our increasing national debt in line with increases in our economic growth. Most notably, our demographic trends of fewer births and increased retirees with longer life spans will put additional strains on our country’s debt/income relationship.

Am I optimistic? Very much so! Our Government has shown before that we can pare our debt down. Our nation restored fiscal soundness after World War II when national debt reached an all time high of 121% of GDP and again in the 1990’s as our Government made significant changes in government spending and taxation policies to curb our debt from 67% of GDP to 58% of GDP.

What should be the goal? I say a debt level of 67% of GDP should be the goal, which is a very average and affordable level of debt. It’s OK for debt to grow as long as it does not become too high relative to the size of our economy or GDP.

The next 5 years will be very important years to establish the fiscal discipline to restore our debt to very manageable levels. If not…well….has anybody heard about Greece?

Discussion Questions:

1. How do economists gain a perspective of just how high a country’s national debt is? Can you think of any other ways to gain a perspective on how high a country’s debt levels are?
2. Respond to the comment: “Reponsible governments should balance their budget (spending = tax revenue)”
3. If Japan’s debt to GDP ratio is over twice that of the U.S. can we conclude that the U.S. has a lot of “breathing room” and can continue to carry large annual deficits out into the future?

For a preview of Jason Welker and Sean Maley’s upcoming book for the new IB Economics curriculum (beginning in fall 2011), click here:

PREVIEW

The book will be available for pre-ordering soon on the Pearson website.

The business cycle is an economic phenomenon which describes changes in the level of economic output compared to a long run average. A simple set of data illustrating the business cycle is shown below. The level of Real GDP in most countries increased by a positive rate each year from 2000 – 2008, before the Global Financial Crisis caused the most significant recession and then recovery in recent history.

In Macroeconomics we can model changes in the level of economic activity using the Aggregate Demand and Aggregate Supply model. This theoretical idea is shown on the following diagram, which explains the link between the business cycle and the level of aggregate demand and aggregate supply in the economy.

When the actual GDP line is above the potential GDP line the economy is said to have a positive output gap as at the peak point. Aggregate Demand exceeds the potential capacity thus shortages occur and prices rise (inflation) also called an inflationary gap. Factors of production such as labour, land and capital are fixed in the short run, and wages can not change. Therefore the inflationary gap will remain in the short run.

When the actual GDP line is below the potential GDP line the economy has a negative output gap as in a recession. At this point there is spare capacity, higher then average unemployment leading to less inflationary pressures in the aggregate economy.  Also called a recessionary gap. We can relate this concept back to the Real GDP data, which explains a dramatic fall in the level of economic activity in 2009.

Each of these two simple scenarios is caused by changes in Aggregate Demand. As we studies last week, changes in Aggregate Demand can be caused by a variety of factors which influence each component

Components of Aggregate Demand (AD)

C – Consumer Spending

I – Investment

G – Government Spending

(X-M) – Net Export Receipts

The two following videos highlight changes to the level of Aggregate Demand and the resulting inflationary and recessionary gaps. The first video explains how the Chinese government is boosting aggregate demand by increasing government spending and investment. It is a likely response to boost economic activity, and to reduce unemployment.

The second video is a quick look at the UK government budget. A government budget explains the countries spending and taxation decisions for the coming year. The UK was forced to reduce government spending due to the countries very high levels of public debt. The UK has been forced to borrow money to pay for current spending, which increases the nations debt to the rest of the world.

Discussion Questions and Activities:

1. Explain any changes to Aggregate Demand that would result in an inflationary gap occurring?
2. When a country is experiencing an inflationary gap, what happens to price levels and the level of unemployment?
3. Video 1: What are the impacts on level of economic activity due to the government investment? Evaluate if you think this is an effective form of investment.
4. Video 2: The UK government is planning to increase VAT tax rates and decrease spending on national defence. Explain the likely effect of the level of economic activity (Real GDP), unemployment and the price level using the AD/AS model.
5. In your notes draw an AS/AD model to explain the impacts of the events shown in each video. Be careful to fully label each diagram with any changes.

This is the kind of humor economists love, from the folks at xkcd comics:

This post is about how Switzerland has successfully employed an innovative system of incentives to encourage its citizens to reduce the amount of garbage they create. Just three weeks in this amazing country and I can already see why it earned the highest score in last year’s Environmental Performance Index.

In the AP and IB Economics units on market failure, we study the concept of negative externalities, which exist when the behavior of one individual or firm creates spillover costs to be faced by other individuals or society as a whole. A simple example is a factory that dumps waste in a river. Clearly, disposing of its waste in such a manner poses little or no cost on the factory owners, but significant costs on downstream users of the river’s water. A community that wishes to use the river for drinking water must now install expensive filtration and purifying systems just to make the water usable. The factory has kept its own costs down by externalizing the cost of filtration by passing it on to downstream users.

Spillover costs exist on micro levels as well. While it is easy to see how a large factory creates negative externalities, it is often harder to imagine how we as individuals create spillover costs for our neighbors and society in our everyday actions. The stark truth, however, is that an individual’s behavior, multiplied by millions upon millions of individuals making up a citizenry, can have as great if not greater negative impacts on the environment and society as the negligent behavior of one firm.

Here in Switzerland, the behavior of each individual citizen is subject to unusually strict scrutiny. No, Big Brother is not watching, as you may be thinking, (however, I have heard stories of snoopy neighbors alerting the police upon witnessing the most minor of infractions by a fellow citizen), rather, one finds it in his best economic interest to strictly monitor his own behavior down to the finest detail. Allow me to explain what I mean.

Let’s take garbage for example. The definition of garbage in Switzerland is very different from that in the United States. Where I’m from, garbage is anything that you can’t use anymore. You throw it “away”, put it on the curb and it disappears.

A garbage bag in the US is usually a 40 gallon (160 litre) plastic bag that could fit an entire family inside, and the typical American family probably produces two to three bags worth of “garbage” each week, which conveniently disappears in the wee hours of the morning to be taken “somewhere”, which most Americans don’t know or care to know where that is. How much does it cost an American household to dispose of this voluminous quantity of garbage? Well, the bags cost around 18 cents each, and monthly removal services vary depending on the community, but are typically a flat rate for almost any amount of garbage.

In the United States, it is very easy for individuals to pass the true cost of their garbage disposal onto society as a whole. It doesn’t matter all that much whether you put one tiny plastic bag on the curb or a half dozen 40 gallon bags on the curb, you are going to generally pay the same amount for collection regardless. The result of such a system is that the typical household has no incentive to reduce the amount of garbage that it produces. Logically, Americans are inclined to over-consume and produce copious amounts of garbage in the absence of any significant system of incentives in place to encourage waste reduction.

So, what’s different about Switzerland? It’s all about incentives. Let me explain. Here, you don’t pay a flat rate for garbage removal. In fact, you don’t HAVE to pay anything for garbage removal! Oh wow, you say, it’s FREE? In fact, quite the opposite is true. You don’t have to pay anything for garbage removal as long as you don’t create any garbage. In other words, you only pay for what you throw away.

Unlike in the US, here a typical garbage bag here is a 35 litre plastic sack, only slightly larger than a plastic grocery bag. Each village requires its citizens to buy official garbage bags for that community, and each individual bag costs anywhere from $1.50 – $2.50. A role of ten 35 litre bags can cost around $25.

When we consider that anything a household wishes to throw away must be put in an official village garbage bag which itself must be purchased for $2.25, and we know that a typical 40 gallon (160 litre) garbage bag in the US costs just $0.18, we can easily calculate and compare the costs of garbage disposal to both US and Swiss households.

• In Switzerland: 100 litres of garbage costs $6.40 to dispose of
• In the US: 100 litres of garbage costs a little over $0.11 to dispose of
• In other words, garbage removal costs Swiss households around 57 times as much per litre as it does Americans, when we consider the price of garbage bags alone.

Clearly, Swiss households are given a significant incentive NOT to create garbage. So what DO the Swiss do with lots of their waste? Recycle it, of course! See, here in Switzerland all recycling is free. The villages even offer free curb side pick-ups for all recyclable materials.

A simple system of incentives (and dis-incentives) is the secret to Switzerland’s environmental success. Other systems are in place to encourage citizens to use public transport, tread lightly while hiking in the outdoors, conserve energy and water at home, and behave in other environmentally friendly ways, but I’ll save my discussion of those items for another time, once I figure out how to reduce, re-use and recycle all my own “garbage” here in Zurich!

Discussion Questions:

1. How does Zurich’s system of garbage collection “internalize” the “externality” associated with household consumption?
2. Incentives matter. This is a basic economic concept that can be used to fix many of the environmental, social, economic and health problems faced in society. Identify one way your parents have used incentives to try to get you to do something or NOT do something they think you should or shouldn’t do.
3. Discourage what society want less of, encourage what society wants more of.  Identify and discuss one example of a market in which a government (local or national) uses incentives to discourage certain behaviors, and one example of a market in which incentives are used to encourage certain behaviors.