YouTube - Chinas empty city – 10 Nov 09.

My buddy living in Shanghai posted this video to his Facebook profile today. It demonstrates how misaligned incentives in China lead local government officials to launch massive government infrastructure projects, all with the goal of meeting the growth targets handed down from Beijing.

Building roads to nowhere and cities that stand empty certainly creates jobs and new spending by the workers employed in their construction, so in that regard at least one goal of such projects is achieved. But whether or not all growth is good growth depends on whether efficiency in the economy is increase or decreased as a result of the growth strategies used.

Hundreds of billions of dollars worth of resources in China are currently being allocated by the government in Beijing towards massive public works projects such as this sparkling new city in remote Inner Mongolia. But it seems that government plans don’t always fall in line with the wishes of the nation’s people. A wise man once said, “build it… and they will come.” Apparently in China, that’s not always true.

I happen to have traveled in Inner Mongolia a few years ago with a group of students from my school in Shanghai. It was a sad thing in my opinion to witness the rampant development of the once pristine and culturally rich Inner Mongolian steppes. Ethnic Mongolians had been put on large reservations (not unlike the Native American people 150 years ago) and turned into tourist attractions. The cities were populated almost entirely with ethnic Han Chinese, there for the purpose of building more new cities, mining raw materials, and selling them to the rest of China’s industries.

Fiscal policy (the use of government spending and taxes to stimulate or reduce the overall level of demand in an economy) is a powerful tool for achieving the macroeconomic goals of full-employment, economic growth and price level stability. When used effectively, government spending can also improve efficiency in an economy by allocating society’s scarce resources towards socially and economically valuable projects. In China, it appears, the government’s incentives are aimed more towards pleasing the higher ups and continuing to inflate the speculative  bubble in real estate that has almost certainly formed, rather than pursuing socially desirable and allocatively efficient projects that actually help the Chinese people. Damn shame!

Discussion Questions:

1. What type of fiscal policy is the government in China pursuing? Expansionary or contractionary? What is the difference?
2. Why is government spending sometimes less efficient than private sector spending?
3. What would have been an alternative policy to allocating over $220 billion of public money into infrastructure projects that may have resulted in a more efficient allocation of China’s resources than projects such as the “empty city” in the video above?

Teaching at an international school affords me the privilege of encountering and learning from truly unique and diverse individuals. Last week, my Economics classes were lucky to have as a guest speaker one very interesting and inspirational young man named Andrew Cunningham. Andrew, originally from Vermont, graduated from Duke University in 2008 and has helped co-found a development NGO in Kenya. WISER (Women’s Institute for Secondary Education and Research) serves a community of 35,000 in Kenya’s Muhuru Bay, an area where the per capita income is around $1 a day and 38% of the population is HIV positive.

Traditionally, less than 5% of young girls complete primary school in Muhuru Bay. In the town’s history, only ONE girl has ever gone to university (she would become the only Muhuru Bay native to complete her PhD and would eventually co-found WISER with Andrew). A combination of tradition, culture, and most importantly poverty had prevented improvements in the plight of woman in this poor corner of Africa. What was needed, decided Andrew and his founding partners, was an all-girls boarding school where opportunities for young women were promoted and academic achievement encouraged and fostered. WISER will open the community’s first all-girls secondary school this January and welcome 130 girls who have successfully competed primary school, an event representing a major step in the reduction of poverty in Muhuru Bay.

Beyond female education, Andrew and WISER have embarked on several other development projects in the last year and a half. In his visit to our IB Economics class last week, Andrew told the story of human development in Muhuru Bay as occurring primarily in three realms. Education, health, and entrepreneurship. Andrew is an amazing, dynamic, inspirational speaker, and his lectures in my class cannot be done justice in a blog post; but the lessons learned during his visit are worth recording here for others to learn from and to document for future use in my own classes. I will briefly summarize the three main development strategies Andrew and WISER have employed in Muhuru Bay, starting with education.

Education as a development strategy:

It should come as no surprise to this blog’s readers that education is a primary and fundamental strategy for eradicating poverty. A nation’s human capital is its most vital resource, and the road to prosperity requires an effective education system that does not discriminate based on race, gender, or socioeconomic status. In Muhuru Bay, which is 14 hours by car across un-paved roads from the Kenya’s capitol, the education system had failed to achieve meaningful results, both for boys and girls. Student performance on national examinations across the primary grade levels had historically averaged around 11% passing rates. Boys out-performed girls, but as a whole only about one in ten Muhuru Bay children passed the examination required for admittance to secondary school in Kenya.

Andrew and WISER needed to improve this dismal statistic. If they were going to build a secondary school for girls, they would need to first get girls to pass the national exam for entrance to secondary school, or else their new building would be full of empty desks. Andrew first talked to my class about the traditional development community (think World Bank, UNICEF, USAID) approach to promoting education in Africa. You are probably thinking the way to help these kids is to give them resources to improve their education. Build better schools, give them textbooks and school supplies, maybe uniforms, build a library, electricity in the classroom, chalk boards, heck, how about we give them laptop computers! All of these ideas represent the traditional development community’s approach to improving education in poor countries. The problem, according to Andy, is that these strategies focus only on the inputs into education, and completely fail to look at the output.

Inputs and outputs are common topics of discussion in any Economics class. To produce anything, three resources are required: land, labor, and capital. The traditional approach to improving education in Africa focused primarily on the land and capital. Things such as pens, notebooks, laptops, and new libraries are great, but they have little actual impact on what gets learned in a school. The neglected factor was the labor (i.e. the teachers!) In Muhuru Bay, teachers were paid so miserably and worked in such dismal conditions that the incentive to actually improve their students’ results was just too weak! With passing rates at 11% on national exams, Andrew and his team set about figuring out how to use incentives to improve the outputs of education in Muhuru Bay.

A simple and relatively low-cost plan was put into action. Teachers were told that if their students’ scores increased by only 15% on the exams, they would receive a 100% increase in their salary. Andrew and WISER worked with the national education ministry to develop interim exams that could be given quarterly to help the teachers measure their students’ improvement before the annual national examination. Wouldn’t you know it, with only minimal investments on the land and capital resources (i.e. textbooks and classroom materials) in Muhuru Bay schools, and by spending less than $10,000 on teacher raises, the passing rate among Muhuru Bay schools increased this year to 36% from last year’s 11%. Hundreds of students, boys and girls, who would not have been able to enter secondary school the previous year, instead passed the exam and were eligible for a secondary education, a crucial step towards a better future!

The teachers’ incentive pay program was such a success in Muhuru Bay last year that the state government has taken notice and intends to implement it in other rural communities throughout Kenya. By focusing on the outputs (student learning), rather than the inputs (classroom resources) Andrew and WISER have assured that when their all-girls school opens in January, its seats will be filled with qualified students who successfully completed their primary education.

Health as a development strategy:

The second topic of Andrew’s discussion with my IB Economics classes focused on health and sanitation, specifically solving the problem of open defecation (“OD” is a technical term used in the development community referring to the fact that in many poor communities basic latrines are non-existent, and therefore people shit in the open). OD in Muhuru Bay contributed to the poor health and low life expectancy of locals; According to Andrew an estimated 60 people have died this year of cholera, a disease spread via human waste.

In the health realm of development, the same basic dilemma between focusing on the inputs or the outputs had stymied previous attempts to reduce OD in Muhuru Bay. Recently, an outside aid organization had made loans to the community to build 30 public latrines. Within a year, however, the latrines had fallen into disrepair and were essentially useless. When Andrew and his team asked the community members why they had let the latrines fall into such a poor state, their answer was predictable. These were not their latrines, they belonged to the aid organization that had built the latrines… If they were broken, the aid organization could fix them! Such logic reflects a common problem in economics, that of the tragedy of the commons. Because the latrines were public, no one owned them. Because no one owned them, no one cared for them. When the latrines fell out of repair, people quickly reverted back to OD, and instances of cholera and other diseases increased once more.

Andy and WISER decided to tackle this problem using a similar approach as the one used to fix primary education in Muhuru Bay, by focusing on the output, rather than the inputs. In this case, the goal was simple: create incentives for people to build their OWN latrines, which they would then have an incentive to take care of and use. The strategy for promoting personal latrines they decided to employ is one that has been successfully implemented throughout the developing world, and is now funded by UNICEF, which trains facilitators to go into a community and in a very short time, and at a very low cost, incentivize the locals to take sanitation into their own hands and build their own latrines.

Community Led Total Sanitation (CLTS) is a mind-blowing and shockingly blunt way to promote sanitation. Rather than spending thousands of dollars to build public latrines, the CLTS approach brings community members together for an afternoon of discussion and education about sanitation issues. Locals are asked to take an index card and go to “where they shit” and collect a sample of their own waste. A large pile of shit is placed on a table in front of a room full of locals right next to a large selection of delicious foods. The facilitator then goes about discussing basic facts related to shit in the community, such as “If you added up all the shit your community produces in a year, how many donkeys would it weigh as much as?” or, “How many bags of rice would you have to eat to create this much shit?” In the mean time, of course, hundreds of flies have descended on the pile of shit in the front of the room, and the community members look on in utter disgust as the flies jump from the feces to the food and back again.

At the end of the lecture, the facilitator turns to the food and says, “Well, it’s time for lunch, who’s hungry?” In utter disgust, the locals ask the facilitator if he has gone mad. The lesson, of course, is that the food and water the community consumes is most likely being contaminated by the shit they produce and deposit in the open around their village. Within a few weeks of the CLTS project in Muhuru Bay, 256 new latrines were built by the community members themselves. Whereas previously, only around 15% of the locals used latrines regularly, after the CLTS project around 75% had access to the “facilities”.

The total cost of the CLTS sanitation project? Around $55, a tiny fraction of the cost of building the public latrines that had previously been neglected by the community. By focusing on the outputs rather than the inputs, real development in the health of the community was achieved at a very low financial cost.

Entrepreneurship and micro-lending as a development strategy:

The final approach to human development in Muhuru Bay Andrew discussed with my classes focused on the economic empowerment of community entrepreneurs. Micro-lending is a much talked about and widely used development strategy that provides financial credit or technology loans to entrepreneurs in poor communities to create small businesses, ideally ones with a socially beneficial purpose. In Muhuru Bay, the micro-lending scheme Andrew has pioneered involved not financial capital, but physical capital (i.e. technology).

Andrew was able to secure several technology donations, including a copy machine, several laptop computers with cellular internet connections, a foot pump for water, and a digital LCD projector. WISER then solicited loan requests from several “young entrepreneurs”. Young men and women wrote business plans outlining how they would use the technology loans to generate income for themselves and the community, and provide services that would benefit others in the Muhuru Bay community. The technology would not be donated to the recipients; rather they would be required to pay back the value of the capital through their business revenues.

It is simply amazing how a few pieces of second-hand technology, items that we in the rich North would take for granted as relatively common and thus of very little social or economic value, can completely change a poor community in Africa for the better. Here’s how some of the capital Andrew and WISER loaned to young entrepreneurs were put to use to achieve meaningful development in Muhuru Bay:

• The copy machine was installed and powered by a generator. It was the first such machine ever installed in Muhuru Bay. Local businesses, students, job seekers and other could now, for a few cents, photo-copy their documents locally, avoiding the two hour drive previously required for such a service.
• The laptops were installed in an internet café and made available to local students and businesses. Farmers and fisherman could check product prices in the cities hours away, increasing efficiency and bargaining positions when middle men came to town to buy their produce. Job openings in the city newspapers’ classifieds could be printed and posted for the local community to see, improving information symmetry between the poor countryside and the cities where job opportunities existed. The cost of access to these services was cheap, yet the entrepreneurs who were granted the laptop loan were able to pay back the cost of the technology in no time at all, and the community as a whole benefited from their existence.
• My favorite entrepreneurial venture involved the LCD projector. This piece of technology, which now hangs from the ceiling of thousands of classrooms around the rich world, had never before been seen in Muhuru Bay. You may think it ended up in a classroom or in an office building, but no; the entrepreneurs who received the projector hooked it up to a satellite dish which captured and projected English Premier League football matches onto the wall of a large room in a local building. The business was to sell tickets to local football fans who were more than happy to pay and watch English football matches in full color on a wall-sized screen. Before the projector, dozens would have huddled around a tiny, ancient television with poor reception to watch football matches. The “football theater” business was the most successful of all, and paid back its loan fastest.

All three of these entrepreneurial endeavors were very low cost, using donated technologies. The reason for their successes, however, must be attributed to the model for implementation. They were not simply “given” to the community. Such a strategy would certainly have led to the same “tragedy of the commons” experienced when the outside aid organization funded the construction of public latrines. The capital would have been neglected and fallen into disrepair. By lending the technology to businesses, however, the incentive for innovative and socially beneficial ventures was created, and a business model was developed to best utilize the resources in a profit-earning, sustainable manner. With very little inputs, fantastic outputs were achieved, enriching not only the entrepreneurs, but the entire Muhuru Bay community.

Economic Development the WISER Way:

Andrew’s visit to Zurich International School was eye-opening in many ways. He brought to light both the successes of WISER and other community projects in rural Kenya, but also shined a light on the failures of the traditional development community’s agenda. When I think about the hundreds of billions of dollars that have been committed to economic development in Africa over the past decades, and on into future decades, I wonder whether the diplomats and the politicians in the “aid community” have any idea how much has been accomplished on the ground in places like Muhuru Bay thanks to community service leaders like Andy Cunningham.

With so little, so much can be accomplished. The poor of Africa and the world need resources, but more importantly they need education, health and sanitation, and business opportunities so that they can enjoy the benefits of development from the bottom up. Development aid, as it has traditionally been distributed, comes from the top down, through national governments. Waste and corruption are rampant, and typically only a fraction of what has been given ends up on the ground in places like Muhuru Bay. Even when it does, the tragedy of the commons often results in inefficiency and waste, as the “inputs” are managed and distributed from the top down, leading to uncertainty of ownership and misaligned incentives once the resources are on the ground. Perhaps aid from the outside is still needed, but Andy’s visit showed me and my students that something much more basic lies at the core of successful economic development. Education focusing on outputs rather than inputs, sanitation focusing on outputs rather than inputs, and entrepreneurship that empowers business leadership, have improved the lives of thousands in one Kenyan community. What could such a re-thinking of development strategies do for the rest of Africa and the developing world?

FT.com / Comment / Opinion – Magic and the myth of the rational market.

Imagine you’re a poor farmer who has always had just enough to feed your family, with no surplus left over to sell. Then one day the government decides to grant your family and your neighbors enough land to grow your own food and plenty more to sell on the market. The government’s intention, of course, is for you to cultivate all your land, sell your surplus, generate income for your family to improve your quality of life, send your children to school and save for the future.

You’re the farmer. You’ve just been given land. What would you do?

1. Plant crops on all your land, harvest the crops, sell the surplus and enjoy the profits from your surplus?

OR

2. Plant crops on only part of your land, grow enough food to feed your family, and let the rest of the land lie uncultivated. You have no surplus, nothing to sell, and continue to live the way you always have lived: poorly.

The science of economics assumes that individuals always act rationally in their own self-interest. Self-interest is the ultimate motive of economic actors: firms are profit-maximizers, individuals are utility-maximizers. The theory of rational behavior would lead one to assume that the farmer would pursue option 1 above. But in Papua New Guinea, where the government recently relocated thousands of displaced farmers to new plots of land, it is more common for farmers to chose option 2:

“If they see me planting too much cocoa, they’ll do things to my land and my family, and they won’t bear fruit; really bad things; puripuri and other witchcraft.”

Such an avoidance of profit maximisation might have appeared economically irrational. But from the perspective of those villagers, putting in extra work just to make oneself a target for the jealousy of one’s neighbours would be highly irrational behaviour.

Economists need to re-think their assumptions on rational behavior. What appears irrational to one person may be perfectly rational to someone else, as in the case of the Papuan farmers who only plant half their land. Humans, it seems, are a bit more complicated than the cold, calculating arithmeticians economists have long assumed them to be.

In the wake of the largest economic crisis since the great depression, the assumption of rational actors interacting in rational markets has come into question. A new field of economics blending the traditional study of resource allocation in the market place and human psychology has arisen to tackle the challenge of better understaning the seemingly irrational behaviors of investors, buyers and sellers in today’s global economy:

One response to the current crisis has been a rise in the popularity of behavioural economics, which examines the psychological and emotional factors behind transactions. These models drop the assumption of the rational actor yet implicitly keep the same model of economic rationality at their heart. We may diverge from the path of rationality for all sorts of psychological reasons but only because emotion, Keynes’s famous “animal spirits”, clouds our judgment.

To break human behavior down to the basic pursuit of profits by producers and utility by consumers neglects to acknowledge the “animal spirits” within us all. Economics is entering a new era, in which psychology and markets are intertwined. Rational behavior will remain a basic assumption of the science, but a re-defining of what it means to be rational will allow economists to better understand the behaviors of individuals, investors and firms as the economy emerges from a slump Alan Greenspan might say was ushered in on a wave of irrational exuberance.

Discussion Questions:

1. Are economists wrong to assume that individuals always act rationally? Why do the Papuan farmers only use half their land? Are they stupid or lazy?
2. Can you think of any examples in which you or someone you know has done something that was not in his best economic self interest?
3. Is charity irrational? What about gift giving? If you calculated that the chance of getting caught steeling something you REALLY wanted was 0%, wouldn’t it be irrational NOT to steal? What would keep you from stealing that thing if you deemed it rational to do so?

Homo Economicus, the “Economic Man” is the concept underlying most economic theories. It holds that all humans are purely self-interested, rational actors who have the ability to make judgments that fulfill their subjectively defined ends. In modern economic theory, the end man seeks is generally accepted to be increasing monetary well-being and material wealth.

Philosophical foundations of “homo economicus“:

Aristotle (350 BC):

Again, how immeasurably greater is the pleasure, when a man feels a thing to be his own; for surely the love of self is a feeling implanted by nature and not given in vain, although selfishness is rightly censured; this, however, is not the mere love of self, but the love of self in excess, like the miser’s love of money; for all, or almost all, men love money and other such objects in a measure. And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. These advantages are lost by excessive unification of the state.

• What does Aristotle think about the interference of government in the private property rights of man?
  

Adam Smith (1776):

In almost every other race of animals, each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer: and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.

• How does Smith believe the pursuit of individual self-interest can lead to benefits for society as a whole?

John Stuart Mill (1836)

What is now commonly understood by the term “economics” is not the science of speculative politics, but a branch of that science. It does not treat of the whole of man’s nature as modified by the social state, nor of the whole conduct of man in society. It is concerned with him solely as a being who desires to possess wealth, and who is capable of judging of the comparative efficacy of means for obtaining that end. It predicts only such of the phenomena of the social state as take place in consequence of the pursuit of wealth. It makes entire abstraction of every other human passion or motive; except those which may be regarded as perpetually antagonizing principles to the desire of wealth, namely, aversion to labor, and desire of the present enjoyment of costly indulgences. These it takes, to a certain extent, into its calculations, because these do not merely, like our other desires, occasionally conflict with the pursuit of wealth, but accompany it always as a drag, or impediment, and are therefore inseparably mixed up in the consideration of it.

• According to Mill, labor is not something humans value for its own sake, but only because it allows us to do what?

Fredrick von Hayek (1930s):

We will benefit our fellow man most if we are guided solely by the striving for gain. For this purpose we have to return to an automatic system which brings this about, a self-directing automatic system which alone can restore liberty and prosperity.

• How would Hayek respond to those who argue that the government’s role in society and the economy is to promote fairness and equality?

Are you a “homo economicus“? - The Golden Balls Game

The prize: $1 million

How to play:

• Find an opponent from among your classmates.
• You and your opponent have never met before today, never spoken to one another, and will never see nor speak to one another again after the game ends.
• Since you do not know or care about your opponent, you must play this game with your own self-interest in mind, and assume that your opponent will play it with his or her self-interest in mind.
• You have in front of you two folded pieces of paper. One says “SPLIT” and one says “STEAL”
• You must decide which piece of paper to select, based on the following possible outcomes

The payoffs:

• If both players decide to “split”, each player will take home $500,000.
• If one player chooses to “split” and the other chooses to “steal” then the one who chooses to steel will take home $1 million, and the one who chose to split will get nothing
• If both players choose to “steel”, both players go home empty handed.

Let’s play!

• You only have one chance to play this game. Remember, you care only about yourself and should do what is best for you.
  
• On the teacher’s command, reveal your decision to your opponent.
  
• Take note of your payoff and report it to the teacher
  

Discussion:

• What was the outcome of your game?
  
• Was the outcome rational? Was it predictable?
  
• Did the outcome reflect the concept of “homo economicus“? Were you and your opponents’ decisions purely self-interested and coldly rational, intended to maximize your OWN payoff?
  
• Are you a homo economicus? What would homo economicus have done? Why?
  

Videos:

Golden Balls – the real gameshow: http://www.youtube.com/watch?v=p3Uos2fzIJ0&feature=player_embedded

• Which player was more like homo economicus? Sarah or Steve?
• Which player acts rationally? What makes it rational?
• Which player acts irrationally? What makes it irrational?

“The Trap”: Intro to game theory and rational self-interest in politics and economics: http://www.youtube.com/watch?v=qzNcY-gZdiA&feature=related

• John Nash’s Game Theory proved that “a system driven by selfishness did not have to lead to chaos”, that “there could always be a point of equilibrium in which everyone’s self-interest is perfectly balanced against each other”? How does such a theory support the concept of homo economicus?
• What is the Prisoner’s Dilemma? “The rational choice is always to betray the other person.” What does this say about humans in society? Is government regulation needed to prevent constant betrayal by greedy, self-interested individuals? Or are constant betrayal and self-interest themselves capable of achieving a socially optimal outcome?

Noam Chomsky on the inefficiency of markets and the threat posed by de-regulation: http://www.youtube.com/watch?v=QPl27BO7fHE&feature=related

• What is the “externality” of financial market failure that Chomsky identifies?
• Why is the failure of a financial market more worrisome than the failure of a market like that for used automobiles?
• How does Chomsky feel about the de-regulation of financial markets? Does he think markets are always rational and efficient?

Modern applications of the concept of Homo Economicus:

• Rational Expectations Theory (RET): This economic theory assumes that humans acting generally in their own self-interest will make rational decision based on the best available information. Therefore, it assumes that people (and therefore, markets, which are made up of rational people) do not make systematic errors when predicting the future.
• Efficient Markets Hypothesis (EMH): Rooted in Rational Expectations Theory, which itself is rooted in the concept of homo economicus, EMH says that prices in markets, particularly financial markets (whose collapse has caused the today’s global economic crisis) represent the best possible estimates of the risks attached to the ownership of various financial assets (stocks, shares, bonds, etc…) Asset bubbles are therefore impossible, since “bubble” implies an irrational and unsustainable increase in the value of an asset which will ultimately “burst”. Markets are “self-correcting”, and the most effective tool for assuring economic stability is free markets, rather than government regulation or oversight.
  

Connecting the dots – from Homo Economicus to today’s Economic downturn:

The general acceptance of theories rooted in the concept of homo economicus led to the de-regulation of financial markets, which allowed money and resources to go whichever way the “market” (rational or not) determined.

• During the last decade, the market decided that more and more money and resources should go towards particular assets, specifically the United States mortgage market (the market for new homes in the US).
• As money flooded the US home mortgage market, it became cheaper and easier for Americans to get loans to build a home. GREAT, RIGHT?! Well, only until it came time to pay back those loans.
• Trillions of dollars worldwide became tangled up in the US mortgage market, representing households’ savings from around the globe.
• When Americans suddenly found their loans coming due, they found it hard to repay them due to adjustable interest rates and falling home price (supply had grown more rapidly than demand).
• American and many Europeans began defaulting on their mortgages, meaning all that money that had been lent to home buyers literally disappeared.
• Banks and financial markets faced a “liquidity crisis”, meaning they had no money.
• Lending stopped to households, firms, and other banks , meaning spending on goods and services decreased, meaning jobs were lost and economies entered recession.
• How could any of this have happened if the concept homo economicus and the economic theories based on the concept are correct? Are humans always rational, calculating, perfectly informed, self-interested beings acting purely in their own self-interest?

Conclusion: The concept of homo economicus has formed the basis for economic theories for centuries and for major macroeconomic policies over the last 30 years. Policies of “market liberalization” (freeing the market from the guiding, regulatory hands of government) have led to great prosperity, but even greater risk and volatility as irrational exuberance over asset prices has led to inefficient market outcomes, bubbles, and financial shocks plunging the “real” economies of the world into recession.

Perhaps a more complete understanding of humans is needed as the human science of economics enters a new era. The human as a cold, rational, calculating creature interested in only his own gain is an over-simplification, and forming theories and policies on such an assumption is dangerous. The future of economics must incorporate a more complete and complex understanding of human behavior if the economic crises of the last two years are to be avoided down the road.

This article was originally published on June 9, 2008

Asia Sentinel – Malaysia cuts fuel subsidy

One of the recurring themes of this blog is the conflict between good politics and good economics. Most of the time in government, smart economic policy is sacrificed in order to achieve political favor with voters. Whether it’s price ceilings on petrol in China, Zimbabwe’s slashing of food prices, harmful import restrictions to benefit domestic producers, or the proposed suspension of gas taxes in a time when fuel conservation is really what’s needed, politicians often act in economically stupid ways to bolster or hang on to their popularity.

So when a government makes a bold move that is economically sound, it sometimes comes as a surprise, as in the case of the Malaysian government this week. The government in Kuala Lumpur has for years subsidized domestic fuel prices, which at under 2 Malaysian Ringit per liter have been the equivelant of roughly $2.40 US per gallon, far below the average price in the west. Drivers benefited from this subsidy, but were not forced to bear any of the burden of rising oil prices, nor had they any incentive to conserve or switch to more fuel efficient automobiles or alternative forms of transportation. The Malaysian government, on the other hand, has had to allocate more and more of its limited budget towards subsidizing petrol prices.

Well, as of yesterday, all price supports for petrol are cancelled, and the effect will be sweeping in the Malaysian economy:

The government announced Wednesday evening that petrol prices would rise by 78 sen (US24¢) at midnight — a 41 percent jump from RM1.92 per liter to RM2.70. That means those spending RM2,000 per month to fill the tanks of their BMWs will now be paying RM2,820. Regardless of income levels, it is likely most Malaysians will feel the pinch.

The subsidy would have cost the Malaysian government 56 billion ringit (around $17 billion) this year. With the money it will now save by ending the subsidy, the government will begin making public transport cheaper and more convenient for commuters who wish to avoid paying for the more expensive petrol to fuel their personal automobiles:

The government hopes to channel the savings into improving public transportation, as it promised many years and elections ago but with little to show. In Kuala Lumpur, despite having a light rail train service and monorail, public transportation is expensive and inconvenient. Worse, intercity travel is still being serviced by old and slow trains, and accident-prone buses.

Malaysia is not the only country taking measures to end government fuel-price supports:

Indonesia has hiked fuel prices by an average of 29 percent, saving about 34.5 trillion rupiah and kicking off a series of street demonstrations… Similarly, after slashing subsidies, Taiwan will distribute US$659 million to middle and low-income families. The latest to raise oil prices is India, whose government announced Wednesday that gasoline and diesel prices will increase by 10 percent.

From today’s New York Times:

Just How Progressive Is the Tax System? – Economix Blog – NYTimes.com

Not as much as you might think. So says Citizens for Tax Justice, which today released an updated analysis of the effective tax rates for Americans at different income levels.

Data released last week by the Congressional Budget Office underscored the progressive nature of the federal tax system. And in an op-ed article today in The Wall Street Journal, Ari Fleischer, who served as President George W. Bush’s press secretary, used that data — in particular, the income tax numbers — to argue that the wealthiest Americans bear an unfair share of the tax burden. Other research has found that many states and local governments have more regressive tax systems, though, that might offset the progressiveness of federal tax rates.

The research from Citizens for Tax Justice — a liberal organization that advocates “fair taxes for middle and low-income families” — uses 2008 data for all federal, state and local taxes combined. It found that the average effective tax rate is 29.8 percent, and that including state and local taxes makes the tax curve look much less steep:

Horizontal axis shows the income group. Vertical axis shows the percentage of income that the average member of that group pays in taxes. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The group also finds that in 2008 the share of total federal, state and local taxes paid by each income group was relatively close to the share of income that that group brings in, at least as compared to comparable 2006 numbers for effective federal tax rates:

Horizontal axis shows the income group. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

Discussion questions:

1. Based on the data above, do the rich in America pay an unfair proportion of the total taxes the US government collects? Why or why not?
2. Why do the richest 5% in America actually pay a lower level of tax on average than the 5% below them?
3. How much of America’s total income is earned by the richest 1% compared to the poorest 20%? Does America’s progressive tax system destroy the incentive for Americans to work hard and become rich? Why or why not?
4. Does the gap between the richest and the poorest Americans surprise you? Do you think that America’s tax system is effective at re-distributing the nation’s income? How does it succeed? How could it do better?

The $165 M in AIG bonuses that we have heard so much about this past week should have, in my opinion, been paid and then defended by Congress and the President!

As a former CFO, I can say with certainty that I have never paid an employee a bonus for poor performance. To underscore this point, I am 100% against any publicly-traded company ever making any bonus payment to an employee for poor performance regardless of the circumstances. The recently paid AIG bonuses are not an exception to my strong conviction. The true facts surrounding the $165 M in AIG bonus payments have not been made clear to the American public. Moreover, our cowardly American leadership (President, Treasury Secretary, Congress, AIG CEO) refuse to do what is right and defend the bonuses because, in my opinion, of their fear of public opinion.

The $165M in recently paid AIG bonuses, funded with a portion of approximately $170B in taxpayer “bailout” funding, are not PERFORMANCE bonuses being paid to the same AIG executives that got us into this financial mess in the first place. That is what most of America mistakenly believes. In fact, the senior executives, including the CEO, whose decisions caused the company’s collapse, are long gone. Moreover, the top 7 officials currently at AIG have agreed to forego all bonuses. The recent bonus payment outrage also excludes the next 43 highest ranking AIG leaders whose bonus payments are appropriately being linked to restructuring the company and paying back the taxpayers the $170B that has been already sent to bail them out.

So what exactly are these bonus payments for that all of America has gone mad over? The $165 Million in recent bonuses paid to AIG employees were RETENTION or STAY bonuses and not performance bonuses. AIG employees assigned to unravel the mess were offered retention bonuses to stay and work out the problems of AIG’s Financial Products division which has already been announced to be shut down. These retention bonuses were paid to incent remaining and new workers to stay until the billions of dollars of derivatives, still at risk, were unwound. Using basic common sense, which is why retention bonuses have been paid for decades, no reasonable, talented worker would agree to work in a discontinued division receiving hate mail and death threats without receiving a retention bonus. A retention bonus helps keeps top employees working on problems of a division being shut down rather than them resigning and moving on to another company.

As Congress tries to recover these just recently paid bonuses, either through the AIG employees paying them back or having them be taxed close to 100%, the tax payer is already losing as these employees working out the problems that they did not create are already starting to resign. Yes, America and the taxpayer will not save $165 M but rather lose far more than we save as those working the issues are resigning.

So, why didn’t the new AIG CEO, Edward Liddy, defend the $165 M in retention bonuses in front of Congress this past week and explain to Congress that these were not performance bonuses paid to the people that got us into this mess? Why didn’t Tim Gheitner, U.S. Treasury Secretary, defend his decision to allow the retention bonus payments as outlined in the recently passed stimulus bill? Why didn’t Ben Bernanke, Chairman of the FED, defend the retention bonuses that were know by him since last summer? And of course, where was our Harvard-schooled president when we needed his articulation skills the most as he could have clearly explained and defended these payments so we would not have to rehire new employees for all of the AIG employees who are now turning in their resignations for having to repay their contractual retention bonuses?

In summary, our U.S. government has increased the exposure to the American taxpayers by not supporting the AIG retention bonuses being paid to the workers that did not create the problem and who are assigned to fix up the mess. This is cowardly leadership, in my opinion. It is an easy path to for our leaders to keep the AIG bonus discussion at a very surface level and say “bonuses shouldn’t be paid to business leaders that fail”. Well, of course, everyone agrees with that! But that is not what is being paid at AIG.

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 all 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!

Inside Obama’s Green Budget – Forbes.com

Some say that Global Warming may be the greatest market failure of all. This podcast was originally broadcast in January of 2007 while George Bush was still in office. The commentator claims that global warming is “nothing but one giant market failure”, arguing that the United States therefore must get serious about tackling the problem.

 Global Warming - one giant market failure [1:28m]: Play Now | Play in Popup | Download

The allocation of resources towards carbon emitting industries has almost undoubtedly contributed to the warming of the planet over the last half century. Only recently have governments begun taking active measures to reduce the impact of industry on the environment through greater regulation of polluting industries, employing corrective taxes in some instances and market-based approaches to pollution reduction in others.

US President Barack Obama, unlike his predecessor, appears to be serious about correcting the “market failure” represented by global warming:

Obama’s budget, announced Thursday, looks to fund a host of new energy programs, from carbon sequestration to electric transmission upgrades. It would also provide the EPA with a $10.5 billion budget for 2010, a 34% increase over the likely 2009 budget. Nineteen million dollars of that would be used to upgrade greenhouse gas reporting measures.

The Interior Department would get $12 billion for 2010. The agency would use part of the money to asses the availability of alternative energy resources throughout the country.

Funding comes from elaborate carbon “cap and trade” program, which puts a price on emitting pollution and is the core of Obama’s plans. Starting in 2012, the government would sell permits giving businesses the right to emit pollution, generating $646 billion in revenue through 2019.

During those years, the number of available permits would gradually decline, forcing businesses to buy the increasingly scarce, and costly, rights to pollute on an open market. Obama hopes that the rising cost of permits will encourage businesses to invest in clean technologies as a cheaper alternative to meeting pollution mandates, helping to cut greenhouse gas production to 14% below 2005 levels by 2020.

Below is a diagram that illustrates precisely how the Obama cap and trade plan is meant to work. Notice that between 2012 and 2020 the cost to firms of emitting pollution will increase dramatically, while at the same time the total amount of carbon emissions in the US economy will fall due to regular reductions in the number of permits issued to industry.

The Obama cap and trade scheme is not the first experiment with such a market based approach to externality reduction:

Europe established such a market in 2005. But some E.U. governments allocated too many credits at the outset, causing the value of some permits to fall by half and making it relatively easy for large polluters to simply buy credits rather than cut emissions. Overall emissions grew in 2005 and 2006. In 2008, E.U. emissions dropped 3%; 40% of that drop was attributed to the carbon trading scheme.

Europe’s cap and trade program took a few years before it began having any noticeable impact on the emission of carbon by European industry. While unpopular among the firms who are forced to pay to pollute, the fall in emissions in Europe shows that a market for carbon may be effective in forcing firms “internalize” the costs of carbon emissions, which until now have been born by society and the environment in the form of the negative effects of global warming.

Discussion Questions:

1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
3. Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

FT.com | The Economists’ Forum | Will Americans demand the cars that Congress wants the big three to build?

It’s been driving me nuts, this whole bailout debate. My frustrations are definitely appartent to my students, who have had to put up with my occasional rants about the insanity of the whole affair since the issue came to the media forefront over a month ago. Here are some of the issues that just don’t add up from the perspective of a high school economics teacher:

The three companies asking for a bridge-loan supposedly want the money so that hundreds of thousands (some reports say as many as 2.6 million) jobs can be saved. But how could Ford, Chrystler and GM possibly maintain their labor force in a time of a recession when nobody is buying new cars in the first place? In the parlance of AP or IB Economics, automobiles are normal goods, ones for which demand falls as incomes fall. By definition, a recession in the United States means falling incomes. A government loan may allow the Big Three to keep making cars for the time being, but WHY WOULD THEY KEEP MAKING CARS when falling incomes point to falling demand in the immediate future? Making cars that nobody will buy represents a gross misallocation of the nation’s productive resources, not to mention taxpayers’ money. What is required of these industries is precisely what the government loan will prevent them from doing, DOWNSIZING, meaning the shrinking of their labor force as well as the number of plants in operation.

The US recession can not be avoided by allocating the nation’s scarce resources towards a bailout of the auto industry. In fact, it will be worsened because the capacity of any nation to emerge from a cyclical downturn requires the flexibility of the country’s labor force to adapt to the structural changes the country is experiencing in the era of globalization and free trade. America’s future does not reside in labor-intensive manufactured goods, especially in the production of a very expensive durable good for which demand falls drastically during recessions; specifically, automobiles.

The Finanacial Times Economists Forum approaches the issue of long-term falling demand for automobiles from another perspective. One of the conditions of the Big Three accepting a loan from the federal government is the mandate that Detroit will begin producing more fuel efficient automobiles to assure Americans more affordable, more environmentally friendly alternatives to the gas-guzzling SUVs that have dominated the industry for the last two decades. But here’s the problem, gasoline has fallen to a price as low as it was when SUVs were at their peak popularity back in the early 2000s! As any high school economics student knows, gasoline and SUVs are what we call complementary goods, or two goods for which demand and price are inversely related. As gas prices fall to their 2000 levels, demand for SUVs promises to rise once again, while demand for fuel-efficient automobiles will likely decline, creating market pressures for the Big Three to make not more fuel-efficient cars, but more SUVs instead! From the Financial Times:

The basic problem is that Americans like to drive sport-utility vehicles, minivans and small trucks when gasoline costs $1.50 a gallon…

Consumers may have regretted their behaviour when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways.

Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked.

The only reasonable solution to this dilemma? If Congress DOES begin mandating that Detroit increase its production of fuel-efficient cars and phase out its manufacture of SUVs, any such requirement should be accompanied by a government-set price floor on gasoline. Several months ago, my colleague and fellow blogger Steve Latter blogged about a proposed price floor of $4 per gallon on gasoline. Such a scheme would likely prove nearly impossible to initiate politcally, but may be exactly what’s necessary to add legitimacy to any government requiremens of Detroit to manufacture fuel efficient automobiles. The FT appears to support such a scheme:

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.

Discussion Questions:

1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?
2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?
3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

This week the CEOs of the “Big Three” US auto makers boarded their private jets in Detroit and touched down in Washington to beg and plead in front of Congress for a “low-interest bridge loan” from the US government to help them avoid bankruptcy. They are asking Congress for $25 billion of taxpayer money to give them the chance to re-structure and re-equip themselves for the future.

Below are eight arguments based on basic economic principles for why a bailout of the United States automobile industry is a bad idea and is bound to fail:

1. Incentives matter: A bailout of the US auto industry ignores the basic economic principle that incentives matter. Individuals and firms respond to incentives, pursuing behavior that is likely to bring them the greatest rewards. In the face of falling demand for their product and ever-increasing competition from more efficient foreign producers, providing a $25 billion bailout creates a disincentive to drastically reduce costs and increase competitiveness, and an incentive to continue using tired old techniques and providing the same old models for which demand has declined among Americans for over a decade.
2. Comparative advantage: The basic economic principle of comparative advantage states that in an era of free trade and globalization, countries should produce the types of goods for which they have the lowest opportunity cost. Since the average American car of a particular class costs the Big Three $2000 more in wages and benefits for workers than its Japanese counterpart, it makes sense that Japan (and other lower-cost countries) produce more cars, and the Big Three produce less.
3. Efficient allocation of resources: The United Auto Workers Union has a member ship of over 400,000 workers. Since the 1970s the union has lost over 1 million workers. Clearly the US auto industry has been in decline for decades, a fact that should be taken as a sign: resources employed in America’s car industry are inefficient and represent a over-allocation of resources. A drastic down-sizing of the auto industry, while resulting in short-run hardships for the hundreds of thousands whose jobs will be lost, will in the long run strengthen the US economy as labor and other resources will be freed up to be employed in sectors in which the US has comparative advantage.
4. Economic Darwinism or “the survival of the most efficient”: America has stood for free trade in the world since helping found GATT in 1948 and later the WTO. The gains from embracing free trade are shared among all stakeholders in the economy. Consumers enjoy lower prices (thus higher real income), firms enjoy access to cheaper inputs and larger markets for their products, and governments enjoy the increased tax revenues from rising incomes driven by export-led economic growth. To bail out an uncompetitive, inefficient, and long-declining industry is to spit in the eye of free trade and denies America any moral suasion it may hold in the future over potential trading nations in our attempt to open their markets to our nation’s products. To protect our own dying industry now will send a clear message to our trading partners. “America does NOT stand for free trade”. If we believe in free trade and the allocative power of markets, then we must let the dinosaurs of American industry meet the fate the natural selection of the marketplace has determined for it.
5. The benefits enjoyed by the few represent costs born by the many: A bailout by the US government of the auto industry will protect a few hundred thousand jobs for a few years at the most but spells a reduction in the disposable incomes and spending power of millions for years to come. The US does not have $25 billion laying around to give the Big Three, which means the money must be borrowed. Increased government borrowing raises interest rates now (further tightening the credit markets) and will result in increased taxes down the road. All government debt must eventually be paid off, and in the immediate future interest on this debt must be paid directly from tax revenue. A $25 billion bailout is the same as a subsidy, meaning it redistributes income and welfare from consumers to producers. Millions are asked to sacrifice for the continued survival of a few hundred thousand in an industry that has failed to evolve in a global auto market that has seen increased competition and efficiency from foreign firms for decades.
6. Moral hazard: Bailing out the Big Three today represent a classic case of moral hazard. When American industries fail to take steps to increase their efficiency and remain competitive in the face of increased global competition, they find themselves not surprisingly on the brink of collapse. To reward these firms by taking money out of Americans’ pockets and handing it to them to do as they will, we send the wrong message and create the wrong incentives in the American economy. The message is: “Don’t worry, the market doesn’t choose the winners and losers in the economy, the government does, and certain industries are too big to fail”.
7. Market failure, or Firm Failure?: The fate of the auto industry is in the hands of the US government. But so is the fate of the free market. My fear now is that the pendulum will swing too far to the left in America’s state of panic over the ill-fated downfall of the financial markets, rooted in the irrational exuberance and over-leveraging of big financial institutions. The failure of the financial markets, however, is an entirely different story from that of a dinosaur industry like automobiles. The Big Three have had decades to reform themselves, lower their costs, improve their products, and remain competitive. THEY have failed, NOT the market. Government intervention is necessary in instances of market failure, but NOT IN CASES OF FIRMS’ FAILURE TO COMPETE IN A WELL FUNCTIONING MARKET like the global auto industry.
8. Inflexible labor markets: I saw the president of the UAW on the news today giving 101 reasons why the government should approve a bailout deal for the Big Three. In fact, the unions that supposedly represent American Auto Workers are a big part of the problem the industry is facing. For decades the UAW has fought against wage and benefit cuts for auto workers, lobbying instead for higher tariffs and other barriers aimed at keeping foreign cars out of the country. This anti-competitive behavior is a major reason the Big Three cannot compete with European and Asian car makers today. Wage inflexibility leads to higher unemployment. Unions keep wages from going down, leaving the Big Three with one of two choices: Drastically downsize your workforce and employ fewer high paid auto workers, or beg the government for a multi-billion dollar subsidy to that the unions can be placated and you can survive for a couple more years until you’re in the same situation all over again. The unions helped cause the problem, now they should pay the price by experiencing the downsizing their demands inevitably foretold.

The US government should allow the free market to function and let the dinosaurs go extinct. Cars will still be made in America, they’ll just be made by the better, more efficient firms that emerge from bankruptcy when this is all over, as well as the numerous foreign firms already making cars in the US. Survival of the most efficient, that’s what markets are all about. Allowing the market to work will strengthen the US auto industry far more than a “short-term low-interest bridge loan” ever will, it will free up labor and capital resources to be employed by industries the country is better at, and make sure household income is NOT reallocated to inefficient firms to be squandered on the manufacture of a product for which demand has steadily declined for the last decade plus.

This post is in response to my colleague and fellow WW blogger Steve Latter’s recent post titled “Private market compesation: AIG CEO vs. Kobe Bryant”. It’s always enlightening to read Steve’s excellent posts, which really put things in perspective. With regards to CEO pay, it is a bit ironic that while Americans are all worked up about the high pay of its top executives, no one’s up in arms about the exorbitant salaries received by America’s professional athletes!

However, I wonder if Steve’s claim that limiting professional athletes’ pay would send the country’s top basketball players packing for leagues in other countries is true. A while back I blogged an article that asked the question of whether Lebron James would be offered a contract from a European club. James claimed that in order for him to even consider playing in Europe, he would require an offer of at least $50 million per year, more than double what he makes playing for Cleveland.

ESPN.com – Source: LeBron would consider European offer of $50M a year or more

…the Cleveland Cavaliers’ strongest competition for LeBron James’ long-term services could be the deep-pocketed new kid on the block — Europe.

A person close to James said Tuesday that the Cavaliers’ superstar would strongly consider playing overseas if he was offered a salary of “around $50 million a year.”

James’ current contract expires after the 2010-2011 season, but he can opt out after the 2009-2010 season, and while several NBA teams are working to create salary cap space for his impending free agency, none could offer a contract beginning at even $20 million a year.

So, would Kobe be on the next plane to Lithuania if the US government (or the NBA) limited his pay to $5 million? I doubt it. That brings us to the more urgent question: Would America’s top business executives begin shipping their families and all their belongings off to Jakarta or Dhaka, Delhi or Singapore, London or Paris, if the US government attempted to limit the compensation packages of its executives? Maybe, but there are many reasons to work and live in the United States beyond the salaries offered by firms for their top executives. And upon a little research, it turns out that European executives’ pay packages have in fact been under regulation by governments for quite some time, and as a result, the incentive for American executives to jump ship for European firms should US executive compensation come under regulation may not be as strong as Steve implies.

Executive pay in Europe | Pay attention | The Economist

How excessive is bosses’ pay in Europe? It has certainly risen sharply in the past ten years, as European firms have had to compete globally for talent. Foreign bosses now run seven of the firms in France’s CAC 40 index and five of Germany’s DAX 30. American-style bonuses and long-term incentive plans are now the norm.

European firms now benchmark pay against international peer groups in their own industries, rather than against domestic rivals, according to Piia Pilv, a pay expert at Mercer, a consultancy. But they still pay a fraction of the sums trousered each year by American executives. According to Hay Group, a management consultancy, the median European executive earns just 40% as much as his equivalent in America (see chart).

Most importantly, European companies appear to be more determined than American ones to link pay to performance. “Firms in Europe have tended to put more stringent conditions on long-term incentive awards than in America,” says Richard Bednarek, global director of executive remuneration for Hay Group. In America grants of shares are often not tied to performance, whereas European firms generally attach performance criteria to any grant of shares, typically depending on a comparison with a peer group. Such schemes often do not pay out at all, says Mr Bednarek. Dan Vasella, boss of Novartis, a Swiss pharmaceutical giant, and a favourite target of pay activists, earned SFr17m ($14m) in 2007, down 33% from 2006, because he missed his targets.

Clearly, the incentive to head to Europe as a result of increased scrutiny of executive compensation in the US is not as great as it would be if there did not already exist a threefold gap between US and European executive pay.

The liberal in me wonders if there is such a thing as “unfair” CEO compensation. The free market advocate in me points to other markets governments have attempted to control prices in, and the clear inefficiency that such regulation creates. Governments limiting executive pay, in theory, should have a similar effects to rent controls, or price ceilings in other markets. The quality and quantity of apartments available under rent controls declines, and price ceilings on other goods often result in shortages, meaning there’s not enough to go around among consumers… the quantity demanded exceeds the quantity supplied.

In the case of CEO pay in America, limiting compensation should, in theory, result in a shortage of highly qualified executives willing to head up American firms. But let’s be honest, even if the government placed highly stringent limits on the compensation of the country’s executives, the average executive in America would still likely be earning more than his counterpart in Europe. And since the average American CEO earns something on the order of 250 times what the average worker in his firm gets paid, increased regulation of CEO pay only help narrow this enormous gap slightly, but the incentive to make it to the top will still be strong among American workers.

Conclusions? It’s a tough issue. I want to have faith in the free market, in the price mechanism, in the efficacy of laissez faire economics. But the moral hazard of “golden parachutes” is a real concern. Should an American CEO be rewarded if he fails in his job? Steve makes the case that this “insurance” policy is necessary to attract the best and brightest to the firms willing to pay them most. Then again, something about the way the free market has created such a huge gap between executive pay and the pay of the average worker, and the threefold gap between America’s CEOs and Europes makes me think, “forget the free market, we need to get this insanity under control.”

“Anger”, more so than “fear”, is perhaps the most often expressed emotion by U.S. citizens, Congressmen, and media analysts when discussing the proposed $700B federal bailout of the U.S. financial system. “Anger” is the primary emotion because the $700B will be put at risk by the American taxpayer to bailout the very same financial institutions that have become increasingly reckless and greedy regarding their investing and borrowing practices.

In America, especially over the last two weeks, the discussion of a bailout to save our financial system and economy from ruin has become logically intertwined with a concurrent discussion of Chief Executive Officer (CEO) compensation packages. Many are outrgaged, especially in light of the horrendous financial results and excessive risk taking, when finding out about the lucrative CEO compensation packages consisting of base pay, bonuses, stock options, and termination (severence) pay.

Let’s analyze this topic by comparing the compensation packages of basketball superstar Kobe Bryant and recently fired AIG CEO Martin Sullivan.

In 2007, Kobe Bryant earned $20 million dollars playing basketball for the Los Angeles Lakers while Martin Sullivan earned $14 million dollars in 2007 running AIG, one of the largest insurance companies in the world.

In 2006, Bryant also earned $20 million for the year, whereas Sullivan earned $27 million as AIG’s financial performance was much stronger in 2006 versus 2007, causing Sullivan’s 2006 incentive-based compensation to be higher than 2007.

Now the big one: Sullivan’s 2008 termination or severence pay upon his firing as AIG CEO was $47 million dollars (two years pay)! Pretty nice “goodbye present” for Sullivan given the fact that AIG failed causing its owners (the stockholders) and potentially our country (taxpayers via bailout) to be crushed! Although Bryant has no termination or severence bonus built into his contract, his contract is guaranteed through 2011 which is somewhat similar to Sullivan’s “severence deal” in that Bryant is guaranteed payment should he be injured.

Thus, both compensation packages (Bryant and Sullivan) are somewhat similar in dollar amount, but beg the question: Is anyone worth that much money?

So the primary question of this blog is to discuss whether private market compensation, should be somewhat controlled or limited by governmental law, and if so, how.

Let’s start with Bryant.

If we passed a law taking the position that Bryant’s salary could not exceed $5 million per year, he would likely go play in Europe where European contracts are becoming more competitive and similar to U.S. contracts. Even if Bryant did stay with the Lakers, despite the new law, at $5 million per year, the $5 million savings (reduced salary) would go to the Lakers owner, Jerry Buss, so Buss would be making $5 million more at Bryant’s expense. In summary, we would have passed a compensation limiting law taking money from Bryant and giving it to the owner! Through the study of economics we ultimately understand that Bryant is, in essence, being paid by you and I whenever we see him at the arena (ticket prices) or watch him on TV (ad revenues). Ultimately, Bryant gets $20 million because we, not Buss, pay him $20 million! This is the private market at work, where voluntarily owners (Buss) pay their employees (Bryant) what they believe they are worth. Said one last way, Buss pays Bryant $20 Million per year because Buss thinks he can make more profit than if he doesn’t and loses Bryant to another team.

Let’s go to Sullivan now.

If we passed a law limiting executive salaries to some arbitrary number, say $5 million per year, the same thing would happen that happened to Bryant. The Harvard & Yale MBAs would not pursue American companies but would go to work at Canadian, European and Asian companies whose compensation would be “free market”. The U.S. would lose its best talent and our companies would become mediocre, fail at an increasing rate, and our standard of living would deteriorate as our leadership quality would deteriorate. It is the CEO that is at the helm of companies helping American businesses to produce an average 10.4% return for their owners (stockholders).

Now we get to the toughest question which is “should CEOs be paid a multi-million dollar severence payment after they have failed and been fired?” The obvious answer seems to be no! But sometimes, what appears to seem to be the obvious answer becomes less obvious in a free market. Any smart, Harvard or Yale MBA knows that they have a 50/50 chance of failing and being fired within their first 3 years as CEO. Statistics bear this out as CEOs are fired all the time as it is easier to fire the CEO than all of the employees. Large firms need the best talent and a talented CEO knows that sometimes their companies fail quickly often for reasons beyond their control no matter how talented they are. Thus, CEOs demand an “insurance payment” called severence pay to compensate them for their high risk and rate of failure. Once the CEO fails it becomes increasingly difficult to get that next CEO job as their reputation in the market place sours. Thus, a CEO looks at the entire compensation package (salary, incentives, and severence) when deciding where to work. If the risk is too high (dedicating their life to their business in lieu of their families) relative to the reward, they will take their talents elsewhere or to a new career.

What is my suggested government solution regarding trying to protect shareholders from excessive executive compensation? I suggest that our government only pass new law to increase ”disclosure requirements” on executive compensation to provide a better ”check and balance” on the Board of Directors who set the pay and severence amounts for the CEOs. The Government (SEC) should not get involved, in my opinion, with compensation limits or restrictions on severence pay, but they should pass a new law to provide greater visibility for the owners (stockholders) on their CEO’s (and other key management) compensation. For example, even though today all executive compensation is publicly accessible by the owners by examining publicly filed documents, the Government could pass new legislation making it mandatory for companies to send an annual letter directly to its owners (stockholders) outlining only their CEO’s and Board’s compensation.

But , please Government, be careful and don’t do anything stupid like setting maximums for CEO compensation.

Discussion Questions:

1. In your opinion, should the Government limit CEO salaries to some maximum? What about their severence payments, should they be limited? If so, how would you set the maximum amount?
2. Is it fair that Kobe Bryant makes more than a police offer? Why or why not?
3. What specific action should the Government take, if any, regarding executive compensation?

Eight reasons you’ll rejoice when we hit $8-a-gallon gasoline – MarketWatch – by Chris Plummer

I selected this article because I really believe in it. It wasn’t until I became a fan of studying economics that I began to believe that rising gas prices are in the LONG TERM ECONOMIC INTEREST of the US economy as these higher prices will incent consumers and businesses to move towards alternate forms of fuels.

I am also no longer in support of US offshore drilling, not because I am an environmentalist, but an economist that understands that it will be necessary to take higher, painful increases in petroleum to incent businesses and consumers to pursue alternative energy and more efficient transportation solutions. Voluntary conservation or asking oil companies to pursue alternative fuel development is nice in concept, but poor in results.

I now root for “steadily climbing oils prices” to provide greater incentive to move faster to more efficient forms of transportation and spawn alternative energy solutions. It’s a little like going to the dentist: it’s not fun, but it is necessary and will leave us in better condition when its over.

For one of the nastiest substances on earth, crude oil has an amazing grip on the globe. We all know the stuff’s poison, yet we’re as dependent on it as our air and water supplies — which, of course, is what oil is poisoning.

Shouldn’t we be technologically advanced enough here in the 21st Century to quit siphoning off the pus of the Earth? Regardless whether you believe global warming is threatening the planet’s future, you must admit crude is passé.

Americans should be celebrating rather than shuddering over the arrival of $4-a-gallon gasoline. We lived on cheap gas too long, failed to innovate and now face the consequences of competing for a finite resource amid fast-expanding global demand.

A further price rise as in Europe to $8 a gallon — or $200 and more to fill a large SUV’s tank — would be a catalyst for economic, political and social change of profound national and global impact. We could face an economic squeeze, but it would be the pain before the gain.

The U.S. economy absorbed a tripling in gas prices in the last six years without falling into recession, at least through March. Ravenous demand from China and India could see prices further double in the next few years — and jumpstart the overdue process of weaning ourselves off fossil fuels.
Consider the world of good that would come of pricing crude oil and gasoline at levels that would strain our finances as much as they’re straining international relations and the planet’s long-term health:

1. RIP for the internal-combustion engine

They may contain computer chips, but the power source for today’s cars is little different than that which drove the first Model T 100 years ago. That we’re still harnessed to this antiquated technology is testament to Big Oil’s influence in Washington and success in squelching advances in fuel efficiency and alternative energy.

Given our achievement in getting a giant mainframe’s computing power into a handheld device in just a few decades, we should be able to do likewise with these dirty, little rolling power plants that served us well but are overdue for the scrap heap of history.

2. Economic stimulus

Necessity being the mother of invention, $8 gas would trigger all manner of investment sure to lead to groundbreaking advances. Job creation wouldn’t be limited to research labs; it would rapidly spill over into lucrative manufacturing jobs that could help restore America’s industrial base and make us a world leader in a critical realm.

The most groundbreaking discoveries might still be 25 or more years off, but we won’t see massive public and corporate funding of research initiatives until escalating oil costs threaten our national security and global stability — a time that’s fast approaching.

3. Wither the Middle East’s clout

This region that’s contributed little to modern civilization exercises inordinate sway over the world because of its one significant contribution — crude extraction. Aside from ensuring Israel’s security, the U.S. would have virtually no strategic or business interest in this volatile, desolate region were it not for oil — and its radical element wouldn’t be able to demonize us as the exploiters of its people.

In the near term, breaking our dependence on Middle Eastern oil may well require the acceptance of drilling in the Alaskan wilderness — with the understanding that costly environmental protections could easily be built into the price of $8 gas.

4. Deflating oil potentates

On a similar note, Venezuela’s Hugo Chavez and Iran’s Mahmoud Ahmadinejad recently gained a platform on the world stage because of their nations’ sudden oil wealth. Without it, they would face the difficult task of building fair and just economies and societies on some other basis.
How far would their message resonate — and how long would they even stay in power — if they were unable to buy off the temporary allegiance of their people with vast oil revenues?

5. Mass-transit development

Anyone accustomed to taking mass transit to work knows the joy of a car-free commute. Yet there have been few major additions or improvements to our mass-transit systems in the last 30 years because cheap gas kept us in our cars.

Confronted with $8 gas, millions of Americans would board buses, trains, ferries and bicycles and minimize the pollution, congestion and anxiety spawned by rush-hour traffic jams. More convenient routes and scheduling would accomplish that.

6. An antidote to sprawl

The recent housing boom sparked further development of antiseptic, strip-mall communities in distant outlying areas. Making 100-mile-plus roundtrip commutes costlier will spur construction of more space-efficient housing closer to city centers, including cluster developments to accommodate the millions of baby boomers who will no longer need their big empty-nest suburban homes.

Sure, there’s plenty of land left to develop across our fruited plains, but building more housing around city and town centers will enhance the sense of community lacking in cookie-cutter developments slapped up in the hinterlands.

7. Restoration of financial discipline

Far too many Americans live beyond their means and nowhere is that more apparent than with our car payments. Enabled by eager lenders, many middle-income families carry two monthly payments of $400 or more on $20,000-plus vehicles that consume upwards of $15,000 of their annual take-home pay factoring in insurance, maintenance and gas.

The sting of forking over $100 per fill-up would force all of us to look hard at how much of our precious income we blow on a transport vehicle that sits idle most of the time, and spur demand for the less-costly and more fuel-efficient small sedans and hatchbacks that Europeans have been driving for decades.

8. Easing global tensions

Unfortunately, we human beings aren’t so far evolved that we won’t resort to annihilating each other over energy resources. The existence of weapons of mass destruction aside, the present Iraq War could be the first of many sparked by competition for oil supplies.

Steep prices will not only chill demand in the U.S., they will more importantly slow China and India’s headlong rush to make the same mistakes we did in rapidly industrializing — like selling $2,500 Tata cars to countless millions of Indians with little concern for the environmental consequences. If we succeed in developing viable energy alternatives, they could be a key export in helping us improve our balance of trade with consumer-goods producers.

Additional considerations

Weaning ourselves off crude will hopefully be the crowning achievement that marks the progress of humankind in the 21st Century. With it may come development of oil-free products to replace the chemicals, pharmaceuticals, plastics, fertilizers and pesticides that now consume 16% of the world’s crude-oil output and are likely culprits in fast-rising cancer rates.

By its very definition, oil is crude. It’s time we develop more refined energy sources and that will not happen without a cost-driven shift in demand.

At Charter School, Higher Teacher Pay – New York Times

A New York charter school opening this year will start teachers’ pay at $125,000. The school’s creator and principal believes that quality teachers, not technology, are what will lead to results for students at his school.

The school’s creator and first principal, Zeke M. Vanderhoek, contends that high salaries will lure the best teachers. He says he wants to put into practice the conclusion reached by a growing body of research: that teacher quality — not star principals, laptop computers or abundant electives — is the crucial ingredient for success.

“I would much rather put a phenomenal, great teacher in a field with 30 kids and nothing else than take the mediocre teacher and give them half the number of students and give them all the technology in the world,” said Mr. Vanderhoek, 31, a Yale graduate and former middle school teacher who built a test preparation company that pays its tutors far more than the competition.

This is certainly an interesting experiment. American schools have struggled for decades to improve results through the implementation countless programs and policies. Lately, one emphasis has certainly been on technology; but this article makes an interesting point: all the technology in the world won’t make a difference if it’s not in the hands of an excellent teacher.

The best basketball players in the NBA make millions more than the average ones. The most skilled doctors are rewarded with the highest salaries. Top lawyers earn hundreds (if not thousands) of dollars an hour while one from a third rate law school toils for $65,000 a year in a county prosecutor’s office. So what’s different about teaching? Why do all teachers in a particular district with a particular number of years experience get paid the same salary? Could you ever imagine all the lawyers in a particular city making identical salaries? The idea is absurd. Clearly the top law firms will pay for the top lawyers, which in turn enables that law firm to achieve the best possible results for its clients.

Yet the vast majority of teachers in America find themselves stuck in a system rooted in an outdated belief in equity, egalitarianism, fairness, whatever you want to call it, where pay is based not on talent, ability, skill, expertise, and all the attributes that determine one’s pay in a competitive labor market like medicine, law, and professional sports; rather the older you are and the more time you’ve “served”, the greater your financial reward. Is it a coincidence that America is known for its cutting-edge medical field, its skilled litigators, and world-class professional athletes. Could someone describe to me the reputation of American public schools? No? I understand, it’s a depressing subject.

In economics we teach the importance of incentives, which when used properly encourage individuals to improve their human capital in as many ways as possible. In other words, if I am rewarded for excellence, I will strive for excellence in my profession. The only incentive in education, it seems, is to grow old and gray, because that’s how I will make more money. Easy for teachers whose only goal is to make it to retirement, right? Without a doubt. Effective for students in a society falling ever further behind other countries in academic achievement? Hardly.

Ironically, some of the teachers most skilled in the application of new technologies and versed in the latest pedagogies are those who grew up learning with those technologies in their own education in a constructivist, student-centered environment. In other words, the youngest, most tech-savvy, who just happen to earn the lowest salaries (practically subsistent in some parts of the country).

Mr. Vanderhoek may be proven wrong. Perhaps it is more technology, more standardized tests, more powerful teachers’ unions, that America’s children need to begin achieving the results that Indian, Chinese, Singaporean, Korean, Japanese, even European students are achieving in the maths, sciences, and other subjects. But if he’s right, then $125,000 (2.5 times the national average for public school teachers) may prove to be just what’s needed attract the kinds of teachers that can achieve results. What if this school does succeed? Will it matter? Or will America’s public schools forever reward teachers not for performance and qualifications, but simply for getting older?

Powered by ScribeFire.