Who's Abusing the First Welfare Theorem?

In an earlier post, I discussed (and seconded) Dani Rodrik's criticism of those who leap to the conclusion that "free markets" always lead to an optimal outcome. A problem with that way of thinking is that applies the conclusion of the first welfare theorem - that markets lead to a efficient outcome - without considering the conditions required for the theorem to hold (including perfect competition and perfect information).

Marginal Revolution's Alex Tabarrok has a riposte. He argues that Rodrik is guilty of misusing the theorem: just because the conditions required for the theorem aren't met in reality does not imply the existence of welfare-improving policy interventions. He writes:

Since the conditions required for the theorem's proof are unlikely to hold in the real world it's common for people to reverse the theorem to suggest that markets cannot be efficient. Thus Rodrik says:

The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions.

Now what is wrong with this is very simple. The First Theorem gives sufficient conditions for a market to be efficient it does not give necessary conditions.

Thus, as a matter of logic, the fact that the theorem's conditions are not satisfied does not prove that market outcomes can be improved, even by "well-designed" interventions.

A valid point, I think. So we've identified two ways to abuse this proposition: (i) to argue that "free market" outcomes are automatically optimal and (ii) to argue that because the theorem's assumptions do not hold, welfare-improving policy interventions must exist. Although many non-economists fail to appreciate the benefits of markets at all, within the world of economics I see the first type of abuse much more often than the second.

Principles of "Principles"

In a NY Times column titled "The Dismal Science, Dismally Taught," Bob Frank relates a familiar experience:

WHEN I began teaching economics in the 1970s, I noticed that people were generally disappointed when they learned what I did for a living. When I began asking why, many said something like this: “I took Econ 101 years ago, and there were all those horrible equations and graphs.”

Frank believes that the teaching of introductory economics is fundamentally flawed:

Their unpleasant memories were apparently justified. Studies have shown that when students are tested about their knowledge of basic economic principles six months after completing an introductory economics course, they score no better, on average, than those who never took the course...

...Why aren’t introductory economics courses more effective? One possibility is that professors try to teach their students far too much. The typical course bombards students with hundreds of concepts, many of them embedded in complex equations and graphs. The mathematical formalism that has become the hallmark of economic research has yielded deep insights. But it does not seem to have helped introductory students learn basic economic principles.

As an alternative, he argues for a pedagogy focused on the repeated application of a small group of principles:

Just as a few simple sentence patterns enable small children to express an amazing variety of thoughts, a few basic principles do much of the lifting in economics. If someone focuses on only these principles and applies them repeatedly in examples drawn from familiar contexts, they can be mastered easily in a single semester.

He may be right, if one takes at face value the idea that the purpose of "Principles of Economics" is solely to impart principles of economics. What his argument seems to miss is that there is a broader purpose to an undergraduate economics course - we are not just teaching economics, we are helping our students learn how to think. This is where that much-derided "mathematical formalism" is invaluable: working with economic models - the process of making assumptions explicit in equations and deriving the implications - helps us learn to connect assumptions and conclusions and think about relationships in a careful, logical manner.

The main educational value of economics lies in the abstract reasoning and quantitative skills the students develop through practice. Other fields cultivate different abilities in their students - e.g. students of English don't merely learn about a set of books, they become more critical readers and better writers. The general point is that the value of a liberal arts education lies not in the body of knowledge students take away, but in the skills and habits of mind they develop when they are challenged.

A couple of subsidiary points:
(i) Frank's argument fits much better for introductory microeconomics than macroeconomics - the factual knowledge in "macro" about how the federal budget and monetary policy work is crucial if we care about what kind of citizens our students will be.
(ii) Though most students of economics (and indeed myself and most economists I know) sometimes lament our reliance on mathematical models, the use of mathematics is absolutely central to economics as it is practiced today. To avoid this for the sake of making it go down easier seems to risk misrepresenting what economics actually is.

Piled Higher and Deeper

This comic strip chronicle of graduate student life is the funniest thing I have seen in a long time, though it may be hard to appreciate if you haven't experienced it yourself.

Financial Market Freak Out

That guy on CNBC is screaming (louder than usual). Financial markets are in "turmoil" and the Fed is "injecting liquidity into the system."

What is the Fed actually doing? The federal funds rate is the interest rate at which banks borrow reserves from each other - its what's called an "interbank" rate because supply and demand both come from banks. Increasing concerns about credit quality have led to a spike in demand for reserves and the Fed is using open market operations to increase the supply of reserves, thereby keeping the fed funds rate at (or at least close to) its target of 5.25%. Economist's View has a nice diagram and explanation. The Journal's Real Time Economics has a roundup of of worldwide central bank actions. As part of its action, the Fed accepted a large quantity of mortgage-backed securities as collateral for repurchase agreements - somewhat unusual, as Economist's View explains.

So, what is this "liquidity" everyone's talking about? According to the glossary in Mankiw's intermediate macro text, "liquid" means "readily convertible into the medium of exchange; easily used to make transactions." Markets for some financial assets, particularly ones associated with mortgages, have completely dried up. That is, they have become "illiquid" - and that makes it hard to know their value since there's no price. One of the events that set off the latest tizzy was the announcement that BNP Paribas suspended withdrawals from several of its funds, citing lack of liquidity. According to the Bloomberg story BNP Paribas said: "The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating." Its far from clear that the Fed's actions will directly affect this problem; people seem to be using the word "liquidity" rather loosely these days.

I do wonder if the "liquidity" story may be somewhat self-serving; surely there are some funds out there willing to scoop up mortgage-backed poop if the discount is big enough. Isn't that what hedge funds are for? Or is "buy low, sell high" too simple a strategy for them?

How unusual is this "crisis"? One typical element of financial disturbances is a "flight to quality" as panicky investors sell risky assets and buy "safe" ones like US Treasury bonds - this results in rising spreads (the extra yield over Treasuries) for low-rated corporate bonds and bonds from "emerging market" countries. Even though nothing's changed about the creditworthiness of, say, Brazil, they will have to pay a higher interest rate today than a month ago because of the mood swing in the markets. Reuters has a useful chart of how much spreads (the difference in bond yields over treasuries) have widened in previous crises. So far, this one's not a biggie.

Have the changes in the financial system made things different this time? Take a look at the analysis of the NY Times' Floyd Norris, who compares the current situation to banking panics of the past. The Washington Post's Steven Pearlstein is critical of the new financial order.

But, for all the sturm and drang, is this really bad news for the economy? Its too soon to tell - serious financial crises in 1998 and 1987 did not lead to recessions. Offhand, I can think of three risks to the real economy: (i) a prolonged credit crunch could be harmful for investment (that is, purchases of capital goods by firms) (ii) if things get really bad in housing markets, people may reduce their consumption and (iii) if the fed overreacts it could lead to inflation and/or new asset bubbles. On the last point, I think Bernanke can be trusted much more than Greenspan.

Update: At Econbrowser, James Hamilton has more explanation of what was going on in the federal funds market.
Update #2: At VoxEU, Stephen Cecchetti has a FAQ on the Fed's actions.

A Bon Mot from the BPEA

From T.N. Srinivasan's comments on Obstfeld and Rogoff, "Global Current Account Imbalances and Exchange Rate Adjustments," Brookings Papers on Economic Activity (2005):

Evsey Domar, when asked by a graduate student at MIT why the questions in the macroeconomics examination do not change from year to year, is said to have replied, "Ah - but the answers do!"

The Rent-Seekers in My Mailbox

Hardly a day goes by without some junk mail from the student-loan industry - why are they so eager to get me to "consolidate" my loans? Because they are subsidized by the government: in the New Yorker, James Surowiecki looks at the political economy of this strange public-private hybrid. He writes:

...it’s four times as expensive for the government to subsidize and guarantee private loans as for it to issue those loans itself. In other words, the current system is not just corrupt. It’s also inefficient. So why are we stuck with it?

In part, it’s ideology, and the dominance of what you might call the privatization mystique—the idea that anything the government can do, the private sector can do better. Often, this makes sense: the free market is more likely to come up with efficient ways of creating and distributing products and services than the government is. But the student-loan market isn’t a free market in any meaningful sense of the term, because the government effectively determines prices, insures against losses, and subsidizes volume. In this environment, most of the competition among private companies is really just squabbling over how to split up the spoils. Economists call this behavior—when a company seeks to manipulate economic conditions rather than actually create value—“rent-seeking.” It’s common in areas where the fetish for privatization has taken hold, such as the outsourcing of homeland security to private contractors and the boom in private Medicare insurers. (The private insurers are less efficient than Medicare and receive billions in subsidies from the government.)...

More than just ideology, though, has kept student-loan companies in their lucrative niche. Economic power has also had something to do with it. Since the mid-nineteen-nineties, the federal government has offered direct student loans, making it unnecessary for students to go through private lenders. The loans are significantly cheaper for the government, but, from the start of this program, private lenders have done all they could to limit its reach. They’ve worked to keep the Education Department from offering discounts and rebates to borrowers. They’ve lobbied against interest-rate cuts on student loans. And they’ve offered colleges millions of dollars to drop out of the direct-loan program...

There are services that most of us believe should be available either universally or at least more broadly than unfettered markets would provide - education and health care being the prime examples. It is an open question (in my mind, at least) whether the public or private sector can deliver them better. In the student loans and medicare cases, it seems like the government does better, but we don't really know how the private sector would do without subsidies. To find the answer, we need to let public and private compete on a level playing field - if the private sector cannot compete without subsidies, let it wither away (and if the private sector can outperform the government, without subsidies, hooray for them).

One reason for my exasperation in the post below with the "first best" economists is that "free markets" are often used as a cover for rent seeking behavior, especially these days. To be fair, any economic ideas are subject to abuse in Washington (and other capitals), so it is important to distinguish between the idea, and the actions taken in the name of the idea. I would imagine there are some similarities in the feelings of true free marketers now about the Bush administration (and late Republican congress) and those of true Marxists about the Soviet Union.

Incidentally, the Democratic congress is making progress on the student loan issue.

Two Kinds of Economists

Dani Rodrik has an insightful (must read!) post, "Why Economists Disagree," where he identifies two types of economists, "first-best economists," and "second-best economists." The world view of the first group is based on the optimality properties of competitive markets - i.e. market outcomes lead to the "first-best" outcome, and any policy intervention is welfare reducing. The second camp understands that the assumptions on which the optimality results depend - perfect competition, perfect information, etc. - never hold in the real world; that we live in a "second-best" world where government policies can be welfare-improving.
Rodrik's "first-best economists" are the same people as the "classical" economists Keynes assaults in the introduction to the General Theory:

...The postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

Seventy-one years later, we're still fighting the same battles. Why do so many economists and students of economics take such a naive, knee-jerk "free market" view? Again, Keynes has an answer (from ch. 3 of the General Theory):

The completeness of the Ricardian victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

I think Rodrik and Keynes have it about right, though some say that there are actually three kinds of economists: those who can count, and those who cannot.

Information, Competition and Congress

There's a public choice lesson in here, though as an international macroeconomist, I'm not really qualified to figure out exactly what it is... Today's NY Times reports that "Pet Projects Are Flourishing in Congress:"

If the idea was to shame lawmakers into restraint, it did not work.

Eight months after Democrats vowed to shine light on the dark art of “earmarking” money for pet projects, many lawmakers say the new visibility has only intensified the competition for projects by letting each member see exactly how many everyone else is receiving.

So far this year, House lawmakers have put together spending bills that include almost 6,500 earmarks for almost $11 billion in local projects, half of which the Bush administration opposed.

The earmark frenzy hit fever pitch in recent days, even as the Senate passed new rules that allow more public scrutiny of them.

Far from causing embarrassment, the new transparency has raised the value of earmarks as a measure of members’ clout. Indeed, lawmakers have often competed to have their names attached to individual earmarks and rushed to put out press releases claiming credit for the money they bring home.

Perhaps its not surprising that more information leads to heightened competition - this is true in many markets; think of how much harder the internet makes it to charge a high retail markup or sell a shoddy product when it is easy for consumers to see competitors' prices and get quality reviews. And it is a reminder that members of congress have a strong incentive to maximize their probability of getting re-elected by keeping their constituents happy, and this does not always coincide with the national interest. One might say their rational earmark-seeking behavior has negative externalities - if only the founding fathers knew about Pigouvian taxes!

Before we get carried away with hand-wringing and indignation, its worth keeping in mind two things: (i) some of the projects probably are worthwhile, even if this is a silly way to allocate resources, and (ii) $11 billion is nothing to sneeze at, but its 0.4% of total federal outlays of $2,655 billion (FY 2006), so even if crusaders against "waste, fraud and abuse" were able to eliminate all the earmarks, it would hardly make a dent (and would not go far towards undoing the damage to our fiscal situation from President Bush's tax cuts).

Incidentally, though the local Congressman, John Boehner, is notoriously chummy with lobbyists and special interests he eschews earmarks. I'm sure he'd say its a matter of principle, though maybe he's just afraid of the competition! Too bad, since I really think Oxford would be a nicer place if they built a bypass for US-27.

Crunch Time?

Much anxiety these days about the possibility of a "credit crunch" - a general tightening of lending standards. Their fingers burned by rising mortgage defaults and the attendant turmoil in markets for mortgage-related securities, the panicky, myopic herd otherwise known as Wall Street suddenly gets prudent. The troubles in the financial sector spill over to the general economy by making it harder to raise funds to finance investment and purchases of housing and durable goods. A credit crunch in the wake of the Savings and Loan crisis of the late 1980's may have been a contributing factor in the 1990-91 recession. In a column titled "Credit Market's Weight Puts Economy on Shaky Ground," the Washington Post's Steven Pearlstein discusses how financial "innovations" mean things may be different this time:

By one estimate, for example, more than half the loans used to finance corporate takeovers are now packaged with other loans and sold as "collateralized debt obligations." And among the big buyers of CDOs are investment banks that package them with other CDOs and sell them again. Those are called CDOs-squared.

One advantage of this packaging and repackaging of loans is that it spreads risk so widely among investors that any default by a borrower will have negligible impact on any one lender or investors. Over the past five years, this has added a good deal of stability to the financial system. And with stability has come lower interest rates.

But at the same time, this financial engineering has encouraged debt to be piled on debt, making the system more susceptible to a meltdown if credit suddenly becomes more expensive or unavailable. And that's precisely what's been developing over the past several weeks.

A credit crunch means not only an increase in risk premiums - the extra interest paid by risky borrowers - but that some deals won't get done at any price. Reuters columnist James Saft says "It'll be a cold day before debt markets reopen":

Hopes that debt markets will reopen for leveraged borrowers after a pleasant summer holiday will be dashed, leaving mergers and buyouts and the stocks which depend upon them very exposed.

The riskier parts of the debt markets, especially leveraged loans, have all but shut up shop. Hedge funds generally can't get credit from their bank lenders and structured finance isn't buying either.

And it's not just that investors could have a long wait before the debt-powered private equity pipeline starts flowing again, it's also possible that a liquidity crisis prompts defaults and wider economic fallout.

He goes on to quote my old boss: "'It's going to take longer than September for the market to fully reopen,' said Meredith Coffey, an analyst with Reuters Loan Pricing Corporation in New York." As I remember well, the only thing more exciting in the Loan Pricing newsroom than big leveraged deals were big leveraged deals in trouble. At times like these, its much better to write about banking than to do it.

Meredith was characteristically cautious, but The Economist is positively sanguine. In their leader (as the Brits call an editorial), they say tighter credit conditions are just what the markets need:

BANKERS and investors might not agree, but the recent sell-off in financial markets is good news. It may, at last, have brought people to their senses. For the past few years, too much money has been lent too cheaply and too easily to too many people, whether it was speculators trying to make a fast buck in Miami condominiums or private-equity groups financing their latest multi-billion-dollar takeover. This wake-up call came too late to save the American housing market from frenzy and subsequent bust. But it may have arrived in time to stop the takeover boom getting out of control—and when the world economy is strong enough to cope with the consequences.

Update: Willem Buiter of the LSE has a proposal on what the Fed should do

If 1028 Economists Agree

Mankiw reports that 1028 economists have signed a petition opposing congressional action to use retaliatory tariffs to pressure China to increase the value of the Yuan (doing so should lead to higher prices for Chinese goods in the US, while making US goods cheaper in China, reducing the trade deficit). Nobody asked me to sign (sniffle), but I'm not sure I would have anyway, for several reasons:

1. The petition is organized by a nutty right-wing group called the "Club for Growth," which automatically undermines its credibility.
2. Though I share the general sentiment that free trade is (usually, mostly) good, China's currency intervention itself represents a significant deviation from free trade in the sense that the government is manipulating prices. The efficiency of "free markets" (in internationally traded goods or otherwise) crucially depends on free adjustment of prices.
3. The petition says that "There is no foundation in economics that supports punitive tariffs." I'm no game theorist, but I suspect a game-theoretic argument could be made that a credible threat of retaliation might lead to a better outcome, i.e. free trade and freely floating exchange rates.

The Washington Post reports that the legislation may pass, by veto-proof margins. The supporters miss some key points: (i) there are significant benefits to our relationship to China including low prices that raise the purchasing power of consumers and low interest rates which help maintain investment and (ii) the relationship is one of mutual interdependence - the flip side of the trade deficit with China is a financial inflow; we do not save enough to finance our own investment and China is helping make up part of the gap. If there was a rupture in our economic relations with China, prices would rise for many consumer goods and long-term interest rates would increase. The current situation is problematic and seemingly unsustainable, but the preferred solution would be some mutually agreed upon gentle unwinding of the imbalances. That seems to be what the Bush administration is going for, though its not clear they are offering any action on the US side (e.g. a tax increase to lower the deficit and thereby increase our national saving). Maybe they'll make more progress if Congress plays a "bad cop" role. Perhaps a better tack is for the Chinese to realize their currency policies are not in their own interest, as Brad Setser discusses in this post.