Maxine Udall (girl economist)

Freedom Is Not Just Another Word for Nothing Left to Lose

I try very hard to confine what I write to economics, but there is an election in the near future that compels me to make some observations.

I'm afraid I'm in agreement with Paul Krugman that if Republicans gain control of the House we should be "very afraid." I'm sorry to say this, but unless you expect to inherit immense wealth or you are already in the top 1-2% of the income distribution I think you would be nuts to vote Republican. I base my opinion on the stark economic results of their nearly invariant beliefs and their performance over the last 30 years.

Watching Tea Partiers, elderly Medicare beneficiaries, disabled Social Security beneficiaries, those who labor (sometimes 2-3 jobs) to put food on the table, and so-called libertarians vociferously oppose the current administration's amazingly conservative efforts to haul us out of the economic crater that the dominant Republican economic philosophy (aided and abetted by at least a few Democrats) has put us in causes me great alarm. It's like watching serfs, entirely dependent on the (hoped for) beneficence of their feudal lord, stripped of every excess over subsistence of the product of their labor, clamoring that more be taken from them and given to that lord. Presumably because someday they might get lucky and miraculously end up to the manor born (or married).

"But, wait," you say, "this can't be right. The Republicans stand for freedom, liberty, and the American way." To which I say, "Well, you've got a funny idea of freedom." You see, the last time I checked, the US Constitution protects me from the US government. As far as I can tell, there is nothing that protects me from large corporations, except the US government and the court system. And these days, the US government and the courts, largely thanks the dominant Republican economic philosophy, aided and abetted by the bipartisan repeal of Glass-Stegall in 1999, aren't doing such a great job of this.

Here's Senator John Sherman, OH-R (back in the days when Republicans understood the harms inflicted on the rest of us by concentrated power and wealth):

“concentered powers” [if] “intrusted to a single man . . . [becomes] a kingly prerogative, inconsistent with our form of government”. “We should not endure a king [over] the production, transportation, and sale of any of the necessaries of life”.

And yet we have endured kings of finance and production. Republicans and their philosophy have shaped our economy for thirty years.

Unfortunately, thirty years of economic distortion is like thirty years of drug addiction. When you try to get sober, it's expensive and it takes a long time. This is because for a very long time you have made the wrong investments in physical, human, and financial capital. Now you have to figure out where you would have been if you hadn't spent all that time and money getting high and try to restore your life (or economy) to something that approximates it. While all this is happening it's hard to tell for sure whether or not you're on the road to recovery or the road to relapse, much like it's difficult to see signs of economic recovery even when we're in one.

Over time, the Sherman Act of 1890 has been eroded, but it remains as an example of the proper role of government in protecting the welfare of the rest of us by limiting the extent to which concentrated wealth and power can distort investment and extract rents from us. Think of rents as a form of tax (yes, I said "TAX") that we pay to corporations. Rents are profits. High profits can be good when they are reinvested to produce more or better products, to signal other firms to enter a market thereby providing more and driving down the price we pay for it, to reduce costs of production (leading to a lower price that we pay), to produce new and innovative products that make us all better, or when they reward all of the above. If they are used to speculate in financial casinos or if they reflect the higher price above cost that excessive size and market power enable without a commensurate addition to our own welfare, then our well-being is almost certainly reduced.

Sherman recognized something that Adam Smith had also recognized. Here's Smith (Wealth of Nations, I.10.82) :

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.

Sherman also recognized something that has been lost in the discourse about capital and commercial exchange: enterprise generally, but large enterprises particularly, have a "quasi-public character." Large firms undertake activities that used to be possible to undertake only by large and wealthy governments. They yield benefits and harms beyond those of the goods produced and exchanged. Benefits might include economies of scale that produce lower prices and higher consumer surplus unless those same economies of scale increase market power and enable monopoly rents. In the case of health insurance, increased scale could lower underwriting costs and spread risk more efficiently. Harms might include pollution and the erosion of competitive forces and the accompanying loss of consumer surplus from monopoly pricing. Harms might also include high unemployment and severe recessions like the current one.

Markets, free or otherwise, will not automatically fix all harms or yield all benefits. That's why, to be successful, capitalism requires regulation and fine tuning.

You see, in a capitalist economy, wealth and well-being are supposed to redistribute to everyone. As capital is allocated and risk managed more efficiently, more opportunities are created for all. Wealth and well-being are supposed to become less concentrated in the hands of a few and more dispersed to the hands of the (often more and increasingly) productive many. Much of Wealth of Nations is devoted to describing the instances and the conditions under which this seemed to be occurring as the economy of Great Britain transitioned from feudalism to one of commercial exchange, industrial production, and small business owners.

After thirty years of Republican economic philosophy, we have extreme and continuing income inequality. Unless you are willing to believe that only a very few possess the skills and abilities necessary to produce universal opulence, you can hardly support a political philosophy hellbent on creating a society in which only a few reap the rewards of societal output while the rest of us bear the costs and fall behind. And if you do believe it, then you had best be able to point to the resulting universal opulence that is supposed to have "trickled down" and in which we should now all be partaking. If you can't, then the underlying philosophy is flawed. This philosophy has dominated the US for thirty years. It has gutted government and packed courts. Things are much worse economically. An alternative philosophy has had only two years to attempt to remedy the culmination of those thirty years and has accomplished much that is good and in the right direction, yet some are ready to throw it out after two years.

Some of you will point out that elected US lawmakers of both parties appear to be wholly owned by corporations and finance. Even if you believe this, it hardly argues for shrinking government, thereby giving corporate and other interests even more unfettered power. It argues for a political philosophy that believes government serves an essential purpose in an advanced, complex capitalist society: that of countervailing force against those interests when they are harmful to the rest of us and helpful to those interests when they are beneficial to us. That philosophy requires government to be as large as it needs to be to countervail. And it requires that government be viewed as capable of being efficient and that the culture and norms of government be those of public service, not public pillage.

Such a philosophy also requires an alert and educated electorate that is not side-tracked by emotionally laden issues, an electorate that recognizes that unless we want to be wholly under the boot of unfettered financial and political power (and the cyclic havoc they can create), some government administered, taxpayer supported economic and ethical stabilizers (such as unemployment benefits that last as long as investment banker-induced downturns, health insurance for everyone, a safety net for the aged, infirm and unlucky, regulation of investment banks and consumer financial products, and government stimulation of aggregate demand when the private sector has become so misshapen that it cannot be jump started through monetary policy alone) are justified.

So when you vote on Tuesday, and you must, remember the goal here should be to elect lawmakers who will stand up to concentrated wealth and power by strengthening government and the laws that protect us, not by dismantling it. Remember that freedom is much more than "nothing left to lose." "Nothing left to lose" is what most of us are likely to achieve if the current Republican party's political philosophy regains power. If that happens, I very much fear, that it will re-create a society not unlike the one that Adam Smith was so glad to see commercial exchange, the division of labor, and the increasingly efficient and prudently risk-averse allocation of capital leave behind.

Food (and Finance) for Thought

What do food and finance have in common?

Reader rjs sent me this morning to this most excellent blog by James Kwak. It touches on something I have blogged about before: the disconnect between utility and preferences in consumer decision-making, a disconnect that is fostered by those who gain financially from it. In my previous blog I attempted to draw the parallel between nutrition and banking, but Kwak has done it far better than I. After laying the foundation for his assertion that knowledge about food and nutritional science has been "shaped" by food manufacturers, aided and abetted by weak or cowed regulators, he draws the link to finance:

What does this all have to do with finance? Roughly speaking, read academic finance for nutritionism; the financial sector for the food industry; subprime loans, reverse convertibles, and CDOs for highly processed food claiming to improve your health but actually killing you; current disclosure laws for the FDA-approved health claims on corn oil; thirty-year fixed-rate mortgages and index funds for the neglected, unsubsidized, unadvertised fruits and vegetables in the produce section; the OCC and OTS for the FDA; and the long-term increase in obesity and diabetes for the long-term increase in household debt.

In both cases, you have an industry that earns profits by convincing people to do things that are not in their long-term interests; that, in the process, creates negative externalities for the rest of society; and that has cowed regulators into submission, if not outright cheerleading. In both cases, the industry defends itself from critics by saying that it is simply providing what customers want, and hence any new constraints (even, say, accurate organic labeling laws) constitute a paternalistic intrusion into people’s economic freedom. And in both cases, the industry claims that if it isn’t allowed to continue on its current course, the economy as a whole will suffer. (After all, our corn- and soy-based diet is what enables the industry to provide huge numbers of calories at low cost.)

I wish I had written that.

I suggested some time ago that the price of casino-like finance is higher than we think in terms of the labor market distortions it has created by siphoning some of our best and brightest away from objectively productive contributions to national output and well-being. As Kwak makes clear, the distortion is not just to the workforce as I and others have suggested, it is also to the information we need to make sound judgements about what we ingest (and I would add: wear, drive, and live in).

How free is a man or woman who is making decisions that affect, not only their own and their children's lives, but the well-being of their friends, neighbors, and countrymen, when the information they base the decisions on is questionable at best and highly distorted to favor someone else's pocketbook at worst?

The food industry has financial incentives to "shape" information and it is not alone. Pharma also confronts considerable incentives to overstate the benefits of the drugs it produces. I don't suppose it helps that medical research may be compromised by the similar conflicts of interest. Nor does applied economics research appear to be free of bias although it appears that it is biased in favor of false null findings (at least in what is published and except when we become aware of and mentally "correct" for the bias, thus allowing us to approximate reality or perpetuate self-delusion depending on the extent to which our pre-existing knowledge, theory, and delusions correspond to reality; of course, without a confidence interval, the size of the false null we failed to reject will remain a mystery).

I don't want to discourage you, but the only solutions that occur to me involve an educated electorate (educated in basic economics, statistics, and probability), regulators who are empowered and responsive to all stakeholders, and applied researchers whose promotion and tenure do not depend only on publication in the top 5 journals of their field and the amount of NIH grant dollars they bring in.  Now there's an interesting and unrealistic idea for an alternative universe, yes?

Read Kwak's blog please.

What We Reward Is What We Get

This is a little technical, at least at first. Econ majors might be interested in all of it, everyone else can probably skim to the last four or five paragraphs (with which many econ majors will most likely be very uncomfortable since in them I discuss normative aspects of economic phenomena).

In a blog published last August, Harvard economist, Ed Glaeser, summarized the results of his econometrically heroic effort with two colleagues to examine the causal effect of low interest rates and other measurable attributes of "relaxed" credit markets, such as higher loan to value ratios, on housing prices during the recent bubble. He concludes in both blog and paper that "credit surely mattered, but I fear that it will take many years before we truly understand how."

It's frustrating when empirical analyses derived from economic theory do not fully account for observed phenomena. A lower "price," whether because lower interest rates have reduced both the monthly payment and the total amount borrowed or because looser borrowing standards require buyers to part with less money up front in the form of a down payment, should translate into increased demand. Increased demand for houses, all else held equal, should drive up the price of houses. Glaeser's study is complicated because he finds some evidence that reduced interest rates and lower down payments probably increased housing prices, but not by enough to account for the dramatic rise in prices between 1996 and 2006. It's further complicated by the fact that after 2006, even as interest rates fell, demand for housing did not rise as theory would predict (all else held equal).

One of the challenges that Glaeser and his colleagues confront is the dearth of good data. By that I mean data that are not measured with considerable error because a data source does not accurately capture key outcomes such as loan to value ratios or approval rates. Good data for such an analysis also requires that we have more detailed information about purchasers than race, sex, and income (the last measured with more error than usual in the case of "liar loans.") In an ideal world, the data we would like to have would include purchasers' expectations of future housing prices, the rates at which they discount future states of the world (their time preference), their levels of risk aversion, and the extent to which they understood the terms and conditions of the loan agreements they signed. All of these, in addition to interest rates and down payment amount, would be expected to influence individual demand for housing.

One key issue in assessing the extent to which home prices were driven by credit market characteristics is the extent to which characteristics of "marginal" purchasers (purchasers who would not have bought a house except in response to credit market changes) changed. If changes in credit availability and interest rates induced more risk takers (aka speculators) with expectations of higher increases in future housing prices to buy houses, I would expect this to drive housing prices higher than if the market were composed mostly of the prudently risk averse. Similarly, if prudently risk averse buyers and unqualified buyers were induced to buy houses they otherwise would not have bought by obscuring or disregarding risk completely, it would also tend to drive housing prices higher. Risk aversion on the part of buyers and accurately signalled risk in markets or by loan originators are important components of well-functioning markets, especially markets for assets, like houses, where values change over time in response to market conditions.

Then there are people who would have bought houses during the boom years no matter what, not in response to changes in interest rates or loan to value ratios, but simply because they moved or had been planning to trade up or down or to buy all along. I'm not saying that these buyers' decisions are not affected by price. My point is simply that in a counterfactual world without a housing bubble, some of the buyers who bought in the bubble would also have bought in the absence of a bubble. Glaeser et al's task if they are to establish a causal effect of interest rates and LTV ratios on housing prices is to identify the effect of interest and LTV ratios on those who bought houses in response to these two variables, to identify econometrically the purchasers who in a counterfactual world of higher interest and lending standards, i.e., in the absence of low interest rates and low down payments, would not have bought houses.

Add to the data problems the possibility of "reverse causality," that higher prices induced bankers and mortgage originators to relax lending standards because they could earn more from origination and other fees and, in a worst case scenario (they thought), could foreclose on and resell an asset that had gained in value. It becomes very difficult to tease out the true causal impact of low interest and lower down payments on housing prices because they are correlated with unmeasured buyer and banker traits and behavior that also influenced demand and prices.

Can you see why it's not easy being an economist who does applied research? Not only do you get no respect from the theoreticians, you spend weeks and months trying to figure out how to get credible estimates from data that were (more often than not) never designed to provide them. But I digress.

After reading Glaeser et al's paper, I found myself impressed by the thought and the econometric techniques he and his co-authors brought to bear in an effort to to answer their seemingly simple question with much less than perfect data:

Did the proliferation of low-down-payment, low-documentation loans cause the housing bubble?

One of the best things about the economics profession (IMHO) is that we have an impressive econometric toolkit for asking simple, but often hard to answer questions of complex non-experimental data. One of the worst things about our profession is that some of us (I'm sure I'm guilty) sometimes delude ourselves that sound methods can wholly compensate for inadequate data, the cost of delusion when we're wrong being lives, jobs, and less than ideal monetary and fiscal policies. For this reason, it was with an incredible sense of suspense that I read the Glaeser et al paper, fearing that at any moment they would conclude that their econometric heroics had produced credible results. I felt immense relief when they concluded that their results were probably not reliable except to demonstrate that, using sound technique, the answer seemed to be: not very much.

Why did I feel such suspense, I asked myself? I think it was mainly that this was one of many cases where sparse data are a real liability, mainly because bubbles are fueled by sentiment, beliefs, and attitudes. The stuff psychologists measure and worry about. Animal spirits, we call them.  It's not surprising that empirical tests of economic theory break down in analyzing situations where animal spirits play important if not dominant roles. It's not that we wouldn't measure and include them if we could (we'd call them "preferences"). It's that the data sets we tend to use seldom measure such things. Behavioral economics will change this, but it will take time.

Animal spirits are in the error term of almost every econometric analysis that involves consumer behavior. In most analyses, they don't matter much. In frothy, bubbly markets, they do. Age, gender, race, and an often inaccurate measure of income are usually insufficient to capture animal spirits, the sentiments that cause you to roll the die of your life savings in hopes that you make some money when you sell the house in six months or three years.  Reliable instruments for animal spirits are often few and far between. The problem is that the kinds of animal spirits that fuel a real estate or any other kind of bubble derive not just from individual risk preferences, they also derive from a rich, inter-related tapestry of beliefs about risk and future prices that comes to characterize many if not all participants in a bubble market. My beliefs become correlated with your beliefs and we all ride to hell in a hand basket together.

But maybe Glaeser et al asked the wrong question. Maybe there's a another question that is more relevant: what other features of the economy might combine with low interest rates and low credit standards to increase the marginal home buyer's desire to take chances or to ignore risk? Specifically, what is the effect of an economy in which low and middle incomes have been stagnating for nigh onto 30 years? Surely, some of those who bought homes induced by lower barriers and prices were simply trying to grab the gold ring that has been receding from their grasp for at least a generation. Salaries may not have risen, but there was apparently money to be made by leveraging what little they had into a home that historically had provided a source of wealth for many working and middle class families.

The allure of a casino is difficult to resist when other means for achieving economic security are diminished. It seems to me there's a more important question here than "did the proliferation of low-down-payment, low-documentation loans cause the housing bubble?" What I find myself wondering is: did the failure of our politics and our economy to deliver shared universal opulence over the last 30 years create incentives for many individuals to opt for speculation and imprudent participation in housing markets, instead of pursuing the (now non-existent) gains that used to accrue to productivity, prudent risk-taking, and creative innovation? If the answer to the last question is "yes," then we can hardly fault individuals for responding rationally to prevailing incentives.

Economists may not always get things right or agree on everything, but one thing I'm pretty sure we all agree on and that we are right about is that incentives matter. If we as a country want productivity, prudent risk-taking, and creative (and productive) innovation, we had best start rewarding it.

This Land is My Land?

Peter Coy at Bloomberg provides an excellent commentary on how banks playing fast and loose with property rights strikes at the heart of capitalism (something bankers, being capitalists, would be expected not to do). Coy directs our attention to Peruvian entrepreneur, Hernando de Soto's, book The Mystery of Capitalism: Why Capitalism Triumphs in the West and Fails Everywhere Else:

While people in developed nations can borrow against their property and use the money to start businesses and accumulate wealth, [de Soto] wrote, squatters in countries like Peru have no such option. Property rights beget prosperity.

That's why the burgeoning foreclosure mess in the U.S. strikes at the nation's economic heart. Confusion is so rife that Bank of America (BAC), the biggest mortgage lender, suspended foreclosures in all 50 states to determine whether faulty documents were used to confiscate homes. Americans took their title-recording system for granted, abused it during the housing boom, and let it deteriorate. "Somehow in the last 10 or 15 years, everything that was good record-keeping isn't telling the truth anymore," says de Soto, reached by phone while traveling in Copenhagen. "My feeling is this: Your recession is going to last. And it's going to last, and it's going to last, because essentially the trust has broken down."

"Americans took their title-recording system for granted, abused it during the housing boom, and let it deteriorate????" Which "Americans" would that be? Certainly not the buyers, I'm thinking. No. This is the part beyond belief: financiers, capitalists, abused the core of our property rights system, the laws that define it, during the housing boom, let it deteriorate, and now may attempt to dismantle it (except, of course, when it works in their favor). (Update: according to the BBC, BofA will be resuming foreclosures on 102,000 homes in 23 states.)

De Soto's take is that "trust has broken down," but if you read his book, especially Chapter 5, "The Missing Lessons of US History," what you will note is that the "trust" was a byproduct of a property rights system that evolved over time to favor he (yes, "he" at least at first) who occupied and improved property. Not necessarily he who paid for or held title to such property. Moreover, it evolved during a time when the US government for a variety of reasons had decided to expand the territories that it held and therefore needed to secure the (new) property as it was acquired. In doing so, property law on the frontier became something of a free-for-all and juries of squatter peers tended not to side always with those who held legal title.

De Soto's contention is that the body of US property rights law tended over time to adapt to and accommodate fairly populist notions of land ownership. Bolstered by the Homestead Act of 1862, under which settlers could hold 160 acres of free land as long as they lived on and developed it, the United States accomplished a redistribution of property and capital from indigenous peoples to future US citizens that while bad for the indigenous peoples would be extremely good for the then agrarian United States.

What is interesting about de Soto's account of this process is that it is not a tale of rugged individualism, at least not in its entirety. In the absence of formal laws and law enforcement, early settlers formed claim associations and other voluntary organizations to protect their property rights from speculators and claim jumpers. These extralegal organizations evolved to protect informally acquired property rights. For example, a claim association would protect members if claim jumpers threatened their holdings. In addition, the members of the claim association would intimidate speculators who attempted to outbid a member claimant at a land auction. E pluribus unum, yes?

And don't go thinking that the claim associations were nothing more than a Rotary Club for early settlers. They had a well developed sense of what they viewed as justice and were willing to act as judge, jury, and executioner should the need arise to protect a member. They weren't above exploiting power for personal gain either. De Soto provides accounts of associations claiming land that was not in fact held by any member and demanding exorbitant payment from individuals attempting to claim and hold it. Monopoly rents, anyone? They also used their power to...well...speculate on land, drive prices up, drive prices down, basically gaming the "system."

Depressing isn't it? Nobody's perfect. Not government. Not corporations. Not John Q. Public. A little power corrupts them all. That's why good, enforceable and enforced laws and regulations are so necessary. Many of us have mute impartial spectators or perhaps we ourselves are deaf. But I digress.

De Soto's chapter makes the point that the US system of property rights evolved as a combination of precedent from British jurisprudence and populist pressure to accommodate what the small landholders and their various voluntary associations viewed as fair and equitable. The latter formed the basis for an evolving common law. It filled a legal void on the frontier of our new nation and most likely also sated early settlers' desires for justice. 

De Soto makes the point that these extralegal institutions supported property rights among the poorest of Americans (unless, of course, they were indigenous). This is very different from how property rights tend to evolve in, say, a feudal or semi-feudal system or in a country dominated by powerful and wealthy interest groups. It placed land (capital) in the hands of many and allowed them to keep it as long as they improved it, i.e., they produced from it. It unleashed productive power at the bottom of the economic pyramid. It almost certainly accounts for what I regard as one of the true sources of any US exceptionalism: the unfailing ambition, creativity, and productivity of its poor and its working and middle classes.

Now, those evolved property rights, rights that tended to favor those with little, may be about to be trampled by those with a lot. I'm willing to bet that, even as I type, the laws and the rights they codify are in danger of being dismantled by Congress out of fear that otherwise bankers will act like spoiled children and trash the economy and the country that made them rich and bailed them out.

The United States became great in part (IMHO) because a revolution in thought and government along with a (sometimes misguided) sense of manifest destiny put us on a path in which those at the bottom of the economic pyramid had opportunities to surpass the circumstances of their birth. Putting land (capital) into the eager hands of hard-working, occasionally extortionist miners, farmers, ranchers, and small businessmen at the bottom and middle of the social and economic pyramid is part of what has until recently given us historic levels of growth and development. 

As a product of the middle class and generations of small business owners and as someone who until recently had firm confidence in markets when they work, regulation when they don't, watching the real wealth of our nation siphoned off and destroyed in a financial casino enabled by laissez faire regulators and lawmakers has been deeply disturbing to me. That I and my own discipline may have provided rhetorical cover in the run up to the crisis also causes me pain. If the players in that casino now succeed in dismantling or weakening the US property rights system, especially those parts of it that favor homeowners and small businesses, they will have done more to destroy, not just the United States, but the Idea of the United States, than any foreign nation, communist or otherwise, ever could have done.

***************

Addendum: see here (hat tip to Raven)

The Death of Capitalism?

Those pesky banks and bankers are at it again. Yves Smith at nakedcapitalism, Mike Konczal, and others have been providing first rate, up-to-date documentation and descriptions of the mortgage morass that may tip our fragile economy into another downturn. A guest post at Barry Ritholz's blog provides the best metaphorical description I have read, one that I wish I had written. It's gotten me thinking about my own experiences with banks and mortgage lenders.

My first encounter with a bank was as a small child when I opened a "Christmas Club" account. I remember my businessman father carefully explaining to 8 year old me that Christmas Clubs were really bad ideas because they paid no interest. One had simply to exercise some self-restraint and foresight in order to accumulate money over time interest-free. He pointed out that there was the problem of where to store the accumulated funds and that for amounts to which one anticipated a need for ready access, banks were a good solution. He let me open the Christmas Club account because he thought it would be a good way for me to see that one could foresee one's future needs at Christmas and by putting a small amount away every week accumulate enough to buy presents. I think he hoped it would also encourage  generosity of spirit.

My next encounter with a bank was as a teen, when my father introduced me to the president of the bank where he did business. We were there to open a checking account for me to deposit and manage my "income" from my after-school and summer jobs and to secure my first car loan, which I would pay with the income from my after school and summer jobs. ("Dad, I need a car." I said. To which he replied: "I'll say to you, Maxine, what my father said to me when I asked him for a car: 'You can have your own car, when you can pay for it' " That's when I got a car, when I could pay for it, and a nice little used Kharmann Ghia it was.) It was at this bank that I developed the (apparently) misguided notion that the bank and I were partners. That's because this bank treated me like a partner. They didn't want to lend me more money than I could reasonably expect to pay back. They didn't want to charge me endless fees. It was a simple arrangement: they provided banking services and I prudently took advantage of them.

Credit is a mixed blessing. Like saving, it allows us to "smooth" our income, to transfer money across time periods. Saving allows us to transfer income forward to the future for which we are rewarded with interest. Credit (or borrowing) allows us to transfer income from the future to the present, but at the price of paying interest on the borrowed funds. I've written before about how I came to have my first credit card. I got off to a rocky start with it, running up a not outrageous, but painful-to-pay-off balance. The pain was sufficient and the lesson was learned and learned well. "Live within your means, Maxine," I said to myself. And so I have.

But credit is the quintessential American capitalist thing most frequently experienced directly by consumers (IMO). I remember in grad school when one year my adjusted gross income was around $6000. Bloomingdales offered me a credit card and I took it. Never used it, but I took it. I remember feeling secretly pleased and amazed that someone so poor could carry around a credit card from an upscale, overpriced retail outlet at which one could not possibly afford to shop. I think I acquired a Neiman-Marcus card the same year. I did eventually use N-M once to buy a wedding gift for someone (after I graduated).

By my last couple years of grad school I was earning enough working part-time to qualify for an FHA mortgage on a small townhouse in the city where I was working and attending school. I cobbled together some small amount for the down payment and the closing costs and I was a homeowner.

I hit one rough patch about 8 years into my 10 year residence in the house. I was non-tenure track faculty, required to fund 100% of my salary from grants. I was about to be down 50% in salary support if a grant or two didn't come through in time.  There was a real possibility that I would lose my job (or more likely drop to part-time while I looked for a new job).

Under the misguided notion that the corporation holding my mortgage was my partner (the loan had been sold several times), I thought I should probably phone them to find out what my (our) options might be. I was thinking I could make interest payments for 3-6 months and then structure some sort of "make up" payment once I was employed full-time again. It took me 3 weeks to track down a phone number for the company that owned the loan. No 800 number. Every time I was put on hold or phoned the wrong department, I paid for it. I finally got to someone who seemed responsible, laid out my situation, explained that there was a good chance I would not lose my job, that even if I did, I was a PhD economist and most likely would have a job rather quickly, that all I wanted to know was what my options might be if I did lose my job. The person on the other end of the line very kindly informed me that there were no options, that he was putting a flag on the account that if I missed one payment they should start foreclosure proceedings immediately. He thanked me for letting him know and saving them some time.

Well, there you are. Doesn't that make you feel better? I know it evoked some interesting feelings in me.

As luck would have it, a fairly large grant on which I was principal investigator came through, my job was saved and my house with it. Being no slouch at spotting losing propositions, I did two things...well, three things actually. I got married. I went on the job market and took a tenure-track position. And I (we) bought another house.

But this time, I knew what to avoid mortgage-wise. We found a local bank that holds all of the mortgages that it originates. We paid an extra half percentage point for this. Well worth it in my opinion. When I had cancer (and thanks to an extremely supportive employer) there was no worry that I would lose my job (at least not right away), but it helped immensely to know that if I had and we had to sell the house, the bank would have worked with us. And they did work with us in non-predatory ways on refinancing, home equity loans, and anything else we needed for the 10 years we owned the home.

Look. This is the heart of capitalism. I want to borrow money to own property. The bank wants to lend money for which it receives a return that reflects risk and the opportunity cost of what it lends. This is a marvelous arrangement for a lot of reasons. Not least, my ownership of said property is a near guarantee that it will be maintained and mowed, improved, and the loan paid off. The fact that all my neighbors face the same incentives to maintain and mow, improve, and pay off creates a web of interlinked well-being. As the neighborhood goes, so go we all.

No good can come from neighborhoods populated by home-owners who have devolved into squatters. Nor can any good come from neighborhoods wholly or mostly owned by banks, particularly large banks with no vested interest in the community. Moreover, capitalism, as experienced and lived by a population whose ancestors started out as squatters with "tomahawk rights," that evolved over time to homesteaders and, eventually, homeowners, is getting a very deserved bad name.

If capitalism has held a special place in the hearts of US citizens, it is almost certainly because most of the working and middle class have been able over time to acquire a little bit of heaven on earth: their own home, bought and paid for by them. Their homes are tangible evidence of their hard work, their prudence, their temperance, and their perseverance. Those homes and the loans that made them possible were also tangible evidence of the partnership between labor and capital; between homeowner and banker; between mini-capitalist and serious-capitalist.

I will say it again. They are tangible evidence of a partnership, a mutually beneficial contract between banker and home buyer. Not adversaries. Partners.

What makes this worse IMHO is that the current mortgage morass appears to be the result of capital's failure to observe and adhere to the rudiments of property rights: the proper and legal transfer and holding of a title and a promissory note; the proper and legal processing of said documents to initiate foreclosure; and a level of outright cruel and confiscatory behavior that until lately I had only associated with totalitarian governments. (If you doubt me, see here).

So this is a message to bankers and anyone else who at least putatively cares about capitalism and commercial exchange. I am probably among the most sympathetic to both and to the institutions that support them. I am losing sympathy. Nay, I have lost it. This is the stuff from which revolutions are born and you will have brought it on yourselves. The problem is that capitalism when done right yields real value, real benefits to us all. So when it dies, when you have killed it, as with all of your other financial chicanery, we will all pay the price.

Fair and Efficient Health

Physician Aaron Carroll at The Incidental Economist has been doing a good job of demonstrating that the US pays too much for the health outcomes we actually attain. And he documents that the US spends more per capita on health and as a percent of national output than any other developed country here. It turns out that even though the US spends more, our population health indicators, such as life expectancy and infant mortality, are significantly lower than similar developed countries, such as the UK, France, Japan, and Germany.  In fact, we rank lower than all but a handful of countries, such as the Czech Republic, Turkey, and Mexico. (See this Commonwealth Fund Report for a detailed recent update.)

Here's infant mortality rates, just in case you remain unconvinced that we spend more and get less than most comparable developed countries:

A related post by economist Uwe Reinhardt provides a very nice explanation of the components of health care costs and why "bending" any of them poses real problems in the current political and economic environment. Reinhardt also provides a very nice chart here showing that the overall objective in fine-tuning costs and health "output" is to produce optimal amounts of good health which in turn lead to higher levels of well-being.

My goal in this post is to highlight some features of the fine-tuning process that make it economically, ethically, and politically complicated. At the same time, I want to lay the ground work for my own conjecture that the US "system" has evolved in such a way that we are delivering too much (over-priced) care that yields very small increments in health to those who are insured and therefore able to pay for it. At the same time, we are delivering too little care to those who are uninsured and therefore unable to pay, but for whom that same amount of care or even less would deliver very large increments in health.

I'm going to start by doing something that always annoys non-economists; I'm going to assume a two-person world. In that world, one person (let's call her Person A) is healthier. By that I mean that she is born healthier and any defined amount of resources she uses to produce health result in a larger absolute gain in health for her than they would if I gave the same resources to the other person in this two-person world. By the same token, the other person (let's call him Person B) is born less healthy than A and any resources he uses result in a smaller absolute gain in health for him than they would if I gave the same amount of resources to Person A. In econ lingo, A's marginal product in producing health is higher than B's for any level of health-producing resources. I'm also going to assume that neither A nor B are over 65 and therefore out of the workforce and possibly in their twilight years (if the above graph on life expectancy is correct).  By focusing on those under 65, I sidestep the economic and ethical dilemmas that surround the disproportionate share of health care costs that are expended in the last six months of life.

Imagine for a moment that A and B are your two children and you, their benevolent parent, have to decide how to allocate your income between the kids in a way that makes you happiest and them healthiest (and let's assume for the moment that there's no health insurance so you are stuck with allocating a fixed amount between your two kids who differ in both level of and ability to produce health.)

In what follows, I'm also going to assume that there is just one continuous health producing input. I don't think this is too much of a stretch if we imagine that what produces health is a mix of inputs such as nutrition, exercise, and some amount of health care. (Even if you object to this simplification, I don't think it is necessary for the final point I wish to make.)

Here is what each child's attainable level of health could be for different levels of resources up to 100% of your resources (and assuming that you could give 100% to each of them):

 

The vertical axis depicts the possible levels of health that could be achieved. Notice how at every level of input (expressed on the horizontal axis as a percent of total resources available), Person A is always at a higher level of health than Person B. Even if you devoted all your resources to your less healthy child, you could not make him as healthy as your more healthy child. The lines curve under the assumption that as health increases, the amount of health obtained from adding another unit of input increases but by less than the amount of health that was obtained from the preceding unit of input. In econ lingo, there is diminishing marginal product of the input as health improves.

But you can't give 100% of your resources to both A and B. You have to divide them somehow. How would a benevolent parent, someone who cares deeply about both A and B, make this decision?

Let's consider three plausible allocation "rules," all of which could be justified by some appeal to fairness.

1. Maximize total health produced from the scarce resources. Allocate resources between A and B so that total health (the sum of A's health plus B's health) is maximized. This is the type of rule one might choose if one had two factories that produced the same output, but with different technologies. For this reason, it fits well into neoclassical conceptualizations of household health production.

2. Equalize Inputs: allocate resources between A and B so that each receives an equal amount of the scarce input regardless of their health. In other words, a 50/50 split.

3. Equalize output: Allocate resources between A and B so that each has the exact same level of health.

Now the problem is that if Person A gets 100% of resources then Person B gets none and vice versa. They have to share and they need to figure out a rule that is fair to each individually and that makes their benevolent parent who cares deeply and equally about both as happy as she can be.

Here's the graph of the problem and the possible solutions for two people who start with the same level of health and differ only in their abilities to produce health (derived from very general and plausible health production functions):

When resources have to be shared, A experiences lower health as more of the resource goes to B and vice versa. The horizontal axis now depicts the amount of resources going to A. The amount going to B is just 100% minus the amount on the horizontal axis.

The yellow line indicates the health maximizing solution. It maximizes the total health of this two-person society. Notice that at this point, the person who is most efficient at producing health receives most of the health producing input. This will always be true if the objective is to maximize societal health.

The blue line is the equal inputs solution. Each person receives 50% of the available resources. At this point, we don't achieve equal health because the two people differ in their abilities to produce health, but we do achieve equality of inputs.

The red line is the equal health solution. At this point, the least healthy is as healthy as they can be given that A must have equal health. However, as you can see, we have imposed a large penalty on A to achieve this result.

Some of you who have read this far are already thinking of reasons why this can't possibly adequately describe the moral dilemma of how to allocate health producing resources. To you I say, "Perhaps not,  but it's a good starting point for thinking about what is an ethically and economically complex problem because it explicitly shows the consequences of different resource allocations if you believe that we live in a world of individuals whose fates and well-being are not intertwined."

B will always prefer the equal outcomes solution, A will always prefer the health maximizing solution. If there are more A's than B's, we're likely to end up at the point closer to the yellow line than to the red line. A benevolent parent will be thinking things like: If I take too much from A, A will resent B and I need A to care for B after I'm gone. Since I need A to care for B, A needs to be as well off as possible, but the better off I can make B, the less B will impinge on A's resources. Also, I love B and I'm happier when B is better off. I have to find a middle ground. What is it?

Let's suppose that we do live in a world with more As and that our health care sector has evolved over time in a way that favors the more healthy. For example, healthier people are more likely to be employed full-time. What if we link health insurance to employment so that those who are healthier are also the ones most likely to be insured? Those who have higher incomes (and better health) will face lower prices for health care. What if the insured A's of the world face not only a lower price, but a system that pays providers for piecework so that the more care they deliver, the more money they make? But it is more lucrative to treat those with better insurance, which (since it is tied to employment) means that those they prefer to and do treat already have better health (the A's of the world). Moreover, the healthier people are, the less money providers will make, unless the healthy people face a reduced price.

Complicated and perverse incentives, yes?

I will suggest that in such a world, it is highly likely that the societal resource allocation could be to the right of the yellow line in the figure above. In other words, more will be consumed, more will be purchased by the healthiest individuals, but the (high) prices paid will yield very small increments in health for them. In addition, the health of the unhealthy will be worse than it would be if we could move to the health maximizing (yellow) point. And, last but certainly not least, total societal health in this world will be lower (since the maximum is at the yellow line and would require a redistribution of health-producing resources from the healthy to the less healthy to move left to it).

If this were the case, if our hypothetical (and heterogeneous in health) society is to the right of the health maximizing point, I would expect to see a country that spends more than other developed countries on health, but that has lower health outcomes. Just like the United States. I would expect to see economically and socially disadvantaged groups that have much worse health than they would have if they lived in a developed country that spent less on health, but allocated it more efficiently (if not more equitably).

Here's another chart from the OECD:

The curve in the above graph can be thought of as the amount of total health (measured by life expectancy) that a nation could expect to obtain from a given amount of expenditure on health. Points above the curve are highly efficient in that they are achieving higher levels of health than would be expected given their expenditures. As you can see, the US is high on expenditures and substantially below the curve, indicating a highly inefficient health production process. It's odd because it is also one of the few health "systems" with a large private sector presence. Remember that, at least in the US, the private sector is imagined always and everywhere to be more efficient than the public sector. I will leave it to you to ponder the meaning of this rather remarkable graph.

I glean several important points from this little back of the envelope two-person analysis:

1. The only technical solution is to equalize as much as possible each individual's marginal productivity with respect to health. If marginal products are equal, but health levels are different, then the 50/50 split is the same as health maximizing solution (the yellow and green lines would fall at the same point). If we could somehow equalize marginal product and level of health, then the health maximizing solution would be the same as the health equalizing solution and the 50/50 solution (the three lines would all fall at the same point). 

2. If people differ in their abilities to produce health from a given amount of inputs, then eliminating health disparities will require us to improve the health production abilities of the disadvantaged. To achieve this, public and private resources will have to be devoted to improving prenatal, neonatal, and child health, particularly among the least advantaged. Public resources will also have to be devoted to preventing and managing chronic illness and improving education among the least advantaged since education has been strongly linked (yes, causally) to better health. Remember, if there are cumulative effects to the inter-generational transmission of bad and good health these will tend to widen the gap over time and make it that much more expensive for future generations to remedy.

3. A technical solution will require long-term strategic societal investment, which is not likely to occur in our time, and is not likely to eliminate health disparities entirely even if it did. This means that a discussion of where we want to be (between red and yellow) cannot be conducted meaningfully unless we first acknowledge that there is no simple short-term technical solution. As with the hypothetical benevolent parent, we are confronted with an ethical dilemma. Science and research can inform it, but in the final analysis, we will have to decide how we as a nation wish to live. Pretending that somehow a market could resolve it will only widen the disparities over time and make the narrowing of disparities even more costly in the future.

4. The national discussion about this must involve some recognition of the interdependencies of A and B. Obvious interdependencies that would lead us to something closer to a Rawlsian blisspoint are the benefits that B derives from A's increased health and productivity. If that translates into A creating innovations, health care technologies, and tax revenues that benefit B, then B should be willing to move right of the equal health point.

5. The interdependencies work both ways. If inequalities of income and health require higher taxes to cover B's health care costs, then the As (and their grandchildren) would benefit from B and B's grandchildren's having better health. There may also be other losses associated with large or growing health disparities. If they foster mistrust and societal discord or inefficiency in health production and national output, or if they force the A's of the world to employ guards and live behind walls, thereby curtailing their liberty and safety in significant ways, then A should be willing to move closer to the red or green line.

6. If we have a value system that requires us to provide equal opportunities to pursue life, liberty and happiness, then commitment to those values would almost certainly move us left of the yellow line and right of the red line, but would probably not inform us on where exactly we should be.

It should be noted that as Reinhardt has recently pointed out, our over-arching goal is to improve well-being, not to maximize health. All of us as individuals make trade-offs and even sacrifice some health in our efforts to achieve something that approximates what we think will make us happy or that will deliver a good life for us and those we love. Indeed, some of us trade off large amounts of health for the short-term "happiness" of tobacco or excessive alcohol consumption, but I have neglected self-chosen bad health here (it clearly muddies the ethical waters). The fact that all of us are willing to sacrifice some health to obtain other things that we believe will make us happy and that some of us make bad choices are other reasons why in an interdependent society, the solution almost certainly is not at either the red line or the yellow line. However, all else equal, to the extent that we derive happiness from the happiness and health of others, we may be willing to sacrifice at least minor gains in health, especially if we are near our individual peak.

I'm pretty sure we spend more per capita than any other developed nation and get less for it because we are at a very inefficient point to the right of the yellow line in Figure 2 (at least among those of us under 65). Add to this the inefficiencies created by the undertreatment of (uninsured) unhealthy people under 65 who age into Medicare with a lifetime of poorly managed often multiple chronic diseases, which then drive up costs during the last six months of life when the marginal benefit of care is often of necessity way below its cost and you have a highly inefficient system. Exactly what we saw in the last OECD chart above.

The fact that we pay too much for all care including care for which the marginal benefit for the mostly healthy is (much, much) less than the marginal cost only exacerbates the problem. We could at a minimum move leftward back to the societal health maximizing point (yellow line) with very little loss among the already healthy insured and with large gains among those who are not healthy or insured (and who are not also elderly and near-terminal), but it would mean restructuring incentives in the private sector and it would mean curtailing use somehow among the healthy and insured. At least making the healthy insured and their providers more prudent. The latter could to some extent be fixed by restructuring incentives in the private sector. Reinhardt has already described how unlikely that is to happen unless US voters become resistant to fear mongering by health care providers and insurance companies and more adept at managing both their own and the public's health. He has also begun to explain pay-for-performance (P4P) incentives and why they may not offer an easy solution.

We have a "system" that evolved to deliver rescue care and curative care, not prevention. And it has insulated most healthy people under 65 (and nearly everyone over 65) from price. Right now, the money continues to be in expensive rescue and curative care. One good thing about the Patient Protection and Affordable Care Act of 2010 is that Medicare payment mechanisms have been altered to make it more profitable for providers to prevent illness and promote wellness. This is a Good Thing for us all, both in terms of health and in terms of future health costs. Others are that elimination of  pre-existing condition exclusions from health insurance and increased funding for federally qualified community health centers will assure that the less healthy get the care they would need to align our health indicators more closely with those of other comparable developed countries. Measures to improve quality should over time also improve efficiency.

Ironically, isolation from market forces has also tended to dampen our own estimation of  the extent to which we as private individuals could control health care costs if only we would recognize, for example, the importance of prevention and of the externalities of infectious disease (I say this while sneezing and sniffling from a cold). Why worry about prevention when a $30 dollar copay covers a $480 dollar antibiotic Rx? A colleague who consults for physician group practices tells me that last year's heightened disease control measures to reduce the spread of H1N1 flu resulted in major declines in income among his clients. Think of it this way: every time you sneeze or grab a doorknob with the hand you sneezed into, a physician or a hospital makes more money. At the same time, productivity losses rise and health status falls. Think about it. Now go wash your hands for at least 30 seconds, sneeze into your elbow, and stay home when you're sick.

Lest you think this is an argument for higher deductibles and copays, it is not. It's nice to tell stories in which a higher out of pocket price will solve everything, but it won't. Especially when prices are so badly distorted and information so asymmetric. Moreover, among the elderly and the disadvantaged, such policy changes are likely to lead to delayed care, higher morbidity and mortality, higher health costs, and widening health disparities. It would put us to the right of the yellow line, maybe further right than we already are if I'm right about this.

We would do much better, all of us, with a true, integrated system that is designed to align private incentives to make money with public objectives to have a healthier, happier populace. Such policies would also be likely to reduce the high cost of end of life care (which I have for the most part ignored in this explication) since a healthier population will have fewer high-cost complications and comorbidities that drive up costs at the end of life.  It's not unlike finance. Aligning private incentives with public objectives for improved health and well-being and lower health-related costs and expenditures would make us all better off. Since many existing private incentives run counter to this, it almost certainly will require a bigger, not a smaller, role for government. This is why I continue to believe that PPACA is an important first step in the right direction and that we, the lucky, healthy and insured, are unlikely to suffer much from the changes that result. It would be a real mistake to repeal this groundbreaking law.

The (Crippled) Invisible Hand

I once had a friend, a rather supercilious fellow (some would say "arrogant"), who tended to look down upon the simpletons he believed populated the earth. I remember that he once described a mutual friend as "so stupid she would tell you the three causes of World War II, as if there were only three." His point being that large, global conflagrations whether political or economic or both are more often than not complex, both in cause and in effect. In response to comments to my last post, I'm going to offer some thoughts on the disproportionate growth in the financial sector over the last 30 years. The memory of my friend bids me caution you that there was much more going on than what I will write about here.

I'm going to talk about self-interest and risk and I'm going to start with my favorite moral philosopher and economist, Adam Smith. Smith should be roto-rootering out of his grave, he has so oft been misquoted, misinterpreted, and mistaken for a proponent of unfettered self-interest, very narrowly defined. Moreover, his single reference to an "invisible hand" in Wealth of Nations has been abused beyond recognition, taken to mean that all self-interest will advance the public interest everywhere and always. It's true that he wrote about how prudent, temperate self-interest will tend to promote the public interest, but he also acknowledged that special interests often collude with each other or with government in ways that benefit the special interests and that harm the welfare of the public. It seems pretty clear that he regards this last also to be a consequence of self-interest.

The quote about an invisible hand that started it all is from Book IV, Chapter II, of his book, An Inquiry into the Nature and Causes of the Wealth of Nations. The chapter title is Of Restraints upon the Importation from Foreign Countries of such Goods as can be Produced at Home. I hope the irony of the title is not lost on you. Smith was describing how commercial interests and investors preferred to keep production and investment within the confines of their own country. Here's the passage that started it all:

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

I urge you to read the entire section linked to above. What you will discover is that Smith was writing about how those who deploy capital in pursuit of profits are constrained in where they deploy it by their aversion to losing said capital. Even if there had been a possibility of higher profits by deploying capital outside of their own country, the higher profits entailed higher risks back then, just as higher returns signal higher risk today. Smith describes how (at the time he was writing) returns within a country might be lower than if the same capital were invested outside the country, but this reflected a risk differential. He also noted that within a country, merchants, manufacturers and investors are likely to have better information about critical aspects of other market players, including that glue of commercial enterprise: trustworthiness.

The key feature here is that risk was more easily evaluated within one's own country than was risk incurred outside of one's country. Add to that differences in legal systems when capital left a country, which could make it harder to resolve disputes or recover capital, slower communications and travel and their impacts both on resolving disputes and in transmitting information, the greater relative ease with which information could be gained within the boundaries of one's own country and it is clear that in Smith's time keeping one's capital at home was beneficial both to oneself and, as a side effect, to one's country.

Smith's invisible hand was risk aversion.

Now fast forward to the 20th century and imagine a financial sector that has discovered that it can obscure risk. Not only can it obscure it by slicing and dicing it in ways that even they (apparently) don't understand, it has discovered ways to obscure risk, package and sell it to their clients, and then bet against those same clients that the inevitable collapse will occur. All that they have done has promoted their own self-interest. It has done little to promote the public interest or even, in some cases, their clients' interests.  And as long as taxpayers and their elected officials remain willing and able to rescue imprudent, intermperate investment bankers or as long as those same bankers believe that taxpayers will do so, there is no brake, no "invisible hand" of risk aversion that will prevent recurrences of the same bad, high-risk behavior.

If fear of losing money is the brake on bad behavior, then risk needs to be preserved and communicated very accurately. Risk should not be eliminated by government policies such as no-strings-attached bailouts. An effective invisible hand requires that agents and principals anticipate real financial loss.

I will  say it again: Smith's invisible hand as used in Wealth of Nations was risk aversion. Not unfettered self-interest aimed at making more money than anyone else in the world. The invisible hand was a constraint on avarice.

The problem is that for the last 30 years we have heard that unfettered self-interest alone was sufficient to assure properly functioning markets, financial and otherwise. That premise was instrumental in dismantling regulation that would have acted as brake on short-term, short-sighted, self-serving self-interest that does not serve the public interest. The result has been a series of bubbles and financial collapses, including a savings and loan crisis, the failure of a major hedge fund (Long Term Capital Management), a tech/dot.com bubble, and now a housing bubble.

I want to make it clear. A crippled risk-averse invisible hand is not the only reason for the concentration of wealth and power in the financial sector, but it is one of the reasons and an important one. That's why a no-strings, no-pain bailout of the same wonderful guys who gave us the most recent crisis was such a mistake. It amputates the invisible hand of risk aversion. With no down side, they're pretty much free to deliver more of the same. The only solution to this particular aspect of finance is wiser, more risk averse investors; wiser, more risk averse shareholders; and wiser, more risk averse managment. This almost certainly means that if even an arthritic invisible hand is to work there must be higher personal and business risks (as in bankruptcy) for the captains of industry and finance and those who aid and abet them in deceiving investors and the public.

And we need regulation, especially regulation that fosters risk aversion or creates it when markets do not. The irony is that effective regulation would actually reduce risk and allow prudent, temperate investors to be more confident that they were not being duped into a Ponzi scheme or into financial instruments that the seller is at the same time betting against. There would be fewer flights to safety, fewer high demands for liquidity, and more financial stability for the rest of us.

We live in a strange world. A world where the avarice of mythical "welfare queens" is accepted blindly and without question and ornate public policies are formulated to guard against it, but the demonstrated avarice (or incompetence if you really believe they didn't understand what they were doing) of real investment bankers, avarice that has done far more harm to all of us, produces public policies, public sentiments, and public rhetoric (at least among some) that encourage more of the same.

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For a much better explication of the misinterpretation of Smith's invisible hand, including his use of the phrase in other contexts (and in other books), please visit Professor Gavin Kennedy's blog, Adam Smith's Lost Legacy.

Thanks to Louis for suggesting a serif font. I had been thinking the same thing for some time. Thanks to Eric for suggesting a larger serif font. :-)