Archive for the ‘Economics’ Category

On “Reviews, Reputation, and Revenue: The Case of”

Tuesday, October 4th, 2011

I, perhaps famously, introduced my parents to Yelp this summer on the way back from our annual North Carolina beach trip by suggesting we have lunch at The Ten Top in Norfolk, VA before heading to the airport to return home. The review instructing me to get the Turkey Apple Club on cinnamon bread and suggesting that the pasta salad was especially good sold me enough to sell my parents. It worked out wonderfully, and is actually my favorite part of the whole trip. That may be because I was raised on going out to eat, and it was one of two restaurants featured on the trip, and certainly it was the better one. A fond memory thanks to strangers on the internet, organized by Yelp.

I use Yelp frequently. In my Wednesday Night Dinner group, where we try a new restaurant most every week, picking a restaurant and sending it out to the group often is done via a one line email with a yelp URL and a time. I don’t know why we still include the time, its always 7:30; the only important information in the email is the Yelp URL. Every member has their own method of picking places, some uses sources other than yelp, as do I. I often use local reviews like this one for last week’s delicious pick, L’Impasto, but I always check the Yelp reviews as well. In fact, the reviews for L’Impasto were so good, and so few in number that I considered the possibility that they were fake. If they were fake, they were at least correct in this case.

Yelp might review Hotels, they do review places that are not restaurants, but I certainly have never looked at those reviews other than as indication that I didn’t hit the restaurants filter button yet. Although, certainly restaurant menu prices are a lot more sticky than nightly hotel rates, there is no reason this tactic could not be attempted with restaurants. The real question raised by this comic, however, is if the erroneous signal sent by enough people operating in dick mode could be enough to cause the place to close, negating the benefit received by the dicks. There isn’t an answer to that yet, but I came across an academic paper today where “in ongoing work, [the author is] estimating the relationship between Yelp and exit decisions” of restaurants. Such information is crucial to answer the question of if the dicks are going to end up screwing themselves.

“Reviews, Reputation, and Revenue: The Case of” by Michael Luca of Harvard Bushiness School, actually finds that there is a correlation between the average Yelp review and restaurant revenue from 2003 to 2009 in Seattle. Actually, “A one-star increase [on Yelp] is associated with a 5.4% increase in revenue.” Yelp was introduced in 2005, so his data set can provide details about the impact of Yelp as it grew to become the dominant resource that it is today. He uses a couple randomization techniques allowed by the way the data is collected and presented to control for correlations between average Yelp review and other factors that may increase restaurant revenues, like having better food, to bolster his argument to the level of causation. The statistics are over my head, but it the theory seems solid, and certainly a lot of his assumptions ring true to my use of Yelp.

The paper brings up another interesting point that rings especially true. It finds that while overall, Yelp reviews correlate with revenues, that “chains already have relatively little uncertainty about quality, their demand does not respond to consumer reviews.” That is, reviews don’t matter for chains, maybe people don’t even read them. I said I was raised going out to eat. I was a picky eater and only child so going somewhere I would not fight about was probably my parent’s primary concern. That means that I was raised eating at chain restaurants, most notably Olive Garden. I believe that from when I turned five until I went to college I was at an Olive Garden at least once a month. If you include college, it might have to grow to once every three months. I still love Olive Garden thanks to all that conditioning, and when I go home to Ohio, I think I eat there within the first 36 hours, without fail. I have not once read a yelp review about the Olive Garden.

My dinner group essentially bans chain restaurants, with a couple of minor exceptions. That is likely one of a number of cultural reasons why, since moving to Boston, I’ve broken my Olive Garden streak. However, apart of my pilgrimage to Olive Garden upon setting foot in the state of Ohio, I seek out independent restaurants there as well. The paper also finds this is a trend much larger than my group. Specifically “chains experienced a decline in revenue relative to independent restaurants in the post-Yelp period.” Since ratings don’t matter for chain restaurants, but they do provide useful information on independent restaurants, there is a pretty good rational “that increased information about independent restaurants leads to a higher expected utility conditional on going to an independent, restaurant. Hence Yelp should … increase the value of going to an independent restaurant relative to a chain.”

With the power that Yelp has amassed of the past 6 years, comes skepticism, the specter of fake reviews, which I feared, and also the specter of intentionally false reviews as evidenced by xkcd. There is still another aspect of power that people take issue with, corruption or extortion of independent restaurants. Clearly, with the power to increase revenues drastically with a small shift in rating, there is an opportunity for yelp to offer to artificially increase rating at a cost to the restaurant, or extort from them with a threat of a lower rating. Enter this Davis Square Livejournal post:

I went to Paddock Pizza in Somerville on Sunday (not usually open Sundays, but there was an event) and I loved the pizza (plain). When I told one of the owners, she said she enjoyed it, too, but the first pizza chef, no longer there, got some bad reviews on Yelp and asked if I might be willing to put in a good one. I would in theory, but I’m not always much with the food review writing. Since I like their pizza and want them to stick around and keep serving it, I am willing to take someone who likes writing such things. (Their pizza is also pretty inexpensive, more so from 4 to 6pm (early bird specials), though they are only open Wed-Sat, 4-10pm). Message me if you are interested and are flexible-ish time-wise.

The text presented has been edited since my original reading. It originally included a line about “detesting” yelp, which was responded to in the comments, and caused a thread about Yelp’s abuse of its power, or at least perceptions of abuse, as no actual abuse has been proven. Here we have a restaurant which is aware of the power of Yelp to affect their bottom line, asking a patron who has expressed a positive experience to help them increase their rating. It seems the restaurant is acting fair in this transaction, they aren’t faking a review, they are merely attempting to turn a positive dining experience they provided into a positive review. Unfortunately for them, their pizza loving patron is not a writer it seems and is unwilling to jump through the hoops to become one because of perceived, unnamed abuses by Yelp. However, the crux of the post is that he is looking to hire someone to write a good review for this place for the price of dinner, presumably half a pizza. That must be some damn good pizza, maybe I should go check the Yelp reviews though. Every review since 2008, when the first review appeared has been >= 3 stars, arriving at a current rating of 3.5/5 stars. True, recent rating seem higher, but haven’t caused a upward trend in the overall rating yet. Verdict? Well no one has picked anywhere for Wednesday yet.

Dear Comcast

Monday, November 29th, 2010

I do not care if the entire city of Boston, New England, East Coast of the US, the entire country, or the entire world is having internet connectivity problems! When I call you because my service is not working I expect to either:

  • Talk to a person, to whom I can explain my service problem and receive help or direction
  • Be able to loge a service out notice with a computer
  • Be told of known service problem in my area and be provided with a estimated time of service restoration

Any of those is acceptable. Just to be clear and ensure that I am not being unreasonable in my request, when my power goes out, my power company offers all 3 of those options depending on the circumstances. Now, the ETA I am told by the power company is not always correct. However, it is updated from time to time, and they will call me back if and when they update the ETA. Also, they call me back after they expect the power has been restored to confirm that my reported outage has been resolved. That is how a service outage should be handled, if you ask me. Excellent job government sponsored monopoly, nStar.

Being told to go online for help when the internet is not working is not acceptable! At the very least your system should detect that there is an internet problem and not play that recording. With the power company, most of those options are handled automatically by a computer, which is fine. No one expects a service provided to have enough people answering calls to deal with the flood of complaints during a service outage. However, we should be informed of the problem, when we call; not disconnected because too many people are calling. If I have to turn to twitter to find out that this is a larger problem and not just me, as well as find the solution (use google’s dns servers), then you as a service provider have failed miserably. I don’t know why I expected that you would not fail in this case, you fail every day all of the time. I really don’t understand why the government monopoly power company provides an entirely different level of customer service than you; you technically do at least have some minor form of competition.

Cotton, the WTO, and You Tube

Friday, November 19th, 2010

I want to share 3 links I uncovered over the past 6 months, 2 of them this week, one thanks to Kara, about the World Trade Organization, how it works, and what Google wants to do with it.

First, an NPR Planet Money podcast about Cotton. The Planet Money team is trying to buy cotton from a cotton farmer, and they get caught up a whirlwind of intentional politics, economics, and enforcement.

Second, if you think cotton is the only industry where this has happens, this re-cap peice from Arstechnica last March sets the record straight about the myriad of WTO claims against the US, which we have ignored or paid off.

Some commentary before we move on. Farm subsidy are awful, economically, you shouldn’t need me to explain that. So we should comply with the WTO decision on cotton. The Antigua ruling about on-line gambling is likewise an easy choice, we should repeal the law and come into compliance. On-line gambling remains legal in Nevada even under the current law, and horse racing exemption make the current policy inconsistent at best. Cuban sanctions should have been lifted long ago, along with all their associated cruft. Now, the music issue, its strange. I think its the Europeans who are wrong on this count, but our radio payment system also needs an overhaul for other reasons. But the real reason why we want a better record for complying with the WTO is because of China, Turkey, and Pakistan.

All of those countries engage in internet censorship. Specifically they have blocked in the past. This Arstechnica piece describes how Google, owner of You Tube, sees that as a very specific trade embargo. If I were the WTO, and based on the Antigua case I would accept that argument and rule against those countries for censorship as it ruled against us. That, if the WTO rulings were enforceable, would be a really great way to force China and the Islamic world to stop censorship, something that sweet talking about human rights has not accomplished in the least.

It all comes down to the Rodrik Hypothesis, which I increasingly see reason to beleive may be accurate. It states roughly that:

Economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance.

In this case, as with most that I am prone to like, we are going the globalization + democray route by getting rid of the nation-state. Making the WTO rules enforceable over the sovereignty of the nation-state has the essential action of eliminating what makes a nation-state a nation-state.

Renwable Biofules Law in MA

Saturday, February 20th, 2010

A couple of weeks ago my Dad sent me an interesting article via e-mail about a law that we will apparently get to vote on in Massachusetts. It caused me to do a lot of thinking about if the law is good or not, and who would be in favor of such a law. Here’s the article, I can not find it on the net to attribute it:

Massachusetts Evaluates Carbon Neutrality of Biomass

WASHINGTON – The carbon-neutrality of biomass is up for debate in Massachusetts at both the regulatory and legislative level, with a study, ballot initiative and legislation in the spotlight. For [company] and the forest products industry, it is critical for biomass to be considered carbon-neutral because our facilities use an average of 60 percent biomass to power our operations. [company] is a leader by using 73 percent biomass to run our U.S. mills, and we support the science that when biomass, such as wood, is combusted for energy, it releases back into the atmosphere carbon dioxide that it absorbed from the atmosphere during growth. When harvested biomass is replanted, the cycle repeats. In contrast, fossil fuel is not carbon neutral. The combustion of natural gas, coal and petroleum fuels results in a net increase of carbon dioxide in the atmosphere since this carbon dioxide was never originally absorbed from the atmosphere and there is no balancing cycle to remove it. Failure to recognize the carbon neutrality of biomass could lead to unintended negative consequences such as increasing fossil fuel use and greenhouse gas emissions, reducing forest land, creating substantial uncertainty and deterring growth of renewable energy, as well as driving jobs away from the U.S. and toward jurisdictions that recognize biomass carbon neutrality.

Biomass Study
The Massachusetts Division of Energy Resources (DOER) has begun a six-month study to examine the carbon neutrality of biomass and biomass sustainability. The Commonwealth has suspended consideration of all applications for biomass facilities under the state’s Renewable Portfolio Standard pending the outcome of the study. It is expected that the study results will be used to inform new regulations addressing biomass facilities and may be precedent-setting elsewhere. The American Forest & Paper Association (AF&PA) attended the public meeting on the study last month and submitted written comments. [company] and AF&PA will continue to be engaged moving forward.

Ballot Initiative
The “Stop Spewing Carbon Campaign” has gathered the required amount of signatures necessary to move forward with a proposed ballot law that would require biomass energy sources to emit no more than 250 pounds of carbon dioxide per megawatt hour to be considered renewable. The proposal would not take offsets into account and would rely solely on smokestack emissions. The initiative, which must be approved by the legislature by the first Wednesday in May, is expected to appear on the November 2010 ballot. AF&PA is working with other organizations that are also opposed to the initiative to discuss formation of a formal opposition campaign.

Related Legislation
Legislation that would prohibit the burning of construction and demolition waste and treated wood in biomass facilities has been pending in the Massachusetts legislature for approximately one year and had previously received minimal attention. After the political and media attention given to the study and ballot initiative, interest in the legislation grew. At a December hearing, a number of environmental groups testified and expanded the conversation to biomass facilities in general. AF&PA is closely monitoring the bill to ensure it is not expanded to an outright ban

These are my Dad’s comments that accompanied the article:

It is an interesting political debate, but I would think the science is well known. I would think that if you burn it, you make CO2. Of course, the paper itself ties up carbon, as long as it is not eventually burned. Fossil fuels are just as carbon neutral as wood – They just took a lot
longer to “repeat” the cycle.

In any event, in Massachusetts, they will actually ask the voters to decide…. Weird !!

Here is my analytical response about the nature of the law and possible laws in this area:

Certainly, in the long run, the amount of carbon and oxygen on the planet remains the same with the exception of fusion, fission, meteors, and material carried by the solar wind. In this sense, we are always carbon neutral. This is the same sense by which it is easy to say fossil fuels are as carbon neutral as wood because they are produced via a cycle.

Now, the carbon neutral everyone else is talking about has to do with where the carbon is stored and in what molecules. Specifically the ratio of C02 (and CH4) in the atmosphere to the carbon stored in biomass, fossil fuels, and other stored resources. In this arena carbon neutrality is all about rates. The rate at which we release carbon from stored resources into the air, and the rate at which stored resources take up carbon from the air.

Fossil fuels take carbon from the air at an incredibly slow rate. First requiring that animals or plants bleed it from the air and then requiring they decompose for a long time. It is because of this slow rate that almost any fossil fuel burning is considered non-neutral. Trees, of course, take up carbon from the air at some, much larger rate, and so stand a much easier chance of being carbon neutral. It appears that ballot initiatives is targeting this exact sort of definition of carbon neutral. Specifically it requires “biomass energy sources to emit no more than 250 pounds of carbon dioxide per megawatt hour to be considered renewable.” This defines a rate at which carbon may be burned for it to be considered renewable. It is a convoluted rate calculation, one that is not expressed in units comparable to carbon intake by trees per unit, but one that fundamentally can be converted and compared.

There does exist a scientific question, the answer to which is also the answer to whether or not this is a good law. That question is, at what rate does biomass pull carbon from the atmosphere, and is that higher or lower than the purposed rate in the law? The law should stipulate a burning limit rate that is exactly equal to the rate at which biomass removes carbon from the atmosphere. To set a rate too high or too low would injure some party without cause. This rate may very based on the type or source of the biomass, perhaps widely, perhaps not. If it varies wildly by type then the law should take different sources and their rates into account, breaking out burning limits by source type. Such a law would correctly include the fundamental scientific nature of atmospheric carbon neutrality, which seems like a reasonable thing to do. Its already a scientific law anyways.

Of course, if the burn limit lower than what [company] burns, then [company] will have to substitute another energy source to make up the difference or it can pay the fines that I’m sure will be the penalty in the law. This is an economic choice, but not one that should be avoided. It would be up to [company] and its competitors to individually choose alternatives that minimized cost. Now, if the proper carbon externality cost is not applied to all sources of carbon, this can create perverse incentives that actually increase pollution. That is why all non-neutral carbon should be taxed at the same rate. Externality taxes (and their functional equivalents) to counteract pollution must treat all sources of pollution in the same way in order to avoid costly perverse incentives.

The fines this law would impose on non-neutral biomass combustion constitute a tax and would need to be set at the same levels as equivalent carbon taxes on other carbon sources. Therefore, this is also a requirement that must be satisfied for this to be a good law. Given that fossil fuels are not carbon taxed in Massachusetts it seems unlikely that this law will meet this standard, unless they also pass fossil fuel carbon tax equivalents at the same time.

As to the paper containing carbon, it is the person who choses to burn it that should pay the tax on the carbon produced by doing so. As stated, the only neutrality we care about is in the atmosphere vs. not. [company] putting carbon in paper should not result in a tax payment. It should result in a carbon tax credit if that carbon (the whole process in general) were to, in some way, result in a net drop of carbon from the atmosphere.

If fact, if one were to credit trees owned by a person for reducing carbon, and tax all carbon put into the atmosphere it should be equivalent to the properly calibrated law that induces taxes only above
the limit at which burning becomes non-neutral. That is, it is equivalent to the government in terms of net tax collected. It may change who pays the tax and who gets the credit. But [company], owning lots of trees, would surly fair the similarly under both systems.

However, I failed to understand until my father responded that his company would be in favor of the law. I had clearly assumed above that they were opposed due to the taxes they may incur if they burned too much. Here is his response:

I would go with your definition, but suspect that is not the one that will be used.

I’m not sure what it takes for “biomass energy sources to emit no more than 250 pounds of carbon dioxide per megawatt hour to be considered renewable” but it takes at least 15 years to grow a tree, and only a few minutes to burn it, so I cannot see how that can be carbon-neutral.

Certainly [company] would benefit greatly from defining biomass as carbon-neutral. We currently generate over 75% of our energy from biomass. I’m sure we could easily move that to 100%. If the price were right, we could exceed 100% [& sell power to the grid]. The problem I have with this is the definition of biomass as carbon-neutral. Burning wood &/or other biomass &/or ethanol or other petro-like products created from biomass actually contribute to exactly the same problem. We need to find cleaner solutions.

I had failed to understand the scope of the badness of the law. I had assumed above that the units did actually work out properly. This time I set out to discover if that was indeed the case:

Lets look at the “biomass energy sources to emit no more than 250 pounds of carbon dioxide per megawatt hour to be considered renewable” part. Lets consider only one adult tree of mass 850kg (when burned) that will be burned under this regime, and we want the burning to result in zero net co2 creation after considering the absorbed co2 during the life of the tree.

250 lb co2/megawatt hour = 0.315×10-7 kg co2/Joule

( wood provides 15 GJ/1000kg = 15×10^6J/kg wood (ignoring energy spent in drying, lets say solar does this for us)

Combining we get: .4724920521 kg co2/kg wood

therefore any wood that we burn will have to produce co2 at a rate equal to or less than that per kg to be renewable. Now, how long will it take a tree to absorb that much co2 per kilogram.

a tree absorbs co2 at a rate of 48lb co2/year ( which is 6.899×10-7 kg/s

it will therefore take a tree 684870 seconds (190.2 hours, 7.9 days) to absorb the co2 that is released by burning 1 kg of it. Therefore out 850kg tree would need to live for 6737.7 days (or about 18.459 years) before it was burned in order for burning it to be renewable.

A more complex calculation can clearly be done involving a varying rate of co2 absorption based on growth, and more exact figures for specific kinds of trees. This type of calculation could produce a graph showing when it would be renewable to burn the tree.

Anyways, that is how the rate comparison pans out I think. I expected that [company] would be opposed to this law. Since they use so much biomass to generate so much power it would be quite bad for them if it turned out that they burned at a non-renewable rate, as defined by the 250 lb co2/megawatt hour.

But yes, I think I see your point. As shown by that rate calculation above this 250 number implies a certain amount of time that our tree needed to be alive, in order for it to be neutral. The law as described imposes no such restrictions on the age of the tree burned, and therefore it has zero bearing on if the burning that takes place is actually neutral or not.

I now understand why [company] would favor this law. When I first responded I assumed [company] would not favor the law, because as we both agree, the burning that they do could easily be non-neural in reality, and clearly I fixated on encoding reality in to law. This law, as described, since it does not include a time factor, violates an assumption I made in my 4th paragraph above. I had assumed that the rates were comparable, equivalent in units, but they are not.

So, fundamentally flawed law has no basis in reality really. Except that as my dad says ~15 years is about how long they usually let the trees grow for other reasons and so as he says:

That is actually a lot closer to carbon-neutral than I had imagined it would be. I wonder who figured out the 250 lb co2 / megawatt hour limit? Maybe they knew something.

Econ Quiz

Wednesday, May 6th, 2009

This was on Greg Mankiw’s Blog a while back, but I just got around to taking it. It’s a little flash based econ AP testlet, consisting of 18 questions. With no preprtion of any kind I managed to get 13 of 18 correct. And, darn it if I wan’t so close on two more.

Paul Romer Agrees with Me

Wednesday, February 18th, 2009

I’ve been catching up on some back issues, well I suppose they are posts, on Greg Mankiw’s blog. I ran across a link to this, Let’s Start Brand New Banks. It sounds pretty familiar to me. Although, it works from evidence instead of first principles, but I still feel justified. If only they would follow our advice.

Economic Something or Other

Wednesday, November 26th, 2008

I read an article today that made me feel much better about what the Federal Reserve is currently doing to help the economy. In short they are doing two things:

  • Dropping loads of money into the economy to fight deflation.
  • Lending directly to non-bank entities

As some of you may recall this second point is something I suggested in my No Bailout post. The lending programs the article briefly mentions are exactly what the Fed should be doing right now. They are well within the Fed’s role as the lender of last resort. The Fed’s job, when facing deflation (a problem economists don’t really know how to solve directly) is to increase the money supply so drastically as to create inflation (a problem economists solve on a regular basis). Since the usual means of increasing the money supply, lending to banks, isn’t working because the banks aren’t lending, its perfectly reasonable to lend directly to others.

The other news this week is that Citibank accepted a bailout from the treasury. This is particularly unfortunate for me as I am both still against the bailout, as enacted, on principle and I am a Citibank customer at some level. I think the treasury’s approach to the bailout is all wrong. The only point of the bailout should be to get us, as an economy, through the shortage of credit until new credit suppliers can enter the market (which requires high interest rates). The goal should be to allow creative destruction of badly managed credit suppliers and only prop up the one or two best managed (as determined by least likely to go bankrupt), and we do that only because we need some credit in the mean time. It seems that the treasury’s idea is to prop up everyone. It may, hopefully as a customer, be the case that Citi is one of the two that should be propped up, but clearly AIG is not. AIG failed early (and often) clearly indicating it should be let die; even now, there still is no reason to throw good money in after bad.

The other bailout, the auto bailout, I’m totally against that as well. The situation with the auto companies is not at all like the banks. First and foremost there is a shortage in the credit market and a surplus in the auto market. The other big difference is that not all car companies are going to fail. The large foreign companies, Honda and Toyota show no signs of failure. This means that the public interest in having companies producing new cars will be served regardless of how the big three American companies do. I argue that there is not a public interest in American car companies existing compared to car companies in general, as that would imply a nationalist impulse that has no place in a worldwide capitalistic system. Since the public interest is served by spending zero public dollars, there is no reason to spend public dollars.

Many argue there is a public interest in protecting jobs, that is true, but misspoken. There is a public interest in having jobs. Protecting existing jobs is a bad idea; it decreases the rate of increase of the standard of living. If GM were to fail, all of a sudden there would be opportunity to start a car company in America and stand a chance a new entreat. Also, the other companies remaining in the market would be less likely to fail. If we were not in a credit shortage people would line up to replace GM with their own ideas. These new companies would still need parts suppliers, and dealerships and all the rest of the infrastructure. This will take time, years for sure, but its not like there won’t be others to produce cars and consume parts in the meantime.

Given the credit shortage it is hard to start a new business right now. That means markets can not properly respond to the long term pressures that they face. That is the problem we must solve, and are working to solve. We need to solve the credit shortage in order to allow new players to enter markets, then the market will resolve any problems in the auto or other industries.

This Newsweek story provides examples of past American industries that have undergone creative destruction. Despite coming at the topic from a more pragmatic, less theory and market driven it echos my main idea regarding the automakers.

No Bailout

Wednesday, September 24th, 2008

I am not in support of a bailout of any kind. I also live in an ivory tower when it comes to economics, and a short, unexperienced or well taught one at that. I am confused somewhat by the push for a bailout. Why am I confused? Well, on the one hand, I can see where the people who are going to get free money want it, and I can even see how the republicans, who generally are against free money for people, are ready and willing to give free money to banks. I understand that Bush is once again saying, “my way or the highway.” Why wouldn’t he? it has worked every other time he’s done that. That stuff is not confusing.

What is confusing is the economic reasoning for a bailout. The entire point of capitalism is that it is the best known method for increasing the standard of living of a society. It does this by selecting ideas that are winners and ideas that are losers by rewarding people who have good ideas, and making people who try to long on bad ideas go broke. Of course, one would hope people with bad ideas get the picture before they go broke, but sometimes they don’t. This idea is called Creative Destruction. I just recently finished Alan Greenspan‘s book, The Age of Turbulence, which stated the importance of this in no uncertain terms. It also stated that as you increase socialism and other safety nets to insulate people from risk, creative destruction occurs less often and the ability of the capitalist system to increase the standard of living decreases.

All that is happening here is creative destruction. Some firms, are going to go out of business. They are going to go out of business because they had some bad ideas and they ran to far with them. There is nothing wrong with these firms going under. They actually increase the standard of living in the long run by going away. Of course, not all firms will fail completely, some will merge and what not, and be able to survive. This is because they did not run as far with or have as bad of an idea as the ones who did fail. They will, however, suffer pain, as a result of the bad risks they took. Everyone who took bad risks will suffer pain, and as a result people will not take these same bad risks again. That’s how its all supposed to work. That’s clearly an ivory tower way of thinking.

But what about the credit market? When firms go out of business it is usually because there is a glut of supply, too many firms are in the market, producing too many goods. This was in fact the problem a year or two ago (or more). There were too many people willing to lend money and not enough people to which to lend money. To solve this they expanded the pool of people they to whom they were willing to lend. Clearly that was a bad idea, and the market is telling everyone who did this that it was a really bad idea, and it is telling them this in a big way. It seems obvious now that it was a bad idea, but we only know that because of the market.

The problem now is that there isn’t enough credit. People can’t get loans. There is a lack of supply, because in effect all the firms who took bad risks can’t loan money, so they are no longer in the market. The call for a bailout is grounded in the idea that we need these firms to re-enter the market so that supply will increase, and people will be able to get loans. I agree that we need more firms in the credit market, or at least that we need to increase the supply of credit. But why do we need these firms? Firms are in the end just people. These people have proven themselves unfit to be in a credit market; that is they have bad ideas about how to make money in the credit market. We should not help them to re-enter a market that they so clearly have failed at.

But how do we increase the supply of credit without them? There is no reason why new firms won’t stream in to the credit market now that there is a shortage. These new firms will need promises to their investors that they won’t repeat the mistakes that were made. They will need to not take as many risks. Investors, who are reeling from taking too much risk will flock to these new firms. This will provide them with the capitol they need to provide the loans, for which people are apparently clamoring. These new firms will flourish with their new ideas, and the old firms will die; creative destruction. As I said before, die is a simplification, some old firms may survive by doing the same thing the new firms are doing. However, if they can’t survive that way, we should not help them, just let a new firm take their place. This whole thing will take time, I don’t know much, but I bet that we can have new firms in the credit market in 2-3 quarters.

What do we do for the next 2-3 quarters? Well, it won’t be easy. There is a shortage of credit, and so people who need credit will have to stand in long lines, and accept higher interest rates (pay more for it).

Who will they borrow money from? Anyone who will lend money of course, be it small banks who see a profitable new opportunity to expand their business, or the vestiges of the old firms still limping along. There is also the federal reserve of course, they are the lender of last resort. They always have money to lend (that’s the point). In the past, large banks have been their customers, but there is no reason why they can’t make loans, at appropriate rates, to smaller customers, or anyone really. Lastly, don’t forget overseas investors.

The only real problem is that there needs to be capitol, money to lend. There is an easy way to generate capitol; raise interest rates until people who do have money are willing to lend it. There should be no free money from the government. There is no reason to think that the only people who have money are the government. There is plenty of money in the country, and even more in the world. If we want people to loan it to us so we can buy houses, we need to provide them with an attractive interest rate. When we do that we’ll get the money, and we can loan it out, to anyone who wants the money badly enough to pay for it. As time wears on the risk premium that is currently going to be required will diminish and things will return to normal. Change leads to normalcy. We need to change the big names in banking, if we just sit tight, this will happen for us. If we meddle, we’ll loose in the long run.

What might really happen? From what I’ve read, which is only a little, they are considering a type of reverse auction where the banks will all place bids. What they are actually bidding in is too complex for me right now, but the way it works out is that the banks who are better off will be able to off the government a lower bid. The lowest bid wins, and every bidder may make trades to the government at that rate. Anyone who can afford that rate, who can avoid bankruptcy by trading some amount at that rate will survive, and those who can’t still go out of business. As you can tell, Bush did not come up with this plan, which is being called his. This plan is reasonable, in that those who took the worst risks still get creatively destroyed. It lesses the short term pain, and the cost of some, intangible amount of long term prosperity. The risk to reward trade off is probably there in this plan, especially since who knows how much prosperity, how far in the future we’re talking about.

So am I for the plan? Well, I still think we should do nothing, but what they plan to do is not brain dead. What the democrats are pushing for, more regulation would be bad. It all sounds good, but markets don’t like regulation. I don’t much care how much CEO’s get paid. As the paper pointed out to day, they are losing a lot of money right now, if you count stock. If you put a cap on how much you can pay them you could end up with a shortage of qualified CEOs. One may argue we already have that, in which case we clearly need to pay more to get the actual good ones, not less. What we really need is a populace who is educated enough to participate in the credit market on both the lender and borrower sides. Until we have that, the only sensible regulation, increased transparency, is worthless. This is roughly the same remorseless conclusion that I came to in my last econ rambling. What I want to see then, are some educational riders on this bill. Assuming the risks the taxpayers are taking on comes up good and we win big. Lets require all that money we made go to education.

Maybe someday soon I’ll have time to see what Greg Mankiew thinks of all this, but I’ve been too busy at work to keep abreast of his position.

Newspaper Columnist’s Financial Knowlege Falls Short

Friday, April 11th, 2008

An unnamed associated press writer based in Washington made an ass of him or herself this week while writing an article titled “Young people’s financial knowledge falls short”. This article reports on results from a “nationwide survey released Wednesday by the Federal Reserve” in which High School students performed poorly when asked to answer finance questions. I have no doubt that this is a real problem and serious deficiency. I do not mean to marginalize it, but clearly, the author needs to brush up on his knowledge just like the High School students. The article cites the causes of the impending/occurring recession as cause for concern at the poor showing. Then it goes on to summarize the current economic situation, for the uninformed reader with this gem of a paragraph:

When the housing market collapsed, home values fell and interest rates rose. That especially clobbered people with tarnished credit or low incomes holding more risky “subprime” mortgages. As these homeowners found it increasingly difficult or possible to make their monthly mortgage payments, home foreclosures took off, some lenders went out of business and financial institutions suffered multibillion losses as mortgage-backed investments soured.

First we have “increasingly difficult or possible” clearly those are synonyms </sarcasm>. I know I get stuff like that wrong all the time, but the author is a professional in the field of writing and should be held to a higher standard. Now, lets look at how things actually happened:

  1. “People with tarnished credit or low incomes holding more risky ‘subprime’ mortgages” saw their interest rates rise as their mortgage contract specified would occur years in advance.
  2. “These homeowners found it increasingly difficult or impossible to make their monthly mortgage payments” due to poor planning or other excuses. It’s not like it blindsided them; they knew their rates would increase. Subsequently many defaulted on their mortgages pushing their homes into foreclosure.
  3. This repeated a few times as each month’s worth of subprime loans lapsed beyond its below market initial interest rate and into an appropriate interest rate for the risk. This contracted and expected increase is what I take the author means by “interest rates rose.”
  4. As this process repeated, more and more people default and are pushed into foreclosures, which have begun to glut the market for homes driving down prices as excess supply is prone to do.
  5. With rising foreclosure rates banks begin to see the follies of their ways, stop offering subprime loans and raise rates on normal loans to cover the money they are losing when people default. This is the so called credit crunch. “Financial institutions suffered multibillion losses as mortgage-backed investments” dropped in price reflecting the actual amount of risk they represent. (Risky investments cost less.)
  6. Only now, that foreclosures have sored and all interest rates have risen does the housing market actually collapsed. This is the start of the feed back cycle where home values have become less than the amount left in mortgage payments, leading to defaults and foreclosures leading to lower home values.
  7. Following the collapse the Federal Reserve has stepped in a lowered interest rates significantly to stabilize the market. This is the traditional method by which interest rates fall.

So lets examine: rising interest rates (if you want to call contracted, expected increases rises) and falling home prices due to sudden oversupply were the causes of the housing market collapse, not the results of it. Granted that home prices continue to fall as a result, but it is clearly incorrect that interest rates rose as a result of the collapse — they have fallen as a result. It is not so much that these factors “clobbered people with tarnished credit or low incomes holding more risky ‘subprime’ mortgages,” as these people clobbered themselves and each other by not planning ahead for their contracted rate increases.

This writer, and many people, portray these people as the victims. I portray them as the antagonists. If subprime loan holders were able to continue to pay their contracted mortgage interest rates we would not have a housing market collapse. Some argue that it is the fault of predatory lending practices by unscrupulous banks who sucked these people into these loans. This hides the truth of the matter, which the national survey this article is about brings to the forefront: predatory lending practices do not work on a financially well educated customer. Such a customer can plainly predict that they will be unable to make payments in the future given reasonable income prospects, and seeking to not go into debt will not take the loan that is sure to bankrupt them. This shifts the blame back to the loan holders, and to this syllogism: if subprime loan holders weren’t so stupid as to hold subprime loans we would not have a housing market collapse. Now, I will grant that once the collapse occurred people who would have otherwise remained in good financial standing in line with their predictions were placed between a rock and a hard place, perhapses, despite their own due forethought. This is unfortunate; I do not mean to paint such individuals as part of the problem. The economic understanding of exactly how we ended up in this mess as presented by this unnamed author clearly demonstrates the widespread problem that is what I think actually got us into this mess. Now, why do we have this education problem? maybe something from the survey can shed some light:

In this year’s survey, only 16.8 percent correctly answered that stocks likely would offer the higher growth over 18 years of saving for a child’s education, while 37.3 percent thought a U.S. savings bond — one of the most conservative investments — would offer the highest growth.

Clearly the one with the higher rate of return over the next 18 years is a prediction, there is not a correct answer. If you study the last 18 years the answer is clear, but as they say, past performance is no indicator of future success. If one were to predict that the stock market is seriously overvalued, and that the rising specter of oil prices will, over the next 18 years, wreak havoc on the profit margins of companies leaving the stock market lower than it is today you may correctly conclude that a U.S. savings bond, with its gaurneteed rate of return, will offer higher growth. To sway the answer to the question (which asks which is more likely) you would need to attach at least a 50% probability to scenarios like this where you expect the market to grow by less than ~3% over 18 years. Of course were that the case an investment tied to the inflation rate, or in precious metals would almost certainly outperform the savings bond, which would likely acrue interest at less than the inflation rate is such damaging scenarios.

The point here is that it may not be an invalid assessment of risk to choose the savings bond. The response I have provided here, or one similar, is pretty much the only actually correct answer to that question. The fact that the questions was provided as multiple choice and did not include such a response indicates why we have such a poorly financially educated population. We fail to even attempt to educate them properly. I personally did really learn all I needed to know about this kind of stuff until my Junior and Senior years of college.