Economics - General

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Book Review: This Time is Different

August 20, 2010 in Books, Economics - General | No comments

What is the history of financial crises?  Why to they occur?  Are they common?  In the book This Time is Different, authors Reinhard and Rogoff assiduously review the history of government defaults and crisis of the financial system. Their data on government default is truly astounding.  They document instance of government default in multiple ways: renegotiating the terms of a loan, failing to pay investors, and reducing the value of their debt through inflation or devaluation.  Although defaults on external debt (from foreign investors) grab the of the headlines of the international media, default on domestic debt occurs as well.

Like most bubbles, the reason for these crisis is the delusion is that “this time is different.”  Astronomical house prices relative to rent are interpreted as evidence of that past ideas of sound fundamentals are obsolete; highly leveraged investments of all types become more and more prevalent.

This is a book of economic history, but one where the last 5 chapters specifically examine how the conclusions drawn from centuries of historical data can be brought to bear to analyze the current Great Contraction.  One of the points I found most interesting is that government debt almost always booms directly after a crisis, however, not for the reasons conventional wisdom ascribes.  It is true that bailouts do add to this debt, but the main short term driver of booming U.S. debt is decreased tax revenues.  During a financial crisis, the economy slows and tax receipts drop precipitously; hence the States’ recent request for more funding from the Feds.

This book is very worthwhile for economic historians and macroeconomists.  The amount of evidence presented is overwhelming.  The key points, however, are repeated over and over; after the first 100 pages, I felt I had already digested  the main points.  This is a book that I do recommend, even if I can’t say it was a page turner.

  • Carmen M. Reinhart and  Kenneth Rogoff (2009) This Time is Different, Princeton University Press, 463 pages.

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Should police departments be privatized?

August 19, 2010 in Economics - General | No comments

With state budgets running low, funding for police has fallen.  Can private security forces step in to fill the gap?  Temple Professor Simon Hakim believes so.

“The police is a monopoly. It’s less innovative than the private sector that is under the gun of competition. A police department will never go bankrupt; private company could go bankrupt. So private companies adopt more technology. I expect we may find contracting out of small police department, ’cause a lot of small police departments really don’t have the justification, in many cases, to exist. And for the consumers, they get better service in much lower costs.”

No one would question whether police have a monopoly, but whether this arrangement is welfare improving or not will depend on what the monopoly is over.  Those who prefer private security firms often claim that the police have a monopoly over security.  The logic then proceeds that allowing private competition will increase innovation as well as the equilibrium level of security supplied.

On the other hand, the police may not in fact be in the business of security but rather in the buiness of violence.  In this case, one of the police’s fundamental roles is to restrain the supply of violence and, by doing so, making themselves more valuable.

One empirical example of a monopoly on violence comes from Colombia during the time of Pablo Escobar.  Escobar was the unquestioned drug king of Medellín and–although he personally was very violent–he did not tolerate violence that he did not sanction.  When Escobar died, the violence market was “open to competition” and the quantity of violence supplied grew exponentially.

Although many tragedies have occurred under the direction of state police, having a single (hopefully responsible) authority to maintain a monopoly on violence may, in fact, be optimal.

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Moral Hazard in Action

August 12, 2010 in Economics - General | No comments

About two weeks ago, I was driving to work and a rock from below a car in front of me flew of the ground and made a quarter-sized spiderweb on my windshield.  ₣@¢כ!!! Fortunately, my insurance company fixes a windshield for free if the damage is smaller than the size of a dollar bill.  I called the insurance company, they ordered a vendor to come to my office and fixed the windshield while I was at work. Perfect!

While the work was getting done, the first question I asked myself was: ‘Why does the insurance company do this?’  This could be a case of preventive care saving money.  If the small ding was not treated quickly, the whole windshield might break and the insurance company would be liable for these damages.  By paying a small amount of money up front, it can save money in the long run.  This is the argument many public health officials make for making insurance pay for more preventive care.  On the other hand, it could just be a low cost service that their customers appreciate.  In this case, no cost might be saved (if it was highly unlikely that a small ding would lead to a full windshield shatter) but providing this service may maintain consumer loyalty.  This is analogous to the modifications to the breast cancer screening that no insurance company will adopt.  Although reducing the breast cancer screening frequency for low risk women would reduce cost, failing to reimburse these services would likely lead to a large number of consumers leaving that insurance plan.

The second concept I want to talk about is moral hazard.  I learned from the windshield fixer that some companies are approaching individuals at carwashes and ask them if they want small dings fixed.  The consumer would not have fixed the ding if they had to pay for it (since they have not already).  When the service is free, however, then they often decide to have the ding fixed.  The windshield fixers benefit since they receive compensation from insurance companies. I even learned about cases of fraud where suppliers will claim to fix a friend or relative’s windshield ding, when none existed.  The supplier and their friend can split the insurance company payment.

After this post, maybe I’ll change my motto.  The Healthcare Economist: blogging on health care…and windshield dings.

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Optimization and Coffee Brewing

July 16, 2010 in Economics - General | 1 comment

While at work last week, I began to spoon coffee grounds to make coffee.  How many coffee grounds should I scoop?  Too few and the coffee will be watery.  To many and the coffee will taste like mud.  Then it hit me, coffee making is a perfect example of a number of economic concepts.  So today I will use coffee brewing as a vehicle to discuss 3 key economic concepts .

OPTIMIZATION

What is the optimal number of scoops of coffee?  The answer to this question depends on the function you are trying to maximize.  Let us assume you want to maximize taste.  The relationship between taste and scoops is:

  • Taste = 10-(Scoops-9)2

By taking the derivative of this function and setting it equal to 0, we can quickly see that the ideal number of scoops is 9.  But what about cost?  If you buy coffee, you know that the supermarket isn’t giving it away for free. Instead, your goal may be to minimize cost.  If each scoop costs $0.15, the the cot function is as follows.

  • Cost = $0.15 * Scoops

To minimize cost, the the ideal number of scoops is 0 (i.e., just drink water).

Most people, however, are concerned with both taste and cost.  Foodies will care more about taste, but frugal individuals may care more about cost.  One way to balance these two concepts is through a utility function.  Assume that your utility function is as follows:

  • Utility = Taste/80 – Cost
  • Utility = [10-(Scoops-9)2]/80 – 0.15*Scoops

Because this function is also strictly convex, we can also take the derivative and set it equal to 0 to determine the optimal number of scoops.  When taking into account both taste and cost, the optimal number of scoops is 3.

CONSTRAINED OPTIMIZATION

In life, you can’t always get what you want.  In these cases, constrained optimization must be used.  For instance, let us assume that you want to maximize taste subject to a constraint that the cost of the coffee has to be less than $1.  The optimal taste level is 9 scoops.  However, you cannot afford 9 scoops since this will cost $1.35.  Instead, what you can afford is 6 scoops ($0.90).  If we were being precise, you could afford 6 2/3 scoops.  If you had a constraint of a $15, however, you wouldn’t want to use 100 scoops of grounds (your coffee would taste like mud).  In this case, the constraint is not binding and you would choose the unconstrained optimal number of scoops (i.e., 9).

PUBLIC GOODS

Let us return to the case where you care about both taste and cost in your utility function.  If you spend more money on coffee you’ll have less money to use for other goods or services.  At my job, however, the kind folks at Acumen supply us with free coffee.  Employees should view this free coffee supply as a public good.  By using more scoops, you do not take away coffee from someone else because there is always more.  Further, because the coffee is readily available, no one is prevented from drinking it.  Thus, free coffee at work is in essence a public good since it is non-rivalrous and non-excludable.

Because I personally do not pay for the coffee, I always choose the number of scoops of grounds to maximize taste.  [In my example, this was 9 scoops].  If I am brewing my own coffee I might hedge towards using slightly less than optimal number of scoops of grounds.

The following spreadsheet gives the numerical calculations behind all the optimizations stated in this blog post.

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A solution to save the postal service?

July 7, 2010 in Current Events, Economics - General | 1 comment

The post office has been struggling lately.  They have been bleeding red ink and losing market share to internet-based communication.  In fact, the U.S. post office recently announced that it will raise the price of a stamp to 46 cents.

What is the post office solution?  According to Marketplace:

Canadian researcher Robert Campbell says post offices in other countries have done better because of fewer regulatory restrictions on the services they can offer.

Robert Campbell: Everything from selling cell phones and phone plans to travel insurance, doing currency exchanges, selling mortgages.

In essence, the solution Campbell offers is to provide more service unrelated to delivering mail.  Ouch.

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More Expensive Placebos Bring More Pain Relief

June 24, 2010 in Economics - General | 1 comment

Why do placebo’s work?  They work because the patient’s mind believes they offer relief and thus patient perception of pain decreases after taking a placebo.  A study by Dan Ariely finds that the more expensive the placebo, the more pain relief it offers.  In particular, a $2.50 placebo works better one that costs 10 cents.

Medical News reports the following:

With pain, Dr. Ariely said, “if you expect it to be worse, it could be worse. So what can we do in the marketplace so people don’t expect it to be worse?”  For instance, he added, poor people are often offered medicines at a discount. “Maybe we don’t want to advertise that it’s discounted,” he said.

One reason that more expensive medical treatments when work better in practice in randomized trials is that patients believe that these treatments will be the most beneficial. Further, treatments that patients perceive to be “high tech” or using big fancy machines may offer better health outcomes due to patient perspectives.

The question is, should physicians lie to patients and tell them that the treatment is expensive or cutting edge when in fact it is not?  Without even considering the moral implications of this strategy, the answer is no.  Although this strategy could be used intermittently to reduce cost and improve patient outcomes, if patients found out that physicians were lying to them about the technical sophistical or price of the treatment, then the pronouncements that a treatment was cutting edge would have much less of an effect on the patient (since they knew it was false).

Thus, knowing that high priced medicine improves outcomes still many not give the medical community an attractive means to improve quality and reduce cost.

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Over the last 15 years, Income Inequality has decreased?

June 2, 2010 in Economics - General, Health Insurance | 6 comments

Many economists have lamented that income inequality has grown over recent decades.  Although it is true that wage inequality has increased, compensation inequality may not have.  When I mention “compensation inequality,” I refer to the total package of compensation that a worker receives.  This includes wages, health insurance, 401(k) benefits, and other non-wage forms of compensation.  In previous posts, I have mentioned that once health insurance is taken into account, inequality may in fact be shrinking.

A recent NBER working paper by Burkhauser and Simon (2010) also shows that inquality is in fact decreasing once one taking into account health insurance costs.  This chart provides information on changes in income and total income between 1995 and 2008.  Income includes only raw wages, but “total income” also takes into account workers compensation in the form of health insurance.  The authors use this evidence to claim that “…ignoring the value of health insurance coverage will substantially understate the level of economic well being of Americans and its upward trend and overstate the level of inequality and its upward trend.”

Read the rest of this entry »

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Anti-depressants and Fiscal Stimulus

May 13, 2010 in Economics - General, Pharmaceuticals | 7 comments

Conventional wisdom holds that physicians can use anti-depressants to treat long term depression.  Many patients, however, spend years or even decades taking these drugs.  Is this how the inventors of anti-depressants believe they would be used?

Author Robert Whitaker believes not:

You find that even with major depression, in the pre-antidepressant era – and this is depression so severe people were hospitalized – they could expect to get better. The episode would eventually pass.

… So when antidepressants were introduced, the thought was okay, we really can hope to improve on this sort of natural recovery, but maybe we can help people recover quicker? So that really was the rationale for the use of antidepressants.

But it’s really interesting if you follow this course through, forward in history. The minute they start using antidepressants in any sort of large numbers, doctors start saying, “Well, you know, my patients may be getting better, the depression maybe lifting faster, but then we’re noticing that they’re also relapsing more frequently than before, back into depression.”

So right away you get this question: Does the drug treatment actually put people on a more chronic course than before?”

This reminds me of government “temporary” spending programs.  In times of fiscal crisis, the government often institutes temporary spending packages to revive the economy (e.g., the Stimulus Bill or ARRA).  Although these actions may help revive the economy in the short run, in the long run they often lead to reduced growth prospects.  Oftentimes, however, as the status quo changes, entrenched interests make it difficult to repeal a bill.

Similarly, giving someone anti-depressants changes the status quo from one of a non-drug user to a drug user.  Physicians become accustomed to treating the patient with drugs and many believe it stabilizes the patient.  Further, the patient often experiences withdrawal symptoms if they attempt to change their status quo from that of a user to a non-user.

Mr. Whitaker also cites a Duke University study from the 1990s examining 3 patient groups: 1) Exercise only 2) Exercise plus antidepressant 3) Antidepressant only.

“After six weeks, the drug-only group was doing slightly better than the other two groups. However, after 10 months of follow-up, it was the exercise-only group that had the highest remission and stay-well rate.”

Both anti-depressants and stimulus packages offer short run relief for the patient or economy.  Excessive use of these short run measures, however, leads to worse outcomes in the long run.

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Homegrown Terror

May 11, 2010 in Economics - General | 1 comment

On 60 Minutes this week, I saw a piece called “Uncovering the Roots of Homegrown Terrorism” which documents the rise in the number of American citizens who are receiving training in Pakistan for Terrorists operations.  Many of these ‘homegrown terrorists’ are ethnically Pakistani, though certainly not all.  The story also documents a similar problem with some young Somalis in Minneapolis.

This leads to the natural (often unasked) question: What are the odds that the Pakistani-looking individual walking down the street is in fact a suicide bomber or terrorist.  The answer, is very low.

To illustrate, let’s assume that 70% of all terrorists are of Pakistani decent.  If there are 1000 American-born terrorists currently on U.S. soil, then this implies that there are 700 Pakistani-American terrorists.  [I made up the 1000 figure.  This figure might be too low, especially if we define a terrorists as a young men with anti-establishment beliefs; if one were to apply this definition, however, it would include almost every teenager in the country.  On the other hand, I doubt that there are 1000 American citizens who would actually blow themselves up to prove a point, despite the number of people on the internet claiming they would do so.] Since there are about 210,000 Pakistani-Americans in the U.S., the chance than any one of them is a terrorist is only 0.3% (700/210,000). This means that if you see 100 Pakistanis in a day, the chances even one of them is a terrorist is very low.

To make a comparison, the incarceration rate in the U.S. is 0.7%.  In fact, 3.2% of all U.S. adult residents (or 1 in every 31 adults) will be on probation, in jail or prison, or on parole at year-end.  Thus, it is more likely that you know an American-born criminal than a Pakistani-American terrorist.

While terrorism is a serious concern to American security, the chances the Pakistani man sitting next to you on the plane is a terrorist is in fact extremely low.

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Duflo Wins John Bates Clark Medal

April 25, 2010 in Economics - General | No comments

From the N.Y. Times:

Esther Duflo, a development economist at M.I.T., has been awarded the John Bates Clark Medal. The award is given to “that American economist under the age of 40 who is judged to have made the most significant contribution to economic thought and knowledge.” Professor Duflo, 37, helped found the Abdul Latif Jameel Poverty Action Lab, whose affiliates do randomized experiments in poor countries to help determine what types of aid and anti-poverty programs actually work.  One of her own recent studies looked at how quota systems for female politicians affected Indian attitudes toward female leadership. Other papers have looked at ways to motivate teachers to have better attendance at Indian schools, and what effect reducing the student-teacher ratio at Kenyan schools has on test scores.

Other contenders included Sendhil Mullainathan, Jonathan Levin and one of my favorite economists Amy Finkelstein.  The Wall Street Journal reviews these ‘nominees’.  For more on Finkelstein, go here.

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