Knowledge Jobs Are The Future Of US Manufacturing

A great blog piece by Robert Reich about the future of manufacturing jobs in the US.

Reich says:

First and most broadly, it doesn't make sense for America to try to maintain or enlarge manufacturing as a portion of the economy. Even if the U.S. were to seal its borders and bar any manufactured goods from coming in from abroad--something I don't recommend--we'd still be losing manufacturing jobs. That's mainly because of technology.

Too bad, neither President Obama nor Lou Dobbs understand what modern manufacturing in the US is all about.
Read the whole article at https://robertreich.org/post/257310389

Excellent Post On Regulatory Arbitrage

James Kwak posted an excellent blog on The Baseline Scenario about Regulatory Capital Arbitrage.

Kwak states:

Regulatory capital arbitrage happens because, all other things being equal, banks would like to hold less rather than more capital….

How does regulatory capital arbitrage work? There are many strategies, but the most straightforward to describe and to implement is securitization….

The magic is that by getting sufficiently high credit ratings for the senior tranches, the bank can lower the risk weights on those assets, thereby lowering the amount of capital it has to hold for those tranches….

Read the entire posting at http://baselinescenario.com/2009/05/30/regulatory-capital-arbitrage-for-beginners/

Incentive Compensation Did Not Induce Excessive Risk Taking

The individuals who are opposed to incentive compensation at financial firms are probably risk adverse individuals who have not experienced the thrill of working on large trades or deals in a financial firm. For example, see comments by James Kwak and Alan Blinder.

Some people are greater risk takers than others. Just as some people drive faster or ski down the expert slopes, people with a greater risk taking profile, take jobs where they can engage in greater risk taking. Trading ranks as one of the most stressful jobs with a high degree of risk.

Lowering the compensation will not change that part of the job profile. Risk seeking individuals will still take these jobs.

Lowering the compensation and incentive pay structure will change the types of people who take these jobs along other measures but it will not stop their risk taking.

People self select for jobs using many attributes of the job as their criteria. Compensation is just one of a job's characteristics. People who enjoy jobs where there is stress and thrills will always seek to be traders and deal makers. They will always push the envelope.

Just as incentive pay is not the defining difference between test pilots and regular pilots, lowering the compensation and incentives will remove those applicants who self-select based on total compensation, but it will not remove thrill seekers as applicants.

Yes, a lower compensation without bonus incentives will change the types of individuals in financial firms, but not along the qualities that you want to eliminate. It will not prevent a recurrence of excessive risk taking, just as it was not the cause of the excessive risk.

Blaming incentive compensation is equivalent to blaming a high performance sports car for a driver's speeding instead of blaming the driver. Drivers who speed choose fast cars and not vice versa.

Home Values Affect Foreclosure Rates More Than Defaults

Foreclosures indicate more about changes in past home values than they do about the current economy or mortgage underwriting standards.

The Washington Post is reporting that mortgage delinquencies reached record highs. Delinquencies resolve in three ways.

1. The homeowner pays the arrears and the mortgage becomes current.


2. The mortgage lender forecloses on the home.


3. The homeowner sells the home and the proceeds pay off the mortgage including all arrears with a possibility of excess fund available for the selling homeowner.

Homeowners become delinquent for two reasons.

1. They had the ability to afford the monthly payments but subsequent events occurred which changed their ability to pay. The common events for mortgage delinquency are unemployment, excessive medical expenses, death of a wage earner, divorce, or a reduction in income.


2. The second reason is a household that never was in a position to pay its mortgage. It cannot manage its total debt, gets overextended and does not have enough income to pay all its debts. Eventually, it defaults on the mortgage even without any changes to total household income.

Due to the current recession and the high unemployment, many homeowners with mortgages have lost their jobs or seen a decrease in their income. Without a positive change to income, these homeowners will default on their mortgages.

If home values had not declined and home sales were strong, these households plus the overextended households would sell their homes, pay off the mortgage, pocket any excess funds and move into a more affordable space. Some possibilities for increasing affordability are to move in with relatives, to rent, or to buy a less expensive dwelling. In these cases, defaults would occur without foreclosures.

With the sharp drop in home values, many homes have mortgages in excess of their sale prices. Homeowners cannot sell their homes because they owe more than they would receive as the sales price. Additionally, many homes are not selling or are taking a long time to sell. While a home is up for sale, the arrears on the mortgage accumulate and increase the debt of the homeowner.

The only viable option, for a defaulting homeowner with a house value below the mortgage amount, is foreclosure. A homeowner sale would not payoff the mortgage. Foreclosures result from an inability to pay coupled with a sales price below mortgage value. There is no data to indicate that homeowners with homes worth less than their mortgages are walking away from mortgages that they can afford to pay and letting the home go into foreclosure. There are anecdotes that some people are not paying a few months of mortgage payments to qualify for mortgage modification programs.

Home values more than high unemployment affect the number of foreclosures. If home values had not declined, defaults would result in more home sales and fewer foreclosures.

The high foreclosure rates we are seeing during this financial crisis and recession is more a product of the decline in home values than any other factor. Even if unemployment and the economy improve, foreclosures will remain higher than normal until home values stabilize or increase.

Single Federal Bank Regulator: What About State Institutions

The Wall Street Journal in its Thursday, May 28, 2009, edition is reporting:

Top Obama administration officials are close to recommending that Congress create a single regulator to oversee the entire banking sector, people familiar with the matter said, a departure from the hodgepodge of federal agencies that failed to contain the financial crisis as it ballooned out of control last year.

A single federal regulator still leaves unresolved the regulation and supervision of state chartered and state licensed institutions. The states and not the federal government supervise insurance companies. Likewise, mortgage brokers and mortgage bankers are state licensed and regulated and not under the supervision of the federal government.

State mortgage entities are not federally charted or federally supervised institutions. They sourced most of the mortgages that went into early foreclosures and defaults at the beginning of our financial crisis. State chartered mortgage institutions originated most of the mortgages with affordability problems, i.e. subprime mortgages, no-documentation mortgages, no down payment mortgages, interest only and negative amortization mortgages.

The FDIC, the Federal Reserve and the OCC had warned the financial institutions under their supervision prior to the current financial crisis to limit their holdings and originations of these types of mortgages. For example, see the 1999 OCC examination guidelines for subprime mortgages.

Computing The True Costs Of Going Green

The comment I posted on Arnold Kling's blog, The Economics of "Going Green", follows:

Production costs do not adequately capture disposal, repair and part replacement "green" costs during the useful product life. These additional expenses can significantly increase the "going green" costs when included and in some cases show that the original process is more beneficial and eco-friendly than the "going green" process.

For example, compact fluorescent bulbs contain mercury, a neurotoxin and soil contaminant, while incandescent bulbs do not. The cost of properly disposing of CFLs to prevent mercury related illnesses and soil contamination exceeds the cost of disposing of incandescent. CFLs lower electrical use and their associated carbon output at the expense of increasing mercury contamination and side effects. These disposal costs (and possibly health costs especially for workers in high concentration areas such as garbage workers) are currently an externality not included in the purchase price of the more energy efficient CFLs. A correct comparison of the relative merits of incandescent bulbs versus compact fluorescent bulbs requires including these post production and post consumer use costs.

Hybrid and electric cars use batteries and sophisticated electronic components that are composed of heavy metals and toxic materials. In addition to the costs of proper disposal, auto accidents will potentially release toxic materials to the occupants, first responders, and the local community. The "green" costs associated with an accident are not part of the production costs or purchase price.

Likewise, hybrid and electric car parts will need replacement while the cars are still in use. A typical hybrid car may need to have its batteries replaced once or twice during its life. A "going green" process, even if adequately priced at time of production, will not be correctly priced for environmental effects after the "green" costs of replacements are included in its total costs.

Google, Auction Theory, and Ads

Wired Magazine has an excellent and interesting article about Google's hiring of economists who understand auction theory.

To quote a paragraph from the article:

But as the business grew, Kamangar and Veach decided to price the slots on the side of the page by means of an auction. Not an eBay-style auction that unfolds over days or minutes as bids are raised or abandoned, but a huge marketplace of virtual auctions in which sealed bids are submitted in advance and winners are determined algorithmically in fractions of a second.

Health Costs Do Not Affect US Competitiveness

Greg Mankiw blogged today about the fallacy of health care cost affecting US international competitiveness.

More recently, the Congressional Budget Office has done a nice job explaining why the idea of international competitiveness as a reason for health care reform is fallacious. The passage below, from page 167 of the CBO analysis, is written in the CBO's traditional understated way, but the point is clear:

International Competitiveness

Some observers have asserted that domestic producers that provide health insurance to their workers face higher costs for compensation than competitors based in countries where insurance is not employment based and that fundamental changes to the health insurance system could reduce or eliminate that disadvantage. However, such a cost reduction is unlikely to occur, except in the short run.

Replacing The GDP Gap Focus

My comment to Arnold Kling's blog post, "What is the GDP Gap?"

GDP is a flow measure comparable to business revenue. Next quarter's GDP does not capture the long-term gains from the economy's current restructuring and capital investment.

In addition to revenue, businesses have a second measure; the present value of all future income streams. For business, it could be market value based on its publicly trading securities or it can be a business sale value based on comparable prices for similar businesses.

Furthermore, business owners consider future sales and profit prospects as part of their business decisions.

The goal of GDP management should be a present value decision, but as far as I know, there are no stock measures of future GDP available. A stock measure would capture the benefits of an economy's restructuring and reinvestment during recessionary times.

It seems that focusing on GDP gap is equivalent to a business owner worrying about next year's revenue without considering the ongoing stream of future revenue and the value of the business.

It reminds me of the occasional criticism we hear against business that it worries too much about next quarter's earnings and not enough about the long term.

If we had some readily available present value measure of all future GDP, I think the focus on next quarter or next year's GDP gap would diminish. Economists that now focus on GDP gap would switch to discussions about the present value measure of future GDP. Maximizing GDP, while maintaining some politically comfortable level of unemployment, would become the goal of economists and government.

Time to Replace The US SEC

Yesterday, the US Securities and Exchange Commission announced that it strengthened "its internal compliance program to guard against inappropriate employee securities trading." In March, the SEC's inspector general sent a report to Chairperson Mary Schapiro indicating possible insider trading using SEC information by two SEC lawyers. A week ago, a US Senator released the report to show the lack of employee oversight at the SEC.

If there were ever a reason to abolish the SEC and create a completely new oversight agency with new employees, the new restrictions are the reason.

The measures the agency is taking include:

* First, the staff has drafted a set of new internal rules governing securities transactions for all SEC employees that will require preclearance of all trades. It also will, for the first time, prohibit staff trading in the securities of companies under SEC investigation regardless of whether the employee has personal knowledge of the investigation. The rules have been submitted to the federal government’s Office of Government Ethics, which approves agency ethics rules.

* Second, the SEC is contracting with an outside firm to develop a computer compliance system to track, audit and oversee employee securities transactions and financial disclosure in real time.

* Third, Chairman Schapiro has signed an order consolidating responsibility for oversight of employee securities transactions and financial disclosure reporting within the Ethics Office. And, she has authorized the hiring of a new chief compliance officer.

The SEC has existed for 75 years. Insider trading is fraud and prohibited by US common law. In 1909, the US Supreme Court found under common law that a company director who traded with information about the company that he did not publicly disclosed committed fraud. Schapiro was a temporary SEC chairperson in 1993.

The new self-imposed SEC requirements are standard operating procedures at all the major brokerage firms and have been in operation in the industry for decades.

To not have in place, required codes of conduct and compliance and monitoring procedures at the SEC indicates that the agency's arrogance, self-deception, delusion and narcissism. Not to have an existing compliance officer at the SEC when the agency expects all the financial firms it supervises and monitors to have a compliance officer is the height of conceit. The entire structure of the SEC is dysfunctional and a new oversight agency needs to be built from the ground up.

CAFE Standards Are Perverse

CAFE is perverse. Politicians say it is supposed to clean the air and reduce our foreign oil dependency.

However, American cars are cleaner because other legislation and regulations limit the amount of harmful automobile emissions from cars and trucks. That is why we have catalytic converters in our cars and engines are designed to produce fewer harmful emissions. CAFE was a response to OPEC and the long gas lines of the 1970s. It predates global warming concerns.

FOREIGN OIL

Most of our imported foreign oil, about a third, comes from North America, i.e. Canada and Mexico. Include South America and we are at about half of our oil imports. Add the UK, Norway, Africa, and Russia (about 4 percent) and we are at 80-85 percent. 15 to 20 percent of our imported oil comes from the Middle East and about two thirds of that from Saudi Arabia. Additionally, a third of our oil comes from the US, which obviously does not count as an import. The Middle East represent about 10- 15 percent of our total oil use. Only, 3 to 5 percent of our total oil use is from the Middle East and is not from Saudi Arabia.

Furthermore, about 45-50 percent of oil is used for gasoline. The rest is used for jet fuel, petroleum products, asphalt, plastics, synthetic fabrics, etc.

Therefore, only 1-3 percent of our gasoline is from Middle East countries other than Saudi Arabia.

If we reduce our imported oil use, how will we know which country will reduce its exports to us. What if they sell it to another country that sells it to us?

CAFE

CAFE is an average based on sales and not miles driven or types of driving, such as low mpg stop and go city driving, or high mpg long mileage highway driving. All cars sold in any year are treated equally.

Figuring the average of two cars is as complicated as those hated high school algebra work and mixing problems. The CAFE average of a 20 mpg car and a 60 mpg is not 40 mpg. It is 30 mpg. Trust me. If the second car got 100 mpg, the average with the 20 mpg car is 33.3 mpg, not 60 mpg. (Hint: The average is computed using gallons per mile and then converted into miles per gallon.)

The practicality of CAFE standards for mpg requires that most cars sold have to be above the average because the computation severely penalizes cars below the average. Significant changes to cars will be made to meet the new CAFÉ requirements. There will be less weight, smaller engines, and less use of heavy materials, such as glass.

CAFE mpg numbers are not the same numbers consumers see on the sticker of a new vehicle. It is based on a different methodology than the EPA uses to compute the mpg window sticker numbers for new cars.

CAFE numbers only apply to new cars sold in a given year.

A gasoline tax is much more effective at achieving our intended results of reducing oil use, and improving the efficiency of automobiles and trucks. A gasoline tax, unlike CAFE, affects all cars and makes mass transportation a better alternative.

Is A Combination Of Old And New Vehicles Better Than CAFE?

President Obama proposed changes to CAFE standards that will increase the average mile per gallon of cars and trucks by 2016. The changes are expected to increase the price of a vehicle, on average, by $1300.

We will have a technological change and a price change, without a functional change. A car and truck will still be a people and goods transporter.

Analyses at this point, prior to actual vehicle prototypes, are assuming that carrying capacity in both weight and cubic feet will remain unchanged. However, this is speculative and carrying capacity may reduce per vehicle or on average. Vehicles are functionally used for business transport and multiple passenger transport.

It is too early to speculate on the physical vehicle changes and the effect they will have on number of cars/ truck needed in actual life situations. Prius and Insights are nice cars, but after a school sporting or social event, you need more of them to transport the kids home or to pizza, than if larger, less fuel-efficient 6-9 seat SUVs were used. Splitting a passenger to put into two cars is not a practical option. A similar logic applies to some cargo. Are there analyses of fuel use inputting real life situations to see what combination of old and new cars/trucks use the least fuel in actual, everyday usage? Since capacity is changing, it is not a price (or mpg) elasticity.

It is an optimization problem with real life inputs. Given the new vehicle and old vehicle characteristics, what quantity mix of the vehicles will minimize fuel use and CO2 emissions?

It could very well be that large, fuel inefficient cars/ trucks in the mix reduce total miles driven, fuel use, and CO2 emissions. It would mean not achieving the new CAFE standards, yet achieving all the end benefits. It is not difficult to imagine than in suburban and rural settings, large vehicles mean fewer vehicles per event, fewer total miles driven and less CO2 production. Does the benefit of higher mpg vehicles more than offset their possible increased usage in both miles and number of vehicles per event? Alternatively, are fuel use and CO2 emissions minimized with a combination of fuel-efficient and non-fuel efficient vehicles so that the combination does not meet CAFE standards?

CAFE standards are determined by car sales and not by actual vehicle usage. Cars that are 30 percent more efficient but get used twice as much, are less environmentally friendly than fuel inefficient cars.

Additionally, price increases per vehicle will make a used vehicle more attractive, in addition to less expensive new models. Moreover, dealers have more profit margin leeway to reduce used car prices to make their prices more attractive. Three times as many used cars and trucks as new ones are purchased each year. The total dollar valued of used vehicle purchases exceeds new ones and the average price of a used vehicle is about 30 percent of a new vehicle. Used vehicles are also more profitable per vehicle to dealers than new vehicles.
http://www.naaamap.com/NAAA/pdfs/The_Importance_of_UsedCars.pdf

In addition to buying cheaper models or used cars, a price increase could also shift families to do more car sharing and to own fewer vehicles per household. One fewer car may or may not reduce total miles driven by two cars in a household.

The goals of Obama's proposal are to reduce fuel consumption and CO2 emissions. However, the metric is CAFE standards and not actual fuel usage or emissions. CAFE is based on sales and not actual vehicle usage. It is not like a water meter. It is a proxy for the desirable results and as such can be achieved without actually producing the intended results at the lowest cost or with the most benefit. Inputs of real life usage of vehicles under different situations into an optimization model are needed to see what combinations of vehicles, old and new, efficient and inefficient, will produce the minimum fuel use and emissions.

Just using economics and engineering could produce results that meet CAFE, but do not achieve the intended objectives.

Benefits of Higher Auto MPG Will Not Occur

The US government is increasing the fuel economy standards for new automobiles. It raised the automobile standard to 39 miles a gallon for cars and 30 for trucks (or a fleet wide average of 35.5 mpg) by 2016.

Unfortunately, economic analysis show that much of the expected benefits will not occur anywhere near the amount announced or expected. (For another, much more detailed analysis reaching the same conclusion, see Keith Hennessey's Blog).

Increasing miles per gallon is the same as lowering the price of gasoline. Increasing a cars mpg from 30.2 mpg to 39 mpg means that for every 100 miles driven, the car will use 2.56 gallons instead of 3.31 gallons of gasoline. It is a savings of almost 3/4 gallons or about a 23% savings in fuel and fuel cost.

Gasoline has two price elasticities. A lower gas price means both more cars on the road, i.e. more traffic, and more miles driven per vehicle. Studies show that a 10 percent decrease in gasoline prices increases traffic by 3 percent and increases driven miles by 6 percent. (Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: A Review, Phil Goodwin, Joyce Dargay and Mark Hanly, Transport Reviews, Vol. 24, No. 3, 275–292, May 2004)

A 23 percent decrease in gas prices (by increasing mpg) means that there will be about 7 percent more cars (.23x.3) on the road and about 14 percent more miles driven per car (.23x.6). In total, it is about a 22 percent increase in miles driven. (107 percent number of cars times 114 percent miles driven).

Since fuel use, due to new mpg, will decrease by 23 percent but total miles driven will increase by 22 percent. In effect, this change will have no effect on gasoline usage or CO2 emissions. It is strictly a political move to placate parts of the electorate, but it will have no effect on the environment, global warming or oil imports.

As fuel becomes cheaper, its total usage increases. It is called the Jevons Paradox and has been known since 1865 when it was studied to explain the increase in coal use in England as steam engines became more efficient.

Additionally, higher mpg leads to people driver further and therefore willing to live farther from work and shopping. It increases sprawl.

Since population will increase and GDP will grow in total, production efficiency is a much better way to control CO2 emissions and to drive fuel efficiencies. The relationship between growth and CO2 is known as the Kaya Identity and is used by world organizations concerned about decreasing global energy use and preventing global warming.

Alternative Causes For High NYC Minority Mortgage Foreclosure Rates

A New York Times' recent article claims that the mortgage default and foreclosure rates are higher for minorities than for non-minorities. Alternative causes for higher minority mortgage defaults exist and data needs adjustment to make NY Times article's claim of higher mortgage default and foreclosure rates statistically valid.

Minorities' percentages of home ownership were increasing so have greater percentage of minority homeowners with mortgages and with higher remaining principal balances as percentage of home value and in dollars than in non-minority group.

Unemployment, loss of income, and uninsured medical expenses are also primary causes of mortgage defaults. Minorities have higher unemployment rates during this recession and are more likely not to have health insurance. Also, maybe more likely to work in jobs where hours are cut backed in recession and their weekly wages have declined.

Need to compare minorities against similar group. Need to adjust non-minority default rate for lower unemployment, lower mortgage balances and lower unexpected medical expense costs.

When two groups are balanced, default rate will most likely be the same, which is why just about every time Fed researchers look at problem they do not find a minority, mortgage discrimination problem.

Higher mortgage foreclosures are not as much due to a subprime problem as it is due to other social and economic factors.

Additionally, credit scores are not a very good way to judge what a loan's interest rate and default rate should be across demographic groups. Credit scores have more validity for assessing risk of default within demographic groups.

An August 2007, a Federal Reserve study, "Report to the Congress on Credit Scoring and Its Effects on the Availability and Affordability of Credit" received a lot of press.

The report found, "Consistently, across all three credit scores and all five performance measures, blacks, single individuals, individuals residing in lower-income or predominantly minority census tracts show consistently higher incidences of bad performance than would be predicted by the credit scores. Similarly, Asians, married individuals, foreign-born (particularly, recent immigrants), and those residing in higher income census tracts consistently perform better than predicted by their credit scores." (p. 89).

PDF version of Federal Reserve report

HTML version of Federal Reserve report

House Financial Services Committee Discourages Dissenting Free Speech

The US House of Representatives Committee on Financial Service does not believe in free speech and the Committee attempts to bully those who oppose its legislation. (HT: Don Boudreaux of Café Hayek, http://www.cafehayek.com/files/this-letter.pdf).

Last October 24th, the Committee sent a letter to William Frey, President of Greenwich Financial Services. The letter stated:

We are outraged to read in today's New York Times that you are actively opposing our efforts to achieve a diminution in foreclosures by voluntary efforts....

We very much hope that you will be able to tell us very soon that you have reversed you position of trying to obstruct the operation of the bill that was overwhelmingly passed by Congress and signed by the President this summer….

The US Medicare Financial Problem

Population Effects

According to US Census Bureau data and projections, the fundamental problem of Medicare is that the over 65 year old population and the over 85 year old population will increase in both absolute numbers and as a percentage: of the US. The US will have a doubling of Medicare enrollees by 2030. The high cost users, those over 85 years old, will quadruple by 2050.

The over 65 group will be twice as large. It will grow from 35 million, 12 percent of the US in 2000, to 71.5 million, and 20 percent of the total US population in 2030.

The US Census Bureau projects that the population age 85 and over will grow from 5.3 million in 2006 to nearly 21 million by 2050. Some believe that the 85 and over number will be higher due to longevity improvements. From 2030 onward, the proportion age 65 and over will be relatively stable, at around 20 percent.

Medicare Costs

More users equal more cost. More high cost users, those over 85 years old, means even more costs. A higher percentage of seniors in the US mean less tax revenue to pay for Medicare costs.

Even if medical costs per person do not grow, the total cost for Medicare will grow due to the doubling of the over 65 age group and the quadrupling of the over 85 age group.

The Medicare Trustee report states that Medicare costs for the over 65-age group is about $11,000 per person. Subtracting Medicare enrollees and Medicare expenditures from total US numbers shows that non-Medicare enrollees', (the under 65-age group less the few other Medicare categories), medical costs average about $8200 per person.

However, the 35 percent difference is due to more than the higher costs per person of a user of medical services. Medicare has a higher utilization of its services than the non-Medicare population. There are fewer non-users and low volume users to subsidize the typical medical service user in Medicare than in the non-Medicare population.

Add medical cost inflationary increases at a rate above the average US inflation rate and the US government faces a difficult problem. The US government cannot afford to continue Medicare as it is currently financed and structured. The senior citizen lobby and voting bloc, whose base is growing as a percent of the US population, makes changes to Medicare structure and costs politically difficult.

Way to a Solution

Politically, universal healthcare dilutes the senior voting bloc and gives the government an opportunity to modify Medicare under another rubric, but successful solutions to control costs that do not limit or ration medical services are not obvious. Additionally, the President and Congress also do not trust the capitalistic, market pricing based system to cost effectively meet the needs of the medical consumer.

When delivery solutions of a business service problem are unknown, the best route for success is the competitive market. Profit-motivated, competitive, market based pricing with costs borne by the end user drives all producers and deliverers to become as efficient as possible. This is what capitalism is all about and how the US standard of living has grown substantially since its founding to become the highest in the world.

Without a well-functioning pricing mechanism, investments in medical services are misallocated and users do not limit their use by need or seek lower cost effective alternatives.

Even the poor and uninsured will have their needs met in a market base system. The delivery system and provider cost per patient will change. There maybe fewer doctors and hospital in an area and longer wait times to increase their volume and profit per doctor and hospital. There will probably be more use of nurse practitioners and other low cost providers, but the medical providers will meet all the demand. Even surgeries will change to become more efficient and less costly. For example, right now surgical procedures have the highest profit margin in the medical profession due to high reimbursement rates. Under a market pricing system, this profit margin will narrow and procedures will become efficient. There will be many other changes that the government cannot even envision, but cheaper delivery systems and other cost-cutting changes are the strength and power of capitalism and market based pricing.

The government should focus on the best way to transition to a market based system for medical services. The government should also remove all the laws and regulations that drove medicine away from a competitive, market based system, such as the employer medical benefit tax deduction and many other misdirected government policies.

See my previous post, "Health Care Is A Pricing Mechanism Problem Not An Insurance Problem"

Low Number Of US Job Openings: Is There A Structural Problem?

In addition to unemployment, layoffs and new hires, the government has another statistic, unfilled non-farm job openings.

The preliminary number is 2.0 percent for March 2009 versus 3.6 percent for March 2001. It is the lowest since the series began in 2000.

There are two possibilities for the unusually low demand for workers. Low end user product demand or high worker productivity, which requires fewer workers per unit.

Structural changes during the Great Depression accounted for some of its continuing high unemployment. Manufacturers were switching to a mass produced, assembly line method of production, which decreased the need for workers.

If, there is an equivalent structural production change currently occurring in the US economy, end user demand and GDP can grow without an increase in employment and a decrease in unemployment. The US will have a long-term high structural unemployment rate. Worker retraining will not solve the problem because there are few openings, which indicate a low level of openings with unmet skills in the workforce.

Regulatory Arbitrage Did Not Cause The Current Banking Crisis

Banks Need Adjustable Capital Amounts Sensitive To Future Economic Conditions

Regulatory capital ratios capture firm specific events but do not capture economy wide events. Regulatory arbitrage did not cause the current banking crisis and its complete elimination would not prevent a repeat of the current banking crisis.

Regulatory capital is set by lending and investment categories, such as mortgages, but the computed capital ratio is formulaic, static and does not vary by regional or US economic conditions. Additionally, it is in part dependent on outside ratings by credit rating agencies, especially SEC approved NRSROs, which are lagging indicators of changing riskiness and default rates instead of leading indicators.

Holding $100 million of residential mortgages outright or holding the same dollar amount of securitized residential mortgages does not change the risk the institution faces. The regulators compute regulatory capital by form instead of the substance of the asset, and the institution can free up required capital by modifying the form of its holding and use the extra capital to increase its holdings and concentration in that asset, i.e. engage in regulatory arbitrage. Effectively, the increase risk comes from increased leverage and loss of diversification through an increase in a particular asset concentration.

Additionally, since regulatory capital ratios do not change to reflect changing economic conditions, the regulators require banks to hold the same amount of regulatory capital in growth as in recessionary economic times. We know asset default risk is not constant and changes based upon different regional and US economic conditions, e.g. during periods of higher regional unemployment, regional residential mortgage default rates will increase. Similarly, area home values decline during regional economic downturns and the decline in value increases an area's mortgage default rates.

High unemployment rates along with a substantial decline in home values are the cause of the high mortgage default rates. A lingering, worsening recession was the underlying cause.

There are areas of the US where the decline in home values is 20-50 percent from their highs. In many areas of the US, unemployment is at 25-year highs, if not higher. If banks did not arbitrage from direct holdings of residential mortgages into securitized mortgages, banks would still face substantial write-downs. Residential mortgage defaults would still be higher than usual or expected (by capital set aside) due to substantial home value declines and high unemployment.

Weak US and regional economic conditions and their effects severely affected the value of all residential mortgages and their default rates. It is extremely likely that banks would need to raise capital, face heightened regulatory scrutiny and increased risk of government takeover independent of the form of their mortgage holdings. Even if we had restricted the amount of residential mortgage holdings of any form prior to this economic downturn, the banks would have invested their funds in other earning assets, such as credit cards, commercial loans or commercial real estate. All loans face higher default rates in bad economic times and just about all assets lose value.

What we need is a more sensitive, adjustable capital ratio to future economic conditions. Requiring capital based on sensitivity analysis (stress tests) requires banks to hold more capital than necessary in good times, acts contra-cyclically by restricting lending in good economic times, and lowers the earnings of banks.

Since economic forecasting of turning points in the economy is notoriously poor, market based solutions, such as market valued balance sheets, are probably the best but they are not fool proof. Market values of long-term assets, such as mortgages, reflect all expected losses including those several years in the future. The market value accelerates the future expected default into the present. For example, suppose an apartment building has a 20-year balloon mortgage with a constant yearly interest payment. The likelihood of default during the early years of interest payments may be quite low, but the market may have high expectations of default at the end of the twenty years on the final balloon principal payment. The market could easily value the mortgage at 60 to 70 percent of its face value. The discounted value would force the bank to either increase its current capital base or decrease it lending. The bank would feel the effect of the future default now, many years before it would realize the default and be necessary for it to replenish its capital base. Asset based market valuations for long-term assets could affect lending and investment in a counter-cyclical fashion.

One would have to rerun recent banking history under an alternative, proposed regulatory structure and reconstruct a bank's new balance sheet. We could see, based on new, proposed restrictions, prior to going into this recession, if there is anything that would be different now under a different set of rules and if the banking industry could have avoided its current crisis by lending and investing differently.

Financial Crisis Was Not A Pure Market Failure

An interesting Financial Times Comment on the financial crisis with an eastern European perspective.

"The argument that we have witnessed a pure market failure fails the most elementary tests. Financial institutions and markets operate within the macroeconomic, regulatory and political framework created and maintained by public bodies, and it is empirically not difficult to point to the serious deficiencies of this framework that contributed to the present crisis…. Mises, Hayek, Schumpeter, Nozick and other thinkers have noted that under democratic capitalism there are always influential intellectuals who condemn capitalism and call for the state to restrain the markets. Such an activity bears no risk and may be very rewarding. (This contrasts strongly with the consequences of criticising socialism while living under socialism.)

Dynamic, entrepreneurial capitalism has nowadays no serious external enemies; it can only be weakened from within. This should be regarded as a call to action – for those who believe that individuals’ prosperity and dignity are best ensured under limited government,"

writes Leszek Balcerowicz in the Financial Times. He is a former Polish deputy prime minister and governor of the National Bank of Poland, and a professor at the Warsaw School of Economics.

What Good Is Modern Finance

Many, particularly the media and elected officials, blame financial institutions and new, sophisticated products for the current financial crisis. Congress will look to pass legislation to increase the oversight of derivatives and financial intermediaries. Additionally, there is the prospect of new regulations for the firms in this industry.

Modern finance added something to the traditional methods of finance. It improved banking, corporate governance and investment risk management. However, it is not foolproof.

A primary objective of modern finance is about improving efficiencies of capital markets, by lowering the costs of raising capital and investing. Modern finance is also descriptive, mathematically and economically.

Modern finance shows why for example owning no load, low expense ratio mutual funds with holdings in a wide breadth of industries is safer that putting all your money in one company and why the low cost fund gets better returns than a fund with high investor expenses. By the way, mutual funds are more than stocks and bonds. Investors buy participation in an entity that owns investments, such as stocks and/or bonds. They are very similar to mortgage back securities, or collateralized mortgage or debt obligations.

Modern finance also allowed the development and issuance of TIPS, US Treasury inflation protection securities. These securities do not lose value if future inflation increases.

A few of the theories that allow for these improvements are the Black-Scholes-Merton option and contingent claim pricing model, the Sharpe-Lintner capital asset pricing model, and Markowitz mean-variance. There are also many other significant concepts, theories and research in other important areas of modern finance that have also helped in improving banking, corporate governance and investment risk management. Such as work by Akerlof, Spence, and Stiglitz on information asymmetry in markets. Work by Samuelson and Fama on efficient markets and many others in many other important areas of finance.

The ability to lower the costs of issuing debt or equity has been one of the most important benefits of modern finance. It also includes lowering the costs of obtaining information, including information about risk, about debt and equity that has tremendously benefited our economy. The lower cost alternatives to traditional banking has been the reason high cost banks' market share of corporate financings has decline significantly since 1950.

Improvements in information about debt and equities include improvements in corporate governance. While the public, a populist president and populist elected officials may object to high corporate salaries, bankers and corporate bondholders could stop this practice almost immediately if they felt it was a cause of concern about either the business health of the company or the company's ability to meet it debt obligations. I do not believe there is a single debt covenant in any public company's loans or bond agreements that prohibits competitive salaries to senior management. If these high salaries did broad based economic harm to our economy in other ways, every corporate bond covenant would have a clause prohibiting the practice to protect bondholders to reduce the risk of an economic downturn and the corporate inability to pay debt holders.

Derivatives exist because they are lower cost than alternatives to these types of transactions. Without options, one would have to use futures, which are more expensive because they require purchasing the underlying. Without futures, one would have to use forward contracts, which are even more expensive than futures. Without forward contracts, one would need partners or vertical business integration.

As an aside, mutual funds use a tiny portion of their funds to buy some options or futures that mimic the fund, to offset the zero return of cash they hold to meet redemptions or they have received from investors but they have not yet been able to invest.

The most surprising thing about the topic of the benefits from modern finance is how much knowledge macro-economists will impart about general equilibrium, GDP, Keynes, etc., but how little of their knowledge (I presume) they have about capital markets and derivatives they are willing to show. For some reason, many macro-economists become populists and resort to public perceptions instead of financial economic wisdom about markets.