James M. Buchanan- In Memoriam Scholar Part 8

James McGill Buchanan, Jr. was born on October 3, 1919 and died recently on January 9, 2013. He is this week’s In Memoriam scholar due to his revered work on public choice theory.

Like many top-scholars in our In Memoriam series, Buchanan received his doctorate from the University of Chicago in 1948. He was influenced by the great Frank Knight and Swedish economist Knut Wicksell who studied how government spent money relative to taxpayer wishes. Buchanan founded the Center for Study of Public Choice at the University of Virginia, where he was a long-time professor, before moving to George Mason University. Additionally, he won a Nobel laureate for economics in 1986 and published many books on liberty, democracy, public goods and public debt.

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He is most known as the co-founder of public choice theory, alongside Gordon Tullock. Their co-authored book, The Calculus of Consent: Logical Foundations of Constitutional Democracy, explains individual decision-making in the context of the public sector. Some excerpts from Buchanan and Tullock’s book can best explain this constitutional calculus that an individual endures when considering public action:

“The collectivization of an activity will be supported by the utility-maximizing individual when he expects the interdependence costs of this collectively organized activity (interdependence benefits), as he perceives them, to lie below (to lie above) those involved in the private voluntary organization of the activity. Collective organization may, in certain cases, lower expected costs because it removes externalities; in other cases, collective organization may introduce externalities. The costs of interdependence include both external costs and decision-making costs, and it is the sum of these two elements that is decisive in the individual constitutional calculus.” (pg. 50)

The two costs that are explained in the book are:

  1. “Costs that you will endure as a result of the actions of others” (pg. 51)

“An external cost may be said to be imposed on an individual when his net worth is reduced by the behavior of another individual or group and when this reduction in net worth is not specifically recognized by the existing legal structure to be an expropriation of a defensible human or property right. The damaged individual has no recourse; he can neither prevent the action from occurring nor can he claim compensation after it has occurred.”

  1. Decision-making costs which are “the number of individuals who are required to agree before a final political decision is taken for the group” (pg. 51)

“If two or more persons are required to agree on a single decision, time and effort of another sort is introduced—that which is required to secure agreement. Moreover, these costs will increase as the size of the group required to agree increases.”

Therefore,

“The rational individual, at the stage of constitutional choice, confronts a calculus not unlike that which he must face in making his everyday economic choices. By agreeing to more inclusive rules, he is accepting the additional burden of decision-making in exchange for additional protection against adverse decisions. In moving in the opposing direction toward a less inclusive decision-making rule, the individual is trading some of his protection against external costs for a lowered cost of decision-making. “(pg. 57)

Buchanan and Tullock show that individuals face a trade-off when deciding upon collective action. Their book which is written in great detail further explains that not all collective activity should be organized the same way and expands on earlier discussion to include rules of when collective action should be taken. Lastly, half the book discusses welfare economics, voting and taxes in a context that incorporates individual rationality. This was unique at the time, because individual decision-making and individual actions were not explained as fundamental to the collective action problem. Buchanan and Tullock popularized this and essentially, became the “fathers” of public choice theory. Much of Buchanan’s work and Tullock’s work go hand-in-hand and Buchanan’s contributions to public choice and political theory are hard to discuss without mentioning his common co-author Tullock.

In this short video, Friedrich Hayek, a past In Memoriam scholar, and James Buchanan both discuss how economic patterns cannot distinctively be explained by mathematics. At 1:40, Buchanan explains that mathematics can fall short of explaining the entire economic problem and individuals neglect emergent choice. Hayek states we should accept “the impossible”—economists cannot make predictions about everything.

The Punch Bowl Stays: Fed Keeps Interest Rates Low

The Dow Jones closes at a market high today at 17,156.85 after the Federal Reserve met and announced that interest rates will be staying the same.  The reasons for keeping the federal funds target rate in the 0-0.25% range  based on the  FOMC press release are:

  1. The unemployment rate has barely changed and we are under-utilizing labor resources
  2. The housing sector is recovering slowly

While other reasons that they mention seem to support increasing the interest rate:

  1. Household spending and business investment is rising moderately
  2. Inflation is below the Federal Open Market Committee’s long-run goals

However, in the end the Committee felt that to attend maximum employment and price stability maintaining the current interest rate is best. Additionally, the FOMC will buy federal agency mortgage-backed securities at a pace of $5 billion per month (rather than the $10 billion they were buying) and Treasury securities at a pace of $10 billion per month (rather than the $15 billion they were buying). By holding a large amount of long-term securities, the hope is that long-term interest rates will make “financial conditions more accommodating” (i.e. to support mortgage markets). Lastly, the FOMC mentioned that the 0-0.25% federal funds rate will remain even after the asset-buying program dies down, which is set for October.

The video on the bottom of the USAToday article, here, explains why the stock market moves after a Federal Reserve announcement and what has happened over the past four announcements this year. It is a short one minute and thirteen second video, but it is a fantastic way to catch-up with what has been happening with Federal Reserve. Also, here is a neat response after the FOMC announcement from Brad McMillian, the Chief Investment Officer for Commonwealth Financial:

 

“The Fed is not going to take the punch bowl away. They didn’t want to spook the market.”

 

Elinor Ostrom: In Memoriam, Part 6

In this week’s edition of In Memoriam—our series in which we honor 10 noteworthy social scientists who have passed away in recent years—I bring you Elinor “Lin” Ostrom. Lin is the only woman on our list and the only woman thus far to win the Nobel Prize for Economics. Her work has also had a great impact on me personally.

1933-2012

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Lin received her PhD in Political Science from UCLA in the 1960’s and spent the bulk of her 40-plus year career at Indiana University Bloomington, where she and her husband Vincent Ostrom founded the Workshop in Political Theory and Policy Analysis. There Lin carried out a research program that was focused on addressing real-world problems—from how organizational theory could offer insight into public administration of local police services in the St. Louis metro area, to identifying the institutional requirements for sustainable local management of common pool resources in Indonesia, to the most effective use of development aid in Africa—and she did so not only through an impressive array of social science methodologies, e.g., econometrics, game theory, etc., but with an emphasis on field research which sought to take seriously the capacity of people in local communities to solve their own problems with appropriate help. In the video below, Ostrom summarizes the Tragedy of the Commons and how local communities can devise strategies to avoid depleting common pool resources:

In keeping with the pattern I established in my Amos Tversky and Herbert Simon posts, I will say a little about Lin’s contribution to the rationality debate.  In the development of theoretical models, Lin warned, researchers should remain well-grounded in the world of real humans:

An important challenge facing policy scientists is to develop theories of human organization based on realistic assessment of human capabilities and limitations in dealing with a variety of situations that initially share some or all aspects of a tragedy of the commons. Empirically validated theories of human organization will be essential ingredients of a policy science that can inform decisions about the likely consequences of a multitude of ways of organizing human activities. Theoretical inquiries involve a search for regularities. It involves abstraction from the complexity of field setting, followed by the positing of theoretical variables that underlie observed complexities. Specific models of a theory involve further abstraction and simplification for the purpose of still finer analysis of the logical relationships among variables in a closed system. As a theorist, and sometimes a modeler, I see these efforts at the core of a policy science. One can, however, get trapped in one’s own theoretical web…Confusing a model—such as that of a perfectly competitive market—with the theory of which it is one representation can limit applicability…

Governing the Commons

People are nested in cultural settings with indigenous norms. Any theoretical account which ignores such phenomena has abstracted away too much from how human decisions are made. When it comes to collective action problems, Lin reminded social scientists that top-down planning by elites is not the only way that collective action dilemmas can be resolved and often not the best way. She called on social scientists to look hard at actual communities and discovery how individuals can often voluntarily cooperate to solve their own problems in ways that make sense on the ground:

What is missing from the policy analyst’s toolkit—and from the set of accepted, well-developed theories of human organization—is an adequately specified theory of collective action whereby a group of principals can organize themselves voluntarily to retain the residuals of their own efforts.

Hat’s off to you, Lin Ostrom!

 

A.K.

Hayek on Equality

Inequality is one of the hot topics in economics and politics today.  Thomas Piketty’s bookCapital in the Twenty-First Century, has taken the economics field by storm by documenting rising income inequality using national income data across countries and years. Piketty is a French economist who sold over 80,000 copies in France, but has well-surpassed that number in America. His book has been on the NY Times Best Seller list for 19 weeks and counting, which speaks to the fact that people care about this topic. Inequality by other means, such as marriage inequality, continues to be debated in state and federal courts, while racial inequality with police and police force, as exemplified by the incident surrounding Ferguson, Missouri, is a highly contested issue right now.  With such an important focus on inequality in society today, I want to explore Hayek’s point about inequality:

 

“From the fact that people are very different it follows that, if we treat them equally, the result must be inequality in their actual position, and that the only way to place them in an equal position would be to treat them differently. Equality before the law and material equality are therefore not only different but are in conflict with each other; and we can achieve either one or the other, but not both at the same time” – Friedrich Hayek, The Constitution of Liberty

 

Marriage and racial inequality with police force is an equality issue before the law, while income inequality is material inequality.  If we treat income inequality as an issue that needs to be fixed by law then the only way to do that is to have unequal laws since people are different. So, we would be fixing income inequality by creating inequality… in the law. With marriage and racial inequality, equality before the law is wanted, but if we treat this problem as one that should be fixed by material equality then we will necessarily create unequal laws to do so. As a society we must choose–equality in law or material equality. What would you choose?

President Obama on “Corporate Deserters”

Burger King is making headlines because it is considering merging with Tim Hortons, a Canadian coffee and donut chain. The motive is to share corporate services with Tim Horton and move the entire headquarters completely to Ontario, Canada to avoid high U.S. corporate taxes. Corporate taxes in the U.S. are 35% and 25.6% in Canada.

President Obama has stated his feelings on “tax inversion” multiple times throughout his re-election campaigns as well as presidency. Recently on July 24 in a speech at a college in Los Angeles, President Obama stated that companies that do cross-border mergers to escape U.S. taxes are “corporate deserters who renounce their citizenship to shield profits”. Later he stated that doing so adds to the tax burden of middle-income families and that companies should exhibit “economic patriotism”. To further sum up his feelings, he stated, “You shouldn’t get to call yourself an American company only when you want a handout from American taxpayers.” In a speech a year earlier, President Obama stated:

“The best way to level the playing field is through tax reform that lowers the corporate tax rate, closes wasteful loopholes, and simplifies the tax code for everybody. But stopping companies from renouncing their citizenship just to get out of paying their fair share of taxes is something that cannot wait. That’s why, in my budget earlier this year, I proposed closing this unpatriotic tax loophole for good.”

Ouch. In the first set of quotes, President Obama feels that corporations who are making the best cost decisions for their companies are “deserters”, while in later quotes he is referencing that many corporations in America do get tax write-offs and benefits (hence “a handout from American taxpayers”).  However, there is nothing “unpatriotic” about choosing to take business elsewhere if it is too costly to run in America.  Is it better for a company to go out of business by having to stay in the original country they incorporated in just to be an “economic patriot”? The tax system should not be driving people out of business. It appears that President Obama, who has been outspoken about tax inversion cannot accurately pinpoint the problem. Yes, the tax system is complicated and should be simplified, but what is “a fair share of taxes” and how is Burger King not going to be paying them? So, long as they are in this country they must pay for taxes according to the tax code and their accountants, you can rest assured, will try and find any tax loopholes if they exist. Is that unfair? The tax code needs fixing, not the companies trying to make more money to create jobs, growth and product.

Moving headquarters or operations to other countries by big brands  may be seen more and more as countries have a much lower corporate tax rate. The Netherlands have a 26% corporate tax rate, United Kingdom has a 21% tax rate and Ireland, 12.5%. The U.S. needs a more competitive corporate tax to incentivize companies to stay in America, rather than name-calling those who choose to make good cost decisions “unpatriotic”.

 

Innovative Financial Derivatives

Complicated financial products have not seen their demise, despite the amount of federal regulation that occurred after the recent financial crisis.  Total-return swaps are the latest swap derivative taking the market by storm and causing some people to question the risk of these assets. Total-return swaps are a bit complicated, so let me explain this more simply.

Total-return swaps explained

Let’s say a bank and an investor engage in a total-return swap agreement. Total-return index swaps usually set the “reference” asset, or the asset they are benchmarking to, to be mortgage-backed securities, bank debt, sovereign debt, loans, equities, commodities etc. A bank is guaranteed to get payments throughout the life of the derivative. (A derivative is an asset that derives its value from the performance of an underlying security, entity, loan etc.) An investor gets a % of the total return of an index when the swap derivative contract expires. If this index makes less than what the contract states, the bank gets paid again for this “depreciation” in value. If the index makes more money than what the contract states, the investor makes money.  Essentially, the investor enjoys the cash flow benefits of a total-return swap derivative, without actually owning it. The investor only loses if this security declines in value. In order to “borrow” the security, the investor makes payments to the bank during the time of the contract. This payment is known as a floating rate payment or financing cost. Typically, the floating rate payments that hedge funds, or any investor, makes is a spread in LIBOR. LIBOR is the average interest rate that the average bank will pay if borrowing from other banks. This rate is calculated by London books and is similar to our federal funds rate. Many mortgage interest rates and financial products set their rate according to the LIBOR rate.

This seems complicated, who does this?

Total-return swaps are off-balance sheet transactions for the investor and balance sheet transactions for a bank. Off-balance sheet financing is used to report expenses (like the rental expense for holding this asset temporarily), whereas a balance-sheet will show whether an asset is capitalized (whether the asset was “leased” out). Hedge funds usually engage in total-return swap derivatives, because little money is due up front (and only a small amount of collateral is asked for). Collateral is any asset that a bank can take if an investor does not pay the agreed amount of the loan back.  Total-return swaps allow hedge funds to gain leverage. Leverage can mean that an investor uses borrowed capital to increase the return of an investment or finance their assets more with debt. Either way, leverage can intensify an investor’s gain AND losses. The high potential for upside is what draws hedge fund managers to buy these swaps.

Who bears the risk?

The investor does not legally own the index that the total-return index swap is benchmarked to. The investor has a long position in the market risk and credit risk of the asset. At the expiration of the swap, the investor can choose to buy the asset at the market price from the bank. The legal owner of the asset is a bank and this asset appears on their balance sheet.  The legal owner has a short position in market risk and in credit risk. A long position in an asset means that the holder of this position benefits if the asset goes up. A short position in an asset means the holder of this position benefits if the asset goes down.  If the underlying asset goes into default (say the asset is benchmarked to mortgage-backed securities and they all go into default) then the investor must pay the bank the difference in value from the initial price to the price after the asset defaults.

Total-return swaps today

For example, a total-return swap derivative from JPMorgan Chase is tied to the total-return of the Markit’s iBoxx USD Liquid Leverage Loan index.  Total-return swaps are not new, yet tying them to certain underlying indices, like Markit’s, is new and starting to cause an alarm. The alarm is sounding, because these derivatives are structured like collateralized debt obligations—the financial derivatives that tied risky housing loans into securities that brought about the financial crisis. Without a simplifying explanation like the one I provided above, reading a news article like the one found here from Bloomberg can be confusing for a general audience. Unlike the financial crisis, these new derivatives put a lot more of the risk on the buyer rather than the seller, which makes them less like CDO’s.

As mentioned in the Bloomberg article, these products do not come out of thin air. Investors, in the face of higher federal regulations and interest rates kept arbitrarily low by the Federal Reserve, are finding new ways to make money. With interest rates continuing to be so low, expect more financial innovation to occur.

In the words of Peter Tchir, of Brean Capital LLC:

‘‘We are moving into a phase where there will be more esoteric products. It does start setting up more problems for the future.’’

These problems, in my opinion, will all involve understanding the risk of new financial products. Total-return swaps turn the risk around to the buyer, which mean that if things get out of hand–a financial crisis, or problem, will start from the demand-side rather than the supply-side of finance.