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.

Bank Mergers are Bound to Change

Bank of America has to pay a record settlement of $17 BILLION dollars due to bad mortgage lending during the financial crisis. This is the same amount as the bank’s profit during the last 3 years, not to mention Bank of America has spent roughly $60 billion navigating all legal issues.  The bank was cited as having bad lending practices with companies they bought: Merrill Lynch and Countrywide Financial. Bank of America’s argument was that they were not the ones making the loans and these loans were originated prior to them merging. However, the Justice Department claimed that Bank of America benefited from the merger since both mergers were completed without government assistance and were not forced by the government.  Citigroup, who had more private ties (with Treasury Secretary, Tim Geithner) and was in more dire financial trouble, only had to pay $7 billion in settlements for bad mortgage loans.


So, what does this settlement mean? It means that any future merges in the banking industry will be more heavily scrutinized by lawyers prior to closing. No bank can afford this settlement over and over again and many banks would fail with such a high legal obligation. Since bank mergers usually only occur when one bank is declining, there is an adverse selection issue with merged banks.  Banks looking to merge are usually in trouble. It may become too costly for a private (healthy) bank to merge with a declining bank if the costs of litigation and possible settlements with the government for past wrongdoings are high. Look for more government forced and assisted mergers, where taxpayers implicitly are guaranteeing stock prices or debt for a troubled bank.

bank of america

Step Right Up and Vote… You Could Win $100,000

The mayoral election in L.A. county on August 12, 2014 had the lowest amount of votes cast in 100 years, at 23.3% of the 1.8 million population. As a result, the Los Angeles Ethics Commission is considering incentivizing people to vote by paying them. One proposal is for a lottery offering a $100,000 prize.

Those opposed dislike that informed voters, who care about voting and take time to learn about the candidate’s platforms, will be alongside people who do not normally get a benefit from voting, but vote anyway to try a win money. Studies by Fordham University Professor Costas Panagopoulus have found that monetary incentives increase voter turnout, although this result is not surprising as many people respond to (dollar) incentives.

In economics, many papers show that the chance of your vote being the marginal vote in any election, especially presidential elections, is infinitesimal. In the 2008 election, the chance of your vote deciding the presidential election was 1 in 60 million or 0.00000001%.  So, why do people vote in the first place if their vote does not matter and why are fewer people voting now than ever before? In the book, To Vote or Not To Vote? The Merits and Limits of Rational Choice Theory, Andre Blais states that there are:

 “two kinds of benefits [that] are associated with voting: investment (or instrumental) and consumption benefits. The investment benefits are those linked to the outcome of the election: they are the difference in utility the individual attaches to having candidate A win rather than candidate B. These investment benefits are contingent on her casting a decisive vote, and the expected benefit is bound to be exceedingly small. The consumption benefits—the sense of satisfaction one derives from fulfilling her sense of duty—are not contingent: she feels satisfied when she votes, whatever the outcome of the decision. She consumes voting for its own sake.”

To making voting fit a rational choice model, one must have a broad definition rather than a narrow definition of rational choice. A broad definition would state that we do not care about a person’s objectives or motives, but rather that the individual is behaving and making choices to maximize their utility. The benefit of voting is a consumption benefit.  A more narrow definition would yield an investment benefit. The problem associated with such a broad definition of rational choice is a risk of tautology—if we argue that a person chooses to do something because they believe the benefits outweigh the cost than the theory never fails.

In an attempt to explain this paradoxical way of thinking about voting, many scholars have made “amendments” to the rational choice theory. Blais explores and refutes them all. Instead, he provides four major alternatives to explain why people vote.

  1. Resources-The decision to participate hinges on time, money and civic skills. The more one has the more likely one is to participate.
  2. Mobilization-Social networks from family, friends, neighbors, co-workers etc. exert pressure on people to behave as a group, rather than as individuals. This peer pressure makes a person more likely to vote.
  3. Psychological involvement- Although a trivial explanation, the more interested a person is in politics, the more likely they are to vote.
  4. Sociological interpretation- an individual acts in their own self-interest and will vote if it is in their best interest to do so.

These alternatives show that the rational choice model is unlikely to be satisfactory at explaining voter turnout. Using these four alternative reasons, the following explanations may explain why people, like those in L.A. county, are voting less than before:

  1. We have just come out of a recession in recent years and people may be working more to meet bills and do not have the spare leisure time to vote.
  2. Although social networking is strong via Facebook and Twitter, face-to-face interaction may be decreasing, so the shame one feels for not voting is not realized.
  3. With all of the arguing in the Federal government and even on local levels, many people are dissuaded from politics.
  4. Individuals may start to realize that voting does not increase their personal job prospects or they are starting to realize that the probability that their vote is the deciding vote in an election is small.

Although, these explanations are simplified, the takeaway is that rational choice theory does not accurately explain why people vote. Instead, as Blais offers, there are physical, cultural, psychological and sociological reasons for why people vote. Offering a monetary incentive to vote will add to Blais’ explanations for why people vote and, empirically, it has been shown that monetary incentives will bring about the desired outcome– more voters.

Paul Samuelson: In Memoriam, Part 5

Samuelson was the Julia Child of economics, somehow teaching you the basics and giving you the feeling of becoming an insider in a complex culture all at the same time. I loved the Foundations. Like so many others in my cohort, I internalized its view that if I couldn’t formulate a problem in economic theory mathematically, I didn’t know what I was doing. I came to the position that mathematical analysis is not one of many ways of doing economic theory: It is the only way. Economic theory is mathematical analysis. Everything else is just pictures and talk.

-Robert Lucas, University of Chicago Professor and Nobel Prize Winner

Paul Samuelson was the FIRST American to win the Nobel Prize in Economics in 1970. He was born in 1915 and went to the University of Chicago for undergraduate studies and Harvard University for his Masters and Ph.D. He started teaching at MIT and worked there his entire career. When Samuelson first came to MIT there was no graduate program in economics, but he is one of the main reasons MIT got one in the 1960s and battles for he #1 graduate program each year. Samuelson, as Lucas hinted at, is essentially the person responsible for marrying economics with mathematics.




After World War II, Samuelson was the main figurehead that wanted to apply economic theories to real-world problems by using math. He is famous in international trade theory with the factor-price equalization where he showed, mathematically, of course, that prices of inputs (labor and capital) will equalize amongst nations with free trade. Then, there was also the  Stolper-Samuelson theorem which stated that the prices of factors of production, (in economics there are 3: land, labor and capital), will rise in proportion to the price in output prices. So for example, if Nike t-shirts are made and the primary factor of production used to make them is labor than if Nike t-shirts rise in price to consumers ($10 to $12) the increase in output price is due to an increase in wages for workers. This assumes a few conditions, such as perfection competition. This theory along with factor-price equalization made waves within the international trade economics field and are the basis of many microeconomic theory classes.

However, his research extends beyond international trade into welfare analysis, price theory and financial economics, all of which I could elaborate pages and pages on (he has written 338 papers). Here is a highlight on some other notable topics you may be familiar with that are standard teachings in economic theory:

  • Revealed preference- by observing a consumer’s purchasing behavior you can determine their preferences for items or moreover, consumers maximize their happiness so by choosing one option out of the set, it must be the preferred option (developing this theory was a component of his dissertation)
  • Cost-push inflation- rising costs on the supply side of economics (by raw materials usually) will cause supply to decrease which could raise many prices and causes inflation
  • Efficient-market theory (he helped develop the theory before Fama eventually made it famous)- Asset prices vary randomly around an optimal path discerned mathematically

“The stock market has forecast nine of the last five recessions” Samuelson in Newsweek, 1966 

But, despite his numerous theoretical contributions, he is equally known for disliking the University of Chicago free-market thought. Instead, he believed in neoclassical synthesis, a slight off-shoot of Keynesian economics and neoclassical economics– government intervention is needed during economic instability, yet supply and demand models and prices do influence choice. Samuelson had a famous column in Newsweek for 15 years (1966-1981) that rebutted many of Friedman’s columns in Newsweek. Friedman was last week’s In Memoriam scholar.

In 1948, Samuelson’s arguably most famous written work, an undergraduate textbook, Economics, was published and is among the best-selling undergraduate textbooks ever. He also served as an adviser to President Kennedy. Samuelson died at the age of 94 in 2009 (he was actively publishing in the 2000s), but his influence on the profession will forever remain.

paul samuelson 2


His video below is a tad long but it starts off by him explaining his reaction when he was notified of winning the Nobel Prize and follows with a discussion about some of his work in financial economics.

Textbook Price Inflation

The Economist reports that textbook prices continue to climb several times the general rate of inflation:

Textbook Prices


But hope is not lost for poor scholars. Foreign editions are easy to find online and often cheaper—sometimes by over 90%. Publishers can be litigious about this, but in 2013 the Supreme Court ruled that Americans have the right to buy and resell copyrighted material obtained legally. Many university bookstores now let students rent books and return them. Publishers have begun to offer digital textbooks, which are cheaper but can’t be resold. And if all else fails, there is always the library.

They note that one of the main reasons for the constant climb is a type of moral hazard: the person deciding which textbook to assign (the instructor) is not the same person who has to come up with the cash (the student). The professor can get an examination copy of the book for free, decide if he/she likes it, and make the call–totally insensitive to whether the marginal value added by the selected text justifies the marginal expense when compared to alternative materials. Some instructors can be quite considerate of cost–I like to think that I am–but instructors are also busy people juggling many responsibilities and trying to find materials quickly which make their own lives easier. Of course publishers are aware of this and market their products accordingly. My advice? Use the secondary markets as much as possible: buy used, buy online, buy the overseas edition, borrow or rent where possible, resell (unless it’s a definite keeper!) quickly before the next edition comes out, or buy a digital edition.