Businomics Blog

Our Health Care Mess: David Goldhill Understands the Economics

I'm trying to avoid the health care issue, but it's getting harder and harder.  Just getting good, clear information and insights is tough.  But the Atlantic (I think they've dropped the Monthly from their name) has a dynamite article by David Goldhill.

The title of the article is stupid, so much so that Mrs. Businomics (an M.D.) tossed the magazine aside.  However, that's a mistake, because Goldhill really understands health care economics, and he writes in a clear, lucid manner.

Goldhill's policy prescription is jolting, but probably as good as we can accept, given that our society does not want to let people who make bad choices die.  More importantly, Goldhill explains how the common health care reform proposals will not work at all.

So who is this guy?  He's apparently CEO of a television company, the Game Show Network, according to Barron's.  And his article is widely quoted in the blogosphere.

If you are only going to read one article on health care, read this one.

New Financial Regulations: Trying to Fix Self-Correcting Problems

In the midst of the banking crisis, the Obama administration is considering sweeping financial regulations.  But before fixing problems with a sledgehammer, let’s assess which of these problems have fixed themselves.  It turns out that many of the private sector errors that helped trigger the financial crisis are not going to be repeated; at least not for many years.  These mistakes are only part of the problem, of course, but the new financial regulations focus on them, yet most of the private sector errors have already self-corrected.

The greatest private sector error was over-optimism in the housing market, which led first-time homebuyers to purchase larger homes than they needed or could afford.  It led people with marginal credit to strive to qualify for a home mortgage. It led individual investors to buy homes either to flip or to rent out.  It led institutional securities investors to believe that mortgage pools were as good as gold, and it led ratings agencies to put AAA labels on bundles of sub-prime mortgages.  However, we do not need new regulations to solve this problem, for now everyone knows that real estate prices can go down.  That memory will last many, many years.

The second private sector problem was a willingness by institutional investors to buy securities they did not understand.  The collateralized mortgage obligations and collateralized debt obligations became terribly complex.  A full understanding requires computer simulations that would dim the lights of a major city.  Investors simply accepted the results of the ratings agencies.  Investor appetite for these securities helped to fuel the lax mortgage lending practices, but what’s happening today?  Securitization has come to a standstill (aside from federally guaranteed issues), not because of regulation but because investors are now scared of anything they do not understand.  When the market for asset-backed securities returns, it will return only for plain vanilla transactions, deals simple enough that anybody can easily understand them.  No one will buy complex pools of sub-prime mortgages for many years to come.

The third private sector mistake was the high leverage of investment banks and hedge funds.  Companies that had historically operated with 10 to 1 debt-to-equity ballooned up to 30 to 1 or higher.  Although the large investment banks have all become bank holding companies to qualify for federal money, even unregulated companies would be more conservative now.  Everyone has seen what happened to Bear Stearns, Merrill Lynch, and Lehman Brothers.  Moreover, the leverage they attained required a willing lender.  In the current environment, no one will lend money to an investment bank or hedge fund that has too much debt already.

Private sector individuals and businesses are not immune from mistakes, but they adjust their behavior to avoid further losses.  In contrast, public sector errors tend to continue.  Fannie Mae and Freddie Mac continue to have government backing with a misguided mission.  The Community Reinvestment Act continues to encourage banks to make high risk loans to people with poor credit.  The tax code continues to encourage excessive leverage, including to homeowners.  Congress and the President should focus their attention to an area in which they can do some good: public policy.  They need not concede that only the private sector made mistakes.  They need only acknowledge that the private sector errors are self-correcting.

Economic Subsidies for Economic Development: Not a Good Deal

Oregon Business Magazine quoted me in its article about two subsidies, one that clearly failed and one that, they say, worked.  If you think these things ever work, here are the facts cited in the article regarding the "good" subsidy.  Genentech received over $32 million of incentives, in exchange for which they agreed to hire 300 workers by 2015.  A great bioscience coup?  Hardly.  The facility will receive large barrels of pills and the workers will divide them into small bottle of pills, then prepare the small bottles for shipment.  High tech?  Cutting edge biochemistry?  Hardly.  This is slightly better than minimum wage work.  And we paid over $100,000 for each job "created."

I expounded on this topic at some length many years ago in a Cascade Policy Institute Report, "The Unseen Costs of Ribbon Cutting."

General Motors and Private Investment: Don't Partner with the Federal Government

The General Motors debt for equity deal reveals a genuine danger to private investors.  If you are considering investing in some other turnaround, be very careful if Uncle Sam might get involved.  An editorial in today's Wall Street Journal presents some estimates of how much different creditors to GM will receive.  I've charted these estimates (and they are not hard figures, just estimates):

From an investor's viewpoint, this is very scary.

From a public policy viewpoint, the GM results will scare off potential investors, leaving even more trouble for the federal government to try to clean up.

From a business strategy viewpoint, be cautious about your business relationships (either as customers or vendors) with entities that may soon be run by the federal government.

Surviving Bad Economic Policy: Why I Am Not Gloomy

My commentary for Cascade Policy Institute was published by the Statesman-Journal newspaper.

Credit Crunch: Latest Data Leads to Doubt

We all know there's a credit crunch, right?  That's the basis for the latest (March 2009) Treasury bailout proposal.  So I went looking for the evidence, just to prove to you skeptics that there really is a credit crunch.  I looked at business loans from banks (data here), comparing all the post-World War II recessions.  Here's what I found (latest cycle in thick blue):

The data link above has a plain-vanilla chart, in case you don't like my recession-comparison baby.

In the current cycle, see that bulge in loans that peaks about 11 months into the recession?  I think the data are misleading here.  When the commercial paper market closed down after the Lehman bankruptcy, large companies shifted to bank loans, using standby lines of credit.  The corporations had been paying fees for the credit lines, and the banks were contractually obligated to make the loans.  I haven't seen any estimates of how big that effect is, but I think it works itself out in six months or so, and may account for some or all of the recent decline in lending volume--but we really don't know.

Comparability issue: in the old days, bank loans were the primary mechanism for short-term corporate borrowing.  That hasn't been the case for some time; there's a lot of non-bank credit out there, not reflected in the chart. 

I can imagine three hypotheses about this recession:

1) The recession was caused by a credit crunch within the banking sector
2) The recession was caused by a credit crunch outside the banking sector
3) The recession was caused by non-credit issues, and the drop in credit is just a normal part of the recession.

It seems to me that for the first hypothesis to be true, we should be seeing a much more severe drop-off in business loan volume.

For the second hypothesis to be true, we should see wider risk spreads in financial markets, which we've certainly seen.  (See Calculated Risk's credit summary.)

For the third hypothesis to be true, we need other triggers.  Candidates for the other triggers:

• The drop in residential construction, as a consequence of past overbuilding
• A collapse of consumer confidence, caused by falling home values and bad news headlines
• A collapse of business confidence, caused by the above as well as regime uncertainty

It's quite possible that hypotheses 2 and 3 could be working together.

What's this mean?  I'm not convinced that the banking credit crunch is much different than in past recessions.  Businesses always have trouble get bank loans in recessions.  The tightening of bank lending standards in this recession is similar to the 1990 recession and the 2001 recession, according to the Fed's survey of bank lending officers (to see a chart, hit that link and then "Charts"). The point that data don't support the bank credit crunch hypothesis has been made by others, most notably researchers at the Minneapolis Fed.

It certainly appears that bank lending is not the central problem of this recession.  Tim Geithner's huge bank lending program seems unnecessary, given that bank lending isn't the central problem.  This is what I wrote for one of my consulting clients in December, before the Obama team took over:

The new Treasury secretary will be Tim Geithner, currently president of the New York Fed, whose career has centered around economic crises, including the Mexican crisis and the Asian financial crisis.  He knows crises, and that’s good, but his instincts are to put together a big bailout rather than let anyone go under.  However, there really are times when we want to let companies go under.  My judgment: his strengths match his weaknesses.

The New Treasury Program (March 2009 edition)

We have another new Treasury program.  The mechanics are best understood through the examples offered by the treasury (full details here), which describe a loan program and a securities program:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is
seeking to divest, the bank would approach the FDIC.

Step 2: The FDIC would determine, according to the above process, that they would
be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.

Step 3: The pool would then be auctioned by the FDIC, with several private sector
bidders submitting bids. The highest bid from the private sector – in this example,
$84 – would be the winner and would form a Public-Private Investment Fund to
purchase the pool of mortgages.

Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of
financing, leaving $12 of equity.

Step 5: The Treasury would then provide 50% of the equity funding required on a
side-by-side basis with the investor. In this example, Treasury would invest
approximately $6, with the private investor contributing $6.

Step 6: The private investor would then manage the servicing of the asset pool and
the timing of its disposition on an ongoing basis – using asset managers approved
and subject to oversight by the FDIC.

Over time, investment returns pay a guarantee fee to the FDIC, interest on the debt, a management fee to the investor, and then further returns split between the government and the investor.

Sample Investment Under the Legacy Securities Program

Step 1: Treasury will launch the application process for managers interested in the
Legacy Securities Program.

Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital
to participate in joint investment programs with Treasury.

Step 3: The Government agrees to provide a one-for-one match for every dollar of
private capital that the fund manager raises and to provide fund-level leverage for the
proposed Public-Private Investment Fund.

Step 4: The fund manager commences the sales process for the investment fund and is
able to raise $100 of private capital for the fund. Treasury provides $100 equity coinvestment
on a side-by-side basis with private capital and will provide a $100 loan to
the Public-Private Investment Fund. Treasury will also consider requests from the
fund manager for an additional loan of up to $100 to the fund.

Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total
capital and commences a purchase program for targeted securities.

Step 6: The fund manager has full discretion in investment decisions, although it will
predominately follow a long-term buy-and-hold strategy. The Public-Private
Investment Fund, if the fund manager so determines, would also be eligible to take
advantage of the expanded TALF program for legacy securities when it is launched.

The best independent commentary is at Brad DeLong's blog.

My evaluation of the new treasury plan:  It's not what I would have done--I'm not convinced that we need this, rather than more reasonable behavior by bank examiners in the field (as I've written about here).  But here's what I like about it:  the private sector actions set the price of the assets.  We economists call this "price discovery," and the Treasury's use of this phrase demonstrates that they have listened to an economist, something many Treasury secretaries never have done.  Leveraging public money with private money is a good idea (if you're going to use public money at all).

However, Secretary's Geithner plan after plan after plan reminds me of the gardener who planted an apple seed.  The next day, he was surprised that he had no apple tree.  So he watered the yard.  The following day he was surprised that he still had no apple tree, so he fertilized to spot where he had planted his seed.  The next day, surprised again, he ran water for half the day.  The following day, surprised, disappointed and angry, he dumped a 50 gallon drum of fertilizer over the ground that had the apple seed.  He never got an apple tree from his seed.  He became a socialist.

What Are Carbon Offsets? Karma Neutral Explains

If you don't understand carbon offsets, here's an hilarious analogy: Karma Neutral offsets.

Did Government Cause the Housing Crisis?

I interviewed Russ Roberts of George Mason on this topic.  Listen here.  He makes a good argument that government was part of the problem, but acknowledges a role for good, old-fashioned private sector mistakes. 

TARP: Banks Give Congres the Right to ^*&*^! Them

TARP is, of course, the Treasury plan to provide capital to banks.  There are terms of the deal described in the press and in official documents from the Treasury.  However, the deal is subject to any modification that Congress wants to make.  Section 5.3 says that Treasury may unilaterally change the terms of the deal to conform with laws passed by Congress.  This is a huge danger.

Back in the savings and loan crisis, Congress changed the terms of deals made between the government and banks.  The Supreme Court said that whenever Congress does that, the government may owe damages to the banks for violating the contracts.  (I was an expert witness in two of the damages lawsuits.)  This time round, it won't be a violation of contract for the terms to be changed, because the contract says the terms are whatever Congress wants them to be.

The biggest fear is that the many people in Congress who want to do good deeds with someone else's money will legislate that banks in TARP must make lots of loans to people who are not credit-worthy (again), that banks have to forgive bad mortgages, or that they not adjust adjustable rate mortgages, etc.  Banks that have not yet decided whether to participate in TARP should be very wary.  Other  citizens should be concerned about this kind of behavior.