Pollution regulation is typically cast as a game between citizens and firms, the first suffering the consequences of pollution while the second are the origin of the pollution. In such a case, there is no incentive for firms to abate pollution, and the government has to mediate. But could a case be made that firms should be willing, individually or collectively, to reduce pollution. One way can be green labeling, which could increase the demand for their products. Another would be if firms realize pollution has an impact on their on productivity or on the labor supply.
Joshua Graff Zivin and Matthew Neidell take the worker productivity angle by using a dataset of dairy farm workers from a large farm in the Central Valley of California. In particular, they look how ozone levels impact the output of piece rate workers. At it is substantial. For example, a 10 ppb reduction of ozone increases productivity by 4.2%, noting that the standard deviation of ozone levels is 13 ppb. And if you object that some of the workers fall under minimum wage law and may not exert the right effort, be reassured, the authors took that into account. In addition, this impact happens even when the ozone level is well below the current national standards. Realizing this, industry should be more willing to accept the suggested tightening of pollution standards for ozone, and for nitrogen oxides and volatile organic chemicals that are the source of ground-level ozone.
Showing posts with label regulation. Show all posts
Showing posts with label regulation. Show all posts
Wednesday, June 8, 2011
Thursday, June 2, 2011
Seat belts lead to safer driving
A classic example of the law of unintended consequences is how seat belt laws gave reasons to drive more dangerously, as car drivers feel more secure. This idea has been popularized by Sam Peltzman and several follow-up studies.
Yong-Kyun Bae puts some serious doubts in this results by pointing out that all these studies were based on aggregate data. Using individual data, which allows to exploit individual characteristics, as well as the circumstances of accidents. And once you control for these factors and exploit cross-state variations of how seat-belt laws became more or less stringent in the last decade, it appears more stringent laws make people drive more carefully. Indeed, pedestrians are getting safer. If this result stands, the challenge is to explain it: do tougher seat-belt laws signal stronger enforcement of other traffic laws? In particular, as Bae suggests, these laws may come in tandem with cell-phone and texting-while-driving laws.
Yong-Kyun Bae puts some serious doubts in this results by pointing out that all these studies were based on aggregate data. Using individual data, which allows to exploit individual characteristics, as well as the circumstances of accidents. And once you control for these factors and exploit cross-state variations of how seat-belt laws became more or less stringent in the last decade, it appears more stringent laws make people drive more carefully. Indeed, pedestrians are getting safer. If this result stands, the challenge is to explain it: do tougher seat-belt laws signal stronger enforcement of other traffic laws? In particular, as Bae suggests, these laws may come in tandem with cell-phone and texting-while-driving laws.
Tuesday, April 5, 2011
Why are Europe and the US so different in terms of regulation?
Europe and the United States have a different attitude towards many things, and one in particular is regulation. Think, for example, how Europe is adverse to genetically modified agricultural goods, while nobody really cares about that in the United States. Other examples abound, like the little checks there are in the American meat industry or the fact that helmets are not required for motorcycles in most US states. How can such drastic differences arise in countries that after all have a similar standard of living?
Johan F.M. Swinnen and Thijs Vandemoortele show that tiny differences in preferences can lead to large differences in regulation. To prove this, they develop a dynamic model with households, producers and political decisions on whether to allow a potentially objectionable technology. It implies that no regulation is imposed below some threshold level of preferences, and the technology is not allowed above that. This results is, I believe, mostly the consequence of the discrete nature of regulation here: either you allow or you do not. With intermediate levels of regulation, the story may be different. More interesting is the result that there is substantial hysteresis: once a decision is taken one way, it is very difficult to revert it even if preferences or the negative consequences of the technology change. This result is reinforced by the discreteness of regulation, but would most likely be present even without it. In other words, it is possible that tiny initial differences in preferences between countries can lead to large regulatory differences that cannot be overturned.
PS: As in much of this kind of literature, quadratic costs are imposed. I always wonder whether this functional form has implications on results, but nobody seems to care.
Johan F.M. Swinnen and Thijs Vandemoortele show that tiny differences in preferences can lead to large differences in regulation. To prove this, they develop a dynamic model with households, producers and political decisions on whether to allow a potentially objectionable technology. It implies that no regulation is imposed below some threshold level of preferences, and the technology is not allowed above that. This results is, I believe, mostly the consequence of the discrete nature of regulation here: either you allow or you do not. With intermediate levels of regulation, the story may be different. More interesting is the result that there is substantial hysteresis: once a decision is taken one way, it is very difficult to revert it even if preferences or the negative consequences of the technology change. This result is reinforced by the discreteness of regulation, but would most likely be present even without it. In other words, it is possible that tiny initial differences in preferences between countries can lead to large regulatory differences that cannot be overturned.
PS: As in much of this kind of literature, quadratic costs are imposed. I always wonder whether this functional form has implications on results, but nobody seems to care.
Thursday, March 24, 2011
You want to restrict bankers' pay
There has been and there still is much outrage about the large bonus payments bankers get. What the public does not understand is that bonus pay is a very large part of total pay, and it is so to encourage bankers to perform really well. And they certainly put in the hours. For example, bonus pay has been criticized because there is most often no "malus," but given that base pay is relatively low, this should capture it. The main criticism is aimed at the disparity of these bonus payments with respect to the average pay of a worker. This is, however, not something that should be regulated at the level of bonus pay, but through redistribution with income taxes. In this regard, whether it is regular pay or bonus pay makes no difference. So, should then bonus pay in banking be left unregulated?
John Thanassoulis does not think so. He argues that as bank compete for top bankers and try to shift the risk on them, they end up paying them too much and all in bonuses. This is optimal for the bank as it lowers its costs right when things get critical. But as a consequence, the bank gets too much into risky activities, as competition for bankers drives bonuses up higher than socially optimal, especially if there is a contagion risk of default for other banks. So you want a regulator to limit bonuses, but in a flexible way, or the benefit of having bonuses in the first place gets eroded. Indeed, it is the top brass that sets the bank level risk, whereas other employees all the way down to secretaries (who also get bonuses) are less influential, even collectively, on the aggregate risk. Thus the idea is not to cap bonuses individually, but at the bank level as a proportion of the balance sheet (which is what matters in terms of default). The pay structure would then presumably be readjusted by the bank, relying more on bonuses where it matters the most. Taxing bonuses has no risk impact, though, except for reducing bankers' pay.
Another possibility could be the dynamic incentive accounts I mentioned before.
John Thanassoulis does not think so. He argues that as bank compete for top bankers and try to shift the risk on them, they end up paying them too much and all in bonuses. This is optimal for the bank as it lowers its costs right when things get critical. But as a consequence, the bank gets too much into risky activities, as competition for bankers drives bonuses up higher than socially optimal, especially if there is a contagion risk of default for other banks. So you want a regulator to limit bonuses, but in a flexible way, or the benefit of having bonuses in the first place gets eroded. Indeed, it is the top brass that sets the bank level risk, whereas other employees all the way down to secretaries (who also get bonuses) are less influential, even collectively, on the aggregate risk. Thus the idea is not to cap bonuses individually, but at the bank level as a proportion of the balance sheet (which is what matters in terms of default). The pay structure would then presumably be readjusted by the bank, relying more on bonuses where it matters the most. Taxing bonuses has no risk impact, though, except for reducing bankers' pay.
Another possibility could be the dynamic incentive accounts I mentioned before.
Thursday, November 18, 2010
Privatization-nationalization cycles
The past two decades have seen an impressive wave of privatizations all around the world, especially in utilities and resources. This trend has recently been reversed though, with several large nationalization waves, in particular Latin America. This kind of cycle is not new, as especially the gas industry has gone through several waves each way during the last century. Why all this back and forth?
Roberto Chang, Constantino Hevia and Norman Loayza observe that nationalizations typically happen when the price of the output of reference is high and inequality of wages is also high. The opposite is the case for privatizations. They can explain this with a model of a benevolent government that maximizes a social welfare function represented by the average utility of workers. Under nationalization, all workers are paid the same and exert little effort. Under privatization, firms can discriminate workers, who then put more heart at work, creating wage differentials. When prices for the commodity increase, this generates larger rents for the most productive, and inequality increases.
The story is then of a inequality-efficiency trade-off for the government. In the naturalized state, inequality is low, but so is efficiency. If prices are low, it is more important to increase efficiency, and the firm is privatized. But as it becomes more efficient and discriminates its workers, inequality becomes more important, and the firm is nationalized back. And the cycle continues, with an average of 12 years of privatization and 25 years for nationalization. While this is a very stylized story, after all the model assume an economy with a single sector that has no impact on world prices, it is still a compelling story.
Roberto Chang, Constantino Hevia and Norman Loayza observe that nationalizations typically happen when the price of the output of reference is high and inequality of wages is also high. The opposite is the case for privatizations. They can explain this with a model of a benevolent government that maximizes a social welfare function represented by the average utility of workers. Under nationalization, all workers are paid the same and exert little effort. Under privatization, firms can discriminate workers, who then put more heart at work, creating wage differentials. When prices for the commodity increase, this generates larger rents for the most productive, and inequality increases.
The story is then of a inequality-efficiency trade-off for the government. In the naturalized state, inequality is low, but so is efficiency. If prices are low, it is more important to increase efficiency, and the firm is privatized. But as it becomes more efficient and discriminates its workers, inequality becomes more important, and the firm is nationalized back. And the cycle continues, with an average of 12 years of privatization and 25 years for nationalization. While this is a very stylized story, after all the model assume an economy with a single sector that has no impact on world prices, it is still a compelling story.
Tuesday, August 10, 2010
The impact of political violence on tourism
Now that Lebanon and Israel are at it again, one can ask whether this can have an economic impact. The prime candidate (a part for the defense industry) is the tourism industry. Casual empiricism seems to indicate that tourist react very strongly to very small probabilities of danger and thus should be deserting those countries.
David Fielding and Anja Shortland look at the case of Egypt, which has suffered from Islamist fundamentalist violence for the last two decades, sometimes targeted at tourists. They find that tourists stay away when violence has occurred, but only when it was directed towards tourists. Violence among locals has no impact. And when the Egyptian government takes (usually heavy-handed) counter-terrorism measures, European tourists stay away, while US ones are not affected. Interestingly, there is substitution: Egypt's tourism industry benefits when things turn sours in Israel, at least if it does not mean local trouble.
David Fielding and Anja Shortland look at the case of Egypt, which has suffered from Islamist fundamentalist violence for the last two decades, sometimes targeted at tourists. They find that tourists stay away when violence has occurred, but only when it was directed towards tourists. Violence among locals has no impact. And when the Egyptian government takes (usually heavy-handed) counter-terrorism measures, European tourists stay away, while US ones are not affected. Interestingly, there is substitution: Egypt's tourism industry benefits when things turn sours in Israel, at least if it does not mean local trouble.
Thursday, July 15, 2010
Does regulating alcohol reduce crime?
Alcohol use has an impact on crime in many ways. Perpetrators maybe mentally impaired by alcohol abuse, may be motivated by an addiction, or venues were alcohol is consumed may give opportunities for crime. Also, being a consumer of alcohol may increase the likelihood of victimization. What economic policy means are available to reduce crime from alcohol use? Obviously, you want to reduce alcohol use and abuse, but let us for once leave the health consequences aside (assume they are already internalized by the consumer).
Christopher Carpenter and Carlos Dobkin perform a meta-analysis of the literature and find that taxing alcohol and putting age limits to its consumption are the best policies. Restricting when or where alcohol can be consumed has, however, little impact on alcohol-related crime.
Beyond what the literature says, I have always been puzzled how different cultures deal differently with alcohol. For example, Italians drink wine already as kids, yet you rarely find drunken Italians. In fact, the only drunks I have encountered in Italy where American students and British tourists. My anecdotal evidence is that the more regulated alcohol consumption is, the more people are drunk. But the causality may very well run the other way. For the current paper, though, what really matters is how alcohol consumption translates into criminal behavior. And the literature seems here counter-intuitive to me.
Christopher Carpenter and Carlos Dobkin perform a meta-analysis of the literature and find that taxing alcohol and putting age limits to its consumption are the best policies. Restricting when or where alcohol can be consumed has, however, little impact on alcohol-related crime.
Beyond what the literature says, I have always been puzzled how different cultures deal differently with alcohol. For example, Italians drink wine already as kids, yet you rarely find drunken Italians. In fact, the only drunks I have encountered in Italy where American students and British tourists. My anecdotal evidence is that the more regulated alcohol consumption is, the more people are drunk. But the causality may very well run the other way. For the current paper, though, what really matters is how alcohol consumption translates into criminal behavior. And the literature seems here counter-intuitive to me.
Friday, June 25, 2010
Smoking ban or cigarette taxation?
While people are now used to widespread smoking bans in the United States, European countries are right now going through the painful transitions, with the expected anxieties from restaurant and bar owners. They will do fine, but one can still ask whether simple taxation of tobacco would not be sufficient and especially more efficient in internalizing second hand smoke.
Charles de Bartolome and Ian Irvine note that taxation has a major problem here: the emergence of a thriving black market. Banning smoking in public areas also has a major disadvantage, namely that one can smoke more at home, potentially exposing more family members and especially children (see previous post in this regard). De Bartolome and Irvine give a counterargument: a ban interrupts to continues flow of nicotine, making it emotionally more expensive to the smoker, and possibly may also drive him to abandon smoking more than a tax could. We now need a paper that disentangles the quantitative effects of the polices to sort it out.
Charles de Bartolome and Ian Irvine note that taxation has a major problem here: the emergence of a thriving black market. Banning smoking in public areas also has a major disadvantage, namely that one can smoke more at home, potentially exposing more family members and especially children (see previous post in this regard). De Bartolome and Irvine give a counterargument: a ban interrupts to continues flow of nicotine, making it emotionally more expensive to the smoker, and possibly may also drive him to abandon smoking more than a tax could. We now need a paper that disentangles the quantitative effects of the polices to sort it out.
Wednesday, April 7, 2010
About the impact of environmental product regulation on the environment in the North and the South
Imagine that the world is separated in two: a more developed North that cares about the environment, and a less developed South that does not. The North imposes restrictions on the consumption of goods that pollute. Conventional wisdom tells us the environment should be improving in the North and deteriorate in the South.
Jota Ishikawa and Toshihiro Okubo tell us the opposite could happen. The crucial aspect here is that firm can relocate. The producer of a polluting good could just stop serving the North and then relocate to the South. This is what all those against environmental regulation are afraid of. As long as the remaining goods are still polluting, and if there is going to be more production and consumption of those, one could get more pollution in the North. For this to happen, though, one needs some particular circumstances: pollution is only global, competition is monopolistic, compliance costs are low, and standards are lax. To make sure the environment is improved this calls for perfect competition (getting rid of protectionist measures), high compliance costs and rigorous standards. Easy.
The reason for the counter-intuitive result is, not unexpectedly, rather twisted. Once the North introduces regulation, firms producing affected goods move South. There is less competition in the North, which attracts firms not affected by regulation from the South. But there is less good variety in the North, and the goods of the newcomers cost less than before because trade costs are dropped, thus consumers buy more. The opposite happens in the South. Kind of hard to believe, but I cannot see where the argument would go wrong.
Jota Ishikawa and Toshihiro Okubo tell us the opposite could happen. The crucial aspect here is that firm can relocate. The producer of a polluting good could just stop serving the North and then relocate to the South. This is what all those against environmental regulation are afraid of. As long as the remaining goods are still polluting, and if there is going to be more production and consumption of those, one could get more pollution in the North. For this to happen, though, one needs some particular circumstances: pollution is only global, competition is monopolistic, compliance costs are low, and standards are lax. To make sure the environment is improved this calls for perfect competition (getting rid of protectionist measures), high compliance costs and rigorous standards. Easy.
The reason for the counter-intuitive result is, not unexpectedly, rather twisted. Once the North introduces regulation, firms producing affected goods move South. There is less competition in the North, which attracts firms not affected by regulation from the South. But there is less good variety in the North, and the goods of the newcomers cost less than before because trade costs are dropped, thus consumers buy more. The opposite happens in the South. Kind of hard to believe, but I cannot see where the argument would go wrong.
Wednesday, March 17, 2010
Why Japanese farms are so small
Why are Japanese farms so small and so inefficient/ As usual under such circumstances, this is because they are protected through subsidies and zoning laws. But why? No matter what the country, agriculture enjoys protection. Some reasons, depending on the country, may include resistance to change, preservation of the landscape, preservation of traditions and securing wartime food for the country. All this can explain why the agricultural sector is subsidized and then inefficient, but that does not explain why Japanese farms are small. They could still merge.
Yoshihisa Godo finds an explanation from political economy. Japanese farmers can make more money from manipulating farmland regulation than from farming itself. In other words, they are extracting rents from holding a regulated asset. For example, as a land-owner, you get money if you preserve its agricultural purpose, and the more prone to conversion to other uses the location is, the more you get. That explains why you would find rice paddies in the middle of dense cities. But when an opportunity arises, farmers convince ("manipulate") authorities to convert the classification of the land to cash in on its market value.
Godo links this to a misunderstanding of democracy, in that people only care for themselves and do not see the consequences for the others. While it may be true that people in Japan a century ago may have been less selfish, the current problem is one of deficient institutions, not deficient people. That institutions cannot be changed may very well be an issue of lobbying and rent-seeking, but you cannot blame it on citizen having little regard on the duties in participatory democracy. Godo's main point is that people complain when a zoning change hurts them, and then exploit other zoning changes for their own gain. He also complains that those hurt ask for compensation. Yet, good economics would precisely ask for such compensation, a very Coasian argument. It would also ask for those who gain to pay for such privilege. This is where Japan is lacking, and once this is implemented, land would be used much more efficiently. Making this happen could very well be a political problem, but it has nothing to do with an implied lack of servitude of the average voter.
PS: I hate it when a paper starts on page 9.
Yoshihisa Godo finds an explanation from political economy. Japanese farmers can make more money from manipulating farmland regulation than from farming itself. In other words, they are extracting rents from holding a regulated asset. For example, as a land-owner, you get money if you preserve its agricultural purpose, and the more prone to conversion to other uses the location is, the more you get. That explains why you would find rice paddies in the middle of dense cities. But when an opportunity arises, farmers convince ("manipulate") authorities to convert the classification of the land to cash in on its market value.
Godo links this to a misunderstanding of democracy, in that people only care for themselves and do not see the consequences for the others. While it may be true that people in Japan a century ago may have been less selfish, the current problem is one of deficient institutions, not deficient people. That institutions cannot be changed may very well be an issue of lobbying and rent-seeking, but you cannot blame it on citizen having little regard on the duties in participatory democracy. Godo's main point is that people complain when a zoning change hurts them, and then exploit other zoning changes for their own gain. He also complains that those hurt ask for compensation. Yet, good economics would precisely ask for such compensation, a very Coasian argument. It would also ask for those who gain to pay for such privilege. This is where Japan is lacking, and once this is implemented, land would be used much more efficiently. Making this happen could very well be a political problem, but it has nothing to do with an implied lack of servitude of the average voter.
PS: I hate it when a paper starts on page 9.
Friday, February 26, 2010
Posting calories in restaurants is Pareto improving
With increasing frequency, it is proposed that restaurants should post on their menus nutritional information. The restaurants resist this because they think it may shoo customers away, or at least make them eat less (assuming they underestimated the calories, which may not be always true). But if they eat less, why not make portions smaller and thus reduce costs and possibly increase profits?
Bryan Bollinger, Phillip Leslie and Alan Sorensen observed Starbucks outlets in New York City as such a calorie posting policy was implemented. They got data about each transaction in a NYC outlet for a 14-month period, including 11 months with calorie postings, as well as in Boston and Philadelphia, which act as control groups. They finding that the posting reduced calories per transaction by 14 units, 10 coming from fewer purchases and 4 from switching to a lower calorie item. You may think this would be bad for Starbucks? Think again, there was no significant change in revenue, in fact there was even a 3% increase for Starbucks outlets close to Dunkin Donuts: the calorie posting attracted clients from competitors.
Bryan Bollinger, Phillip Leslie and Alan Sorensen observed Starbucks outlets in New York City as such a calorie posting policy was implemented. They got data about each transaction in a NYC outlet for a 14-month period, including 11 months with calorie postings, as well as in Boston and Philadelphia, which act as control groups. They finding that the posting reduced calories per transaction by 14 units, 10 coming from fewer purchases and 4 from switching to a lower calorie item. You may think this would be bad for Starbucks? Think again, there was no significant change in revenue, in fact there was even a 3% increase for Starbucks outlets close to Dunkin Donuts: the calorie posting attracted clients from competitors.
Monday, January 4, 2010
Charities: competition vs. the social planner
Charities need to raise funds, and it is costly doing so. As the number of charities increases, so do these costs. This raises the question whether there is an optimal number of charities and whether some sort of regulation can bring us closer to this optimal number.
Murat Mungan and Yoruk Barls should that free competition leads to a suboptimal number of charities, in particular because some donors are solicited by several charities. In this respect, is a regulated monopoly the solution? One would think this is not optimal because charities pursue very diverse goals. Mugan and Barls show that in a spatial model this charity "ideologies," some extent of competition is good for maximizing net charity revenues as long as the fixed costs is sufficiently low. That seems like a trivially simple result, but it one worth pointing out. The way charities are regulated is by restricting entry and then taxing or subsidizing them to get the "right" fix cost.
Murat Mungan and Yoruk Barls should that free competition leads to a suboptimal number of charities, in particular because some donors are solicited by several charities. In this respect, is a regulated monopoly the solution? One would think this is not optimal because charities pursue very diverse goals. Mugan and Barls show that in a spatial model this charity "ideologies," some extent of competition is good for maximizing net charity revenues as long as the fixed costs is sufficiently low. That seems like a trivially simple result, but it one worth pointing out. The way charities are regulated is by restricting entry and then taxing or subsidizing them to get the "right" fix cost.
Wednesday, June 10, 2009
Regulation and the financial crisis
Various people have argued that the current crisis has been the result of a lock of regulatory oversight, that basically allowed banks to do silly things. I fail to be convinced about this argument for the simple fact that the only financial entities that have run into trouble were regulated ones, and the unregulated hedge funds, while obviously facing losses, are still in business without outside help. But it is still worthwhile thinking whether regulation is at an optimal level.
Joshua Aizenman provides a rather intuitive model of banking regulation: regulation reduces the risk of a crisis, but the perceived lower risk reduces support for regulation. Thus, one would always have under-regulation and even no regulation after sufficiently long, crisis free spell. This under-regulation is exacerbated by the fact that the public typically does not observe (or understand) the regulator's efforts. Of course, there is over-regulation immediately following a crisis, especially if it is very costly. Bayesian updating will do that to you. How to prevent these issues? Essentially the same way one prevents the inflation bias of a central bank: independence, transparency and predefined goals.
That said, and I mentioned it above, under-regulation may not necessarily be the trigger of the current crisis. What is sure, however, is that additional regulation is certainly not necessary now. All the activities that people have decried (under-priced sub-prime lending, over-leveraging, etc.) have disappeared without regulatory intervention. Such is the market...
Joshua Aizenman provides a rather intuitive model of banking regulation: regulation reduces the risk of a crisis, but the perceived lower risk reduces support for regulation. Thus, one would always have under-regulation and even no regulation after sufficiently long, crisis free spell. This under-regulation is exacerbated by the fact that the public typically does not observe (or understand) the regulator's efforts. Of course, there is over-regulation immediately following a crisis, especially if it is very costly. Bayesian updating will do that to you. How to prevent these issues? Essentially the same way one prevents the inflation bias of a central bank: independence, transparency and predefined goals.
That said, and I mentioned it above, under-regulation may not necessarily be the trigger of the current crisis. What is sure, however, is that additional regulation is certainly not necessary now. All the activities that people have decried (under-priced sub-prime lending, over-leveraging, etc.) have disappeared without regulatory intervention. Such is the market...
Thursday, June 4, 2009
Ponzi and regulation
Ponzi scheme are much more frequent than one would think, although not as big the Madoff scheme. Ana Carvajal, Hunter Monroe, Brian Wynter and Catherine Pattillo report about a series of them in the Caribbean and in particular on how regulators intervened. For example in Jamaica, regulators alerted the public that the schemes were not licensed to accept deposits and to trade in what they advertised. The schemes were defended by other officials, seeing their effective sponsorships of events and parties. A legal battle ensued over the licensing, giving much publicity and leading, perversely, to further growth of the schemes and copycats. Looking at other instances, it appears that independence of the financial regulator is essential, as well as speedy courts. The regulator needs to have broad authority and be proactive.
Now, one may question why regulation is needed in the first place, as investors just need to draw the consequences of foolish acts. Well, first Ponzi scheme have a social cost, in the they unnecessarily reduce the confidence in the financial sectors, draw funds away from productive investments and can cause civil strife. The other is that if every investor needs to independently monitor, the cost of verification is much larger than if a regulation agency could do it. This could also be delegated to a private agency, but the latter does not have deep pockets if it screws up.
Now, one may question why regulation is needed in the first place, as investors just need to draw the consequences of foolish acts. Well, first Ponzi scheme have a social cost, in the they unnecessarily reduce the confidence in the financial sectors, draw funds away from productive investments and can cause civil strife. The other is that if every investor needs to independently monitor, the cost of verification is much larger than if a regulation agency could do it. This could also be delegated to a private agency, but the latter does not have deep pockets if it screws up.
Thursday, April 2, 2009
Credit rating inflation and naive investors
Imagine that employers determine the quality of job applicants by looking at their GPA (grade point average). Then obviously, colleges would want to give good grades to their students to give them better chances on the job market. To attract tuition paying students, colleges promise good grades. This scheme will work as look as there are some naive employers that do not see that they are getting fooled by grade inflation.
Patrick Bolton, Xavier Freixas and Joel Shapiro argue that this is exactly what happened with the credit rating agencies, which are financed by the very institutions they are rating. And the latter shop around for the better ratings. As long as there are naive investors willing to believe whatever the credit rating agencies say, the rating inflation will continue. The authors show with a model that the optimal policy response is to force disclosure of all ratings. One would not have needed a formal model to realize that. More interesting is that they show that a monopoly can in fact lead to better outcomes, for once, because it does not lead to rating inflation. Monopolies bring other inefficiencies, however, and we are already advocating the public provision of ratings...
Patrick Bolton, Xavier Freixas and Joel Shapiro argue that this is exactly what happened with the credit rating agencies, which are financed by the very institutions they are rating. And the latter shop around for the better ratings. As long as there are naive investors willing to believe whatever the credit rating agencies say, the rating inflation will continue. The authors show with a model that the optimal policy response is to force disclosure of all ratings. One would not have needed a formal model to realize that. More interesting is that they show that a monopoly can in fact lead to better outcomes, for once, because it does not lead to rating inflation. Monopolies bring other inefficiencies, however, and we are already advocating the public provision of ratings...
Wednesday, October 1, 2008
What is the FDIC thinking?
I have been trying on this blog to focus on other things than the current financial situation that everybody else is covering, but it is getting really difficult. The government is trying to find ways to get lending institutions to lend again, and guess what the FDIC is doing?
Preventing them from lending. That's right. The FDIC is going through the banks, looking at their balance sheets, readjusting the risk measures of the loans (I am fine with that), downgrading to junk anything that is related to real estate. That is problem number one: Not every real estate loan is poorly performing. In fact, most are still paying their mortgage every month, and will be until maturity. Forcing bank to basically write off every real estate loan is poor risk management. The consequence for most banks is that their rating with the FDIC is tanking, they must pay higher premiums to the FDIC and must recapitalize.
But it gets worse. The FDIC forces bank not to make loans, unless they are backed by cash. Banks are even asked to call back loans of well capitalized borrowers that were performing just fine. The FDIC is taking a wholesale approach killing all real estate loans, severing long-standing business relationships and basically negating all government efforts to get lending going again.
The FDIC has a mission, ensuring depositors can get to their money if needed. But it should not act in isolation of the other agencies, and it should not kill performing, sane business relationships. We definitely need to reduce the alphabet soup and merge the regulating agencies so that they can cooperate.
Preventing them from lending. That's right. The FDIC is going through the banks, looking at their balance sheets, readjusting the risk measures of the loans (I am fine with that), downgrading to junk anything that is related to real estate. That is problem number one: Not every real estate loan is poorly performing. In fact, most are still paying their mortgage every month, and will be until maturity. Forcing bank to basically write off every real estate loan is poor risk management. The consequence for most banks is that their rating with the FDIC is tanking, they must pay higher premiums to the FDIC and must recapitalize.
But it gets worse. The FDIC forces bank not to make loans, unless they are backed by cash. Banks are even asked to call back loans of well capitalized borrowers that were performing just fine. The FDIC is taking a wholesale approach killing all real estate loans, severing long-standing business relationships and basically negating all government efforts to get lending going again.
The FDIC has a mission, ensuring depositors can get to their money if needed. But it should not act in isolation of the other agencies, and it should not kill performing, sane business relationships. We definitely need to reduce the alphabet soup and merge the regulating agencies so that they can cooperate.
Wednesday, August 20, 2008
Regulating private money
With the emergence of electronic money and prepaid cards, the debate about private money has reemerged. Stephen Williamson has long been and advocate of private issuance of money, even the complete privatization of this central bank activity. But he also acknowledges that there can be a lemons problem, as the quality of issued notes may vary. Think for example of gift certificates which may lose their value when the issuing store goes bankrupt or, more often, when they have an expiration date. This may call for some regulation.
Among proposed regulations is the requirement that private money be exchanged at par with "official" money. Clearly, if private money is perfectly credible, this would be an equilibrium outcome anyway. But if there are some doubts about private money issuers, their money should be redeemed at a discount in equilibrium. Imposing parity could clearly constrain the economy away from some optimum. This is the argument of David Mills in the lead article of the latest International Economic Review.
I like very much the money search approach, which is arguably still very crude, but has the immense merit to give true micro-foundations for money, instead of money-in-the-utility, ad hoc nominal rigidities or assumed Phillips curves. It allows to explicit the impact of institutions or policy on agents' behaviors. Search theory can also make statements about welfare.
In this case, the modeling allows to explicit the differences between a regime where market participants are free to determine the price of private money and free to accept it or not. It highlights how much stronger the gambles of accepting private money becomes when its price is fixed and the monitoring of private money issuers are imperfectly monitored. The essential issue is that with parity, price cannot function as signals anymore.
Among proposed regulations is the requirement that private money be exchanged at par with "official" money. Clearly, if private money is perfectly credible, this would be an equilibrium outcome anyway. But if there are some doubts about private money issuers, their money should be redeemed at a discount in equilibrium. Imposing parity could clearly constrain the economy away from some optimum. This is the argument of David Mills in the lead article of the latest International Economic Review.
I like very much the money search approach, which is arguably still very crude, but has the immense merit to give true micro-foundations for money, instead of money-in-the-utility, ad hoc nominal rigidities or assumed Phillips curves. It allows to explicit the impact of institutions or policy on agents' behaviors. Search theory can also make statements about welfare.
In this case, the modeling allows to explicit the differences between a regime where market participants are free to determine the price of private money and free to accept it or not. It highlights how much stronger the gambles of accepting private money becomes when its price is fixed and the monitoring of private money issuers are imperfectly monitored. The essential issue is that with parity, price cannot function as signals anymore.
Thursday, July 24, 2008
Speculators are not the problem
The US Congress has finally found the scapegoat for high oil prices. While most of the increase is due to the fall of the US dollar that will eventually rectify itself, it found speculators to be guilty and intends to rein them in. This is nonsense.
Speculators are regularly vilified because they manage to make money without being apparently productive. Yet, they provide some very important functions on the market: they help hedging against risks, and more importantly, they help prices being informative of true economic conditions. Through their arbitraging, they make sure that goods are properly priced. For example, if an under-supply of oil is expected, they make sure that the price of oil reflects this. This allows producers and consumers to adjust to conditions. If prices would not reflect markets conditions, rationing could appear.
Yet it seems Congress wants exactly that: prices that do not reflect economic conditions. The current proposal is to inhibit the ability of speculators to arbitrage by preventing them to resell (which is at the core of arbitraging) and to deal with foreign markets.
There is no question that whenever markets are manipulated, intervention is necessary. How do you define manipulations? Albert Kyle and S. Viswanathan define a two-pronged test: Price manipulation needs to simultaneously undermine both pricing accuracy and market liquidity. In other words, their is manipulation if prices do not provide signals about economic conditions while there is evidence that someone is preventing trades from happening. Prices could be poor signals in liquid markets, but their is nothing one can do and nobody is benefiting from it. Prices can be accurate in illiquid markets, and that is not a problem. But both happening at the same time is a sign of manipulation.
Are oil prices currently manipulated? Given the size of the market, this is unlikely. But it has happened before, for example when the Hunt brothers manipulated the silver bullion market in 1979-80. At that time, they severely curtailed the liquidity of the market by hoarding. That does not seem to be the case with oil today. Oil markets are very liquid, and prices do reflect a real scarcity in addition to risk.
Note that what Congress proposes would be considered price manipulation, as transactions are prohibited (which lowers market liquidity) and prices likely would not reflect economic conditions (which undermines pricing accuracy). In other words, the proposal would make things worse... But it is responding to the call of doing something, and this is what counts in politics, right?
Speculators are regularly vilified because they manage to make money without being apparently productive. Yet, they provide some very important functions on the market: they help hedging against risks, and more importantly, they help prices being informative of true economic conditions. Through their arbitraging, they make sure that goods are properly priced. For example, if an under-supply of oil is expected, they make sure that the price of oil reflects this. This allows producers and consumers to adjust to conditions. If prices would not reflect markets conditions, rationing could appear.
Yet it seems Congress wants exactly that: prices that do not reflect economic conditions. The current proposal is to inhibit the ability of speculators to arbitrage by preventing them to resell (which is at the core of arbitraging) and to deal with foreign markets.
There is no question that whenever markets are manipulated, intervention is necessary. How do you define manipulations? Albert Kyle and S. Viswanathan define a two-pronged test: Price manipulation needs to simultaneously undermine both pricing accuracy and market liquidity. In other words, their is manipulation if prices do not provide signals about economic conditions while there is evidence that someone is preventing trades from happening. Prices could be poor signals in liquid markets, but their is nothing one can do and nobody is benefiting from it. Prices can be accurate in illiquid markets, and that is not a problem. But both happening at the same time is a sign of manipulation.
Are oil prices currently manipulated? Given the size of the market, this is unlikely. But it has happened before, for example when the Hunt brothers manipulated the silver bullion market in 1979-80. At that time, they severely curtailed the liquidity of the market by hoarding. That does not seem to be the case with oil today. Oil markets are very liquid, and prices do reflect a real scarcity in addition to risk.
Note that what Congress proposes would be considered price manipulation, as transactions are prohibited (which lowers market liquidity) and prices likely would not reflect economic conditions (which undermines pricing accuracy). In other words, the proposal would make things worse... But it is responding to the call of doing something, and this is what counts in politics, right?
Tuesday, July 1, 2008
Markets trump policy: illicit drugs
Among developed economies, the United States has the most restrictive policy relative to illicit drug. The Netherlands have a much more relaxed one. Guess where more people use drugs.
According to a study published in PLos Medecine, Americans are far ahead of anybody else. this table shows that 16.2% have tried cocaine, New Zealand is second at 4.3%, and the liberal Netherlands have 1.9%. For cannabis, it is 42.4, 41.9% and 19.8%.
So much for the war on drugs. This shows that markets are much more powerful than regulation, they find a way to circumvent rules and laws. How can one really reduce drug use, if this is the true goal? Make it legal, thus reducing its price, as the risk premium drops. Supply will then drop. If the price goes too low, tax it like tobacco and alcohol. At least revenue would then end up in the pockets of the government instead of crooks.
According to a study published in PLos Medecine, Americans are far ahead of anybody else. this table shows that 16.2% have tried cocaine, New Zealand is second at 4.3%, and the liberal Netherlands have 1.9%. For cannabis, it is 42.4, 41.9% and 19.8%.
So much for the war on drugs. This shows that markets are much more powerful than regulation, they find a way to circumvent rules and laws. How can one really reduce drug use, if this is the true goal? Make it legal, thus reducing its price, as the risk premium drops. Supply will then drop. If the price goes too low, tax it like tobacco and alcohol. At least revenue would then end up in the pockets of the government instead of crooks.
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