Economics & Finance

Why Don’t We Just Cut China a Check?

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The really stupid thing about Obama’s carbon cap-and-trade system  [h/t Instapundit] is that it will simply relocate more manufacturing to countries that don’t give a damn about global warming.

The growing economies of China, India, and other parts of the world still have people living the lives of preindustrial  subsistence  farmers.  Right now, today, they have people in dire need of food, clothing, shelter, medical care, education, transportation and every other facet of modern life we take for granted.  They don’t give a crap about hypothetical dangers that will hypothetically manifest a century from now.

Such areas will use dense, rich, reliable sources of energy like coal and nuclear to power their factories while we try to smelt iron with windmills. We will be poor and eventually powerless in the face of such competition. Worse, if global warming is a problem, it will happen anyway. Our sacrifices will simply mean we have fewer resources to deal with the problems posed by global warming.  

Obama plans to shut down our carbon-emitting power sources today, decades before we bring their hypothetical  replacements online. If the technology doesn’t work as predicted, where will we be then?

Obama’s plan will be a massive wealth transfer from America to China and India. We will simply be handing them our current and future economic productivity on a platter.  

“Rational” Behavior

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This post and the subsequent discussion prompt me to make a point about the use of the term “rational” in economics and game theory.  

I think the people in the linked posts confuse the common definition of “rational” with the way that economists and game theorists use the term. Economists and game theorists axiomatically define a “rational” choice as one that will give the highest chance of accomplishing a previously defined goal given a specific set of parameters. That choice is defined axiomatically as the “rational” choice. Rational in this context does not mean wise, intelligent, most-good-for-the-most-people or any of the other concepts attached to the word in common speech. For example, in poker, game theory defines a different set of choices as rational depending on whether you want to make a killing, come out even or use the game as a pretext to transfer some money to a friend. Game theory does not comment on which of the three goals constitutes the most rational choice.  

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Clever Mathematicians vs. Financial Risk

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See here (via here).

This is a timeless issue. The specific risk model under discussion isn’t the central issue. It never is. The central issue is that financial-risk models whose effectiveness depends on the accuracy of their assumptions about the distribution of securities-price movements eventually blow up. This is why “portfolio insurance” failed in (helped to precipitate) the 1987 crash, why Long Term Capital Management blew up, why Fannie Mae’s risk estimates vastly understated the real risk and why countless other “value at risk” schemes cause more problems than they mitigate. In simple terms, these schemes assume that in the event of portfolio losses you will be able to sell off your portfolio incrementally without incurring further large losses. In practice, the very fact that your portfolio is experiencing an extreme decline in value means there are no buyers except at lower prices and that further losses are probably inevitable: if the life boats are all on one side of your supposedly unsinkable ship you may still capsize if the passengers move there en masse. This is human nature and can’t be hedged away by invoking clever math, though clever people keep making this mistake (and will keep making it, because human nature doesn’t change).

In the long run the only reliable way to limit the risk in your market portfolio is to structure it so that you don’t lose money if the impossible happens. But this is expensive (insurance usually is), and it’s always tempting to lower your costs, and raise your short-run returns, by assuming you don’t have to worry about 100-year floods. The problem is that 100-year floods occur in financial markets every five or 10 years.

BTW, this is also why the notion of “stress testing” banks is fatally flawed. You cannot assess the risk of loss in a financial portfolio by asking what happens under conditions of moderate, i.e., likely, financial stress. If there is a systematic fatal weakness, however improbable, in your financial system the markets will eventually find it and the system will blow up.

What Date is It? Part II

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From the New York Times:

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.
 
In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.
 
”From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison a resident fellow at the American Enterprise Institute. ”If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

When was this piece of sage advice from the  libertarian  American Enterprise Institute given? 2009? 2008, 2007? Try  September 30, 1999.  

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What Date is It?

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From the New York Times:

The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis…
 
Under the plan, disclosed at a Congressional hearing today, a new agency would be created within the Treasury Department to assume supervision of Fannie Mae and Freddie Mac, the government-sponsored companies that are the two largest players in the mortgage lending industry.
 
The new agency would have the authority, which now rests with Congress, to set one of the two capital-reserve requirements for the companies. It would exercise authority over any new lines of business. And it would determine whether the two are adequately managing the risks of their ballooning portfolios. [emp added]

Freddie Mac and Fannie Mae are absolutely ground zero for the  financial  collapse. Most of the major lenders who failed did so because the mortgage securities they brought from the
two  Government  Sponsored  Enterprises (GSEs) proved nearly worthless.  

I know what you’re thinking, “It’s too bad Bush didn’t try to fix the problem with the GSEs before the wheels came off.”

The New York Times story is datelined  September 11, 2003.  

The Times give the prized final word to these two clowns:

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”
 
Representative Melvin L. Watt, Democrat of North Carolina, agreed.
 
”I don’t see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing,” Mr. Watt said.  

The  financial  collapse  was not caused by unbridled  capitalism. It was caused by politicians trying to distort the free market to get something for nothing. Far from being oblivious to the dangers posed by the GSEs, Bush and other Republicans tried to make them work more like free-market companies, but Frank and other Democrats blocked them.  Bush failed in four attempts to reform the dangerous GSEs, until last summer when it was far too late.  

The Democrats’ creation of the GSEs and their decades-long coddling of them inflated minor, localized housing booms into a single, massive economy-wrecking bubble. We shouldn’t forget how we got here.