Thursday, October 31, 2013

What should we do during the next financial crisis?

NY Times interview with Nobel Laureate Gene Fama:

In the financial crisis, do you think the government should have bailed out the big banks?
No, I don’t. I would’ve favored nationalizing the banks, not bailing them out.

Really? That’s not very libertarian, is it?
Well, we’re talking about realistic alternatives. It’s not credible that in a financial crisis, the government will do nothing. It never has. There are going to be demands for it to do something. So you’ve got two choices now. Nationalize them or bail them out. Bailing them out gives them terrible disincentives; it encourages them to take risks because they’ll be bailed out. So I’d nationalize them — and clean them up and then reprivatize them.

HT:  Merle Hazard

Reverse deductible creates incentive to shop for healthcare

Here is how it works.  One employer noticed that it was paying between $20,000 and $120,000 for a single surgery.  The employer said it would pay up to $30,000 for the procedure, and identified 41 hospitals that charged less than this.  Patients were free to go to higher priced hospitals, but they had to pay the difference.

Guess what happened next:

Half of the high-price hospitals cut their rates, many by a considerable amount....Across all hospitals, prices charged to Calpers for joint-replacement surgery declined by 26% in the first year and by even more in the second.

HT:  Nick

Risk-on, Risk-off trading

In our chapter 9 video, we illustrate how Vanderbilt Treasurer made money by selling risky assets and buying less risky ones when risk premia (the extra return investors receive for investing in risky assets) moved to historic lows.  He correctly reasoned that investors were ignoring risk in search of higher return, so when risk premia widened, in 2008, the price of risky assets fell relative to their less risky counterparts.  In the jargon of finance, this is known as a "risk off" trade.

We can illustrate risk-off trading, uusing Don Marron's "history of the European Union in one simple chart" below. It shows the premia that the Southern European PIIGS (Greece is in orange) had to pay to borrow money. 

In 1995, for example, Greece (in orange) had to pay 18% to borrow money, representing an 11% premium over Germany's (in red) 7% rate.  The risk premium disappeared in 2002 when Greece joined the EU.  In 2008, the risk premia re-appeared, as the interest rate on Greek debt rose to 16%, a 12% premium over Germany's 4%. 

From investopedia:

...During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.  ... The 2008 financial crisis was considered a "risk off" year, in which investors attempted to reduce risk by selling existing risky positions and moving money to either cash positions or low/no-risk positions, such as U.S. Treasury bonds.

If you can anticipate changes in risk premia, you can make money:

  • A prescient "risk-off" trade would have been to short Greek debt and buy German debt in 2007, and sell in 2011.  
  • Conversely, a prescient "risk-on" trade would have been to buy Greek debt and short German debt in 1995, and sell in 2001. 

Did "Cash for Clunkers" work?

A new paper confirms what the graph below shows: 

in 957 U.S. cities, the surge in automobile sales was short-lived while the program was in place. About 360,000 automobile purchases were induced in July and August 2009. Most of these purchases simply were brought forward by a few months: a sharp decline in sales after the program ended suggests that it had a muted total effect on auto purchases, the authors conclude. 

One of the criticisms of Keynesian stimulus is that Keynes never told us what happens in his model when taxpayers must pay back the money that the government spent to stimulate the economy.  Famously, he said, "in the long run, we are all dead." (See this post for a discussion of Keynes).  So in essence, Keynesian stimulus borrows consumption from the future. 

This looks like what happened. 

Wednesday, October 30, 2013

Open enrollment must be limited, or ...

...healthy people will wait until they are sick to enroll.  This is a type of moral hazard.

“If you can enroll at any point in the year, then you can just wait until you get sick,” Brian Wright, an analyst with Monness Crespi Hardt in New York, said in a telephone interview. “This isn’t the industry crying foul and exaggerating the issue, this is actually one of those issues where there is a well-grounded reason for the concerns.”

President Obama's extension of the open enrollment period would make insurance more expensive, as insurers anticipate this reaction from a long open enrollment season. 

Wednesday, October 23, 2013

DC Teacher Incentives

Michelle Rhee's tenure as Washington DC's Chancellor of Public Schools was controversial mostly because she instituted reforms designed to hold teachers accountable for classroom performance. This episode provides the backdrop for studying the role of high-powered incentives linked to multiple measures of teacher performance. The effectiveness of one of these reforms have recently been analyzed by Thomas Dee and James Wyckoff in their paper "Incentives, Selection, and Teacher Performance: Evidence from IMPACT." So how did it do? From the abstract:
Our RD [Regression Discontinuity] results indicate that dismissal threats increased the voluntary attrition of low-performing teachers by 11 percentage points (i.e., more than 50 percent) and improved the performance of teachers who remained by 0.27 of a teacher-level standard deviation. We also find evidence that financial incentives further improved the performance of high-performing teachers (effect size = 0.24).

So screening mitigated both the adverse selection and the moral hazard problems and not by small amounts.

Tuesday, October 22, 2013

Heads the unions win, tails the taxpayers lose

NY Times on the debacle of municipal pensions:

The city’s pension system made extra payments for decades to thousands of people, on the thinking that the base pensions were too small. The pension board thought it found the money for the extra payments by skimming off “the excess” when returns on investments exceeded the plan’s target — 7.9 percent in Detroit.

But the pension fund also had years when its investments fell short of the target. And with millions of dollars being paid out each year in the extras, the fund missed out on all the investment income that money would have brought in. So the extra payments fundamentally undercut the health of the pension plan.

Reform seems to come only from the threat of bankruptcy.

HT: Matthew

Signs of intelligent life in Nashville

... as voters forced Mayor Karl Dean to withdraw a plan to borrow $200M to help cover Nashville's unfunded pension liability.

Future Nashvillians are on the hook for about 2.5B (2B for medical pensions, 0.5B for regular pension) to city workers.  To help cover the short fall, the city proposed to borrow $200M at 4% interest, invest it and earn 7.5%. 

If the investments work out, then we can expect to net 3.5%, money that would ostensibly be used to pay down our unfunded liabilities.  In reality, it would likely fund more current government spending.

If the investments don't work out, our unfunded liabilities get even bigger. 

An Auction Reserve Clause with Consequences

"Glass on the Tracks" is local event in a suburb of Dallas-Fort Worth in which glass artwork is auctioned off. The highlight is the "Glass Guillotine" where, if the bidding does not go high enough, the piece gets destroyed. The hope is that this will motivate bidders.


HT: Olga

Why are young people leaving the workforce?

The graph above illustrates the sorry state of the US labor market.  Unemployment is falling only because people are dropping out of the labor force in record numbers.  Some of them are going onto social security disability.  You can see this in the falling labor participation rate (number of people who have jobs or are looking for jobs divided  by the working age population) while the number of working divided by the number who could be working has not recovered from the recessionary lows.

NPR had another story, The Startling Rise of Disability in America, that is making me re-think my opposition to subsidies for public broadcasting.  Here is the essence of the problem:

There's no diagnosis called disability. You don't go to the doctor and the doctor says, "We've run the tests and it looks like you have disability." It's squishy enough that you can end up with one person with high blood pressure who is labeled disabled and another who is not.
As a consequence of the squishy diagnoses, you get moral hazard, i.e., some people on disability don't belong there.  

Interestingly, Great Britain has tried to reduce disability rolls by testing recipients.  Here is what happened:

... in an attempt to make the replacement scheme more rigorous, applicants now undergo the WCA, which can require them to undergo a face-to-face medical assessment and provide a report from their doctor.
But government figures have shown that more than nine out of 10 people who claimed the new sickness benefit have been deemed fit enough to work.
More than a third of the 1.3 million people who applied for Employment and Support Allowance were found to be fully capable of working.

Is it time for a similar test in the US?

Donald Marron tells me that the trust fund for the disability part of Social Security is currently expected to run out of money in 2016. So there may be a budgetary "forcing" event requiring Congress to consider what changes to the program might make sense.

WSJ has a front page article on the growth of Social Security Disability Program.

When you pay people to be unemployed, ... get more unemployment.  Or so says a new paper from NBER.  What is interesting is the mechanism through which this works:

Everything else equal, extending unemployment benefits exerts an upward pressure on the  equilibrium wage. This lowers the profits employers receive from filled jobs, leading to a decline  in vacancy creation. Lower vacancies imply a lower job finding rate for workers, which  leads to an increase in unemployment.

This can understood as a movement up the demand curve (as the price of labor increases, quantity demanded for labor falls).

HT:  Greg Mankiw

When is being a Good Samaritan Bad for Business?

Kristopher Oswald was fired by Walmart for rescuing a young woman from being assaulted (though he was later reinstated). The altercation violated company policies for customer interactions.
The 30-year-old has said he was in his car on his break about 2:30 a.m. Sunday when he saw a man grabbing a woman. He said he asked her if she needed help and the man started punching him in the head and yelling that he was going to kill him. Oswald said he was able to get on top of the man, but then two other men jumped him from behind.
Livingston County sheriff's deputies arrived and halted the fight.

Why does Walmart have a policy against protecting their patrons? Rather than a policy of terminating these employees, don't they have a social responsibility to the local community to help thwart crime when doing so would be easy? Of course, what Walmart worries about is a mistaken employee altercation with perfectly innocent patrons. The possible resulting liability cost could easily outweigh the reputation loss due to more parking lot altercations. Hence the policy. The policy protects Walmart's bottom line but might encourage more crime in the area. Here is a case where there is tension between the pursuit of profits and the pursuit of larger social goals.

HT: Leah Hunter

Friday, October 18, 2013

Simple pricing: the "stay even" quantity

The marginal analysis of simple pricing, i.e., price at the point where MR=MC, is sometimes implemented by using a version of break-even analysis.  Instead of asking which price maximizes profit, you instead ask "will a given price increase, e.g., 5%, be profitable?"  To answer the question, we

1. Compute the stay-even quantity, the quantity you can afford to lose and still break even

2. Predict (or guess) whether the actual quantity lost will be greater or less than the stay-even quantity.

3.  If the actual quantity lost is less than the stay-even quantity, then the price increase will be profitable.  

Here is the derivation of the stay-even quantity:

The benefit of a price increase is the extra revenue you earn at the new (and lower) quantity, Benefit=dP*(Q+dQ)

The cost of a price increase is the margin on the lost sales, Cost=dQ(P-MC)

where dP=P1-P0, dQ=Q1-Q0, P0=initial price, P1=final price, Q0=initial quantity, and Q1=final quantity.

You compute the Quantity at which you are indifferent between raising price or not, and you get the formula:


where m=(P-MC)/P, dQ/Q=% change in Q, and dP/P=% change in P.


The stay even quantity for a 5% price increase for a firm with a 40% contribution margin is 11.1%=(5%)/[(5%)+(40%)].  If you expect to lose less than 11%, then a 5% price increase will be profitable.

REFERENCE:  Page 9 of
A Critical Analysis of Critical Loss Analysis,
Daniel P. O’Brien and Abraham L. Wickelgren, January 2003 (Published in Antitrust Law Journal) [PDF 236K]

How will the the municipal bankruptcies end?

For years, I have been trying to convince Nashville politicians to stop spending more than we are taking in, by fully-funding our pensions. 

Here is an interesting talk about what is likely to happen in places like Detroit, Chicago, Philadelphia, and Nashville.   It is long, so I will summarize:

  • Cities bargain with municipal employees, but since employee unions support policitians, the bargaininig is far from "arms length."
  • It is unlikely that overly generous, unfunded pensions will be restructured, except through bankruptcy.
  • Fortunately, restructuring is likely to be found legal under the bankruptcy laws because funding is like "collateral." 
  • This will fix the balance sheets of city governments, but also give the unions a stake in funding the pensions (fix the income problem)

Patent invalidation ==> entry ==> lower (or higher?) prices

The summer, the Supreme Court invalidated patent rights for human DNA.

Until the ruling, Myriad held patents--which gave them a monopoly--on genetic screening tests used to predict the risk of breast and ovarian cancer. These tests generated $519 million in revenue for Myriad, about 85% of the company's total revenue.

Since the ruling, Quest Diagnostics has begun selling its own tests that will have a list price of $2,500, $800 less than the incumbent's price.

If customers are all similar, then it is likely that Myriad will respond with price cuts of its own.  However, as we have noted before (When entry raises price) this is not necessary:

When a branded drug faces entry by a generic copy, it will stop promoting the brand (as that increases demand for the generic), and raise price. The brand loses its low-value (and more price-elastic) customers to the generic so that branded demand becomes less elastic. The brand responds by raising price.

If entry by Quest makes Myriad's demand less elastic--by stealing its more price sensitive customers--Myriad may end up raising price.

What happens when hospitals start serving sicker patients?

Revenue, and profit increase:
...during its better-than-expected second quarter, HCA posted solid same-facility admissions growth and piggybacked on that with sizable increases in revenue per patient. Same-facility revenue per equivalent admission for Q3 is expected to be up 3.4 percent year over year. The company said its treatment of patients with more acute conditions accounted for two percentage points of that rise.

Friday, October 4, 2013

Dirigiste et absurde: France and its labor unions

France and its labor unions are taking extraordinary measures to stay mired in recession.  They have a raft of regulatory rules that deter wealth creating voluntary transactions, like:

...strict limits on opening and closing hours, the rules only allow sales during certain periods of the year, price promotions are circumscribed, loss leaders are illegal, store sizes are limited and even the types of shops allowed to open up are regulated. 

But now the labor unions have won a case against Sephora to prevent the retailer from staying open late, protect workers from unscrupulous owners who force them to work antisocial hours. ...The cosmetics chain reckons it does about 20 percent of its business after 9 p.m., and the 50 sales staff who work the late shift do so voluntarily — and are paid an hourly rate that is 25 percent higher than the day shift. Many of them are students or part-time workers, and they have publicly expressed their indignation about being put out of work by labor unions.

Why do Chinese SOE's manufacture goods that no one wants?

Because State-Owned-Enterprises (SOE's) are judged on employment, not on profitability.  Eye-popping article in Forbes:

Of the 100,000 machines manufactured in the last twelve months, some 60,000 were manually operated. This is the functional equivalent of making typewriters. When my friend told his contact that that world market for such machines simply didn’t exist, the SOE-operator explained that production could not be cut without laying off workers, so the company continued the rate and was simply storing the machines they knew they could not sell. ...

Of course, this makes it difficult to compete with SOE's:

I repeated the story of the SOE machine tool manufacturer to another American friend working as a the China CEO of an American software-as-a-service company. He nodded somberly: he was trying to recruit an executive from a state-owned competitor, having lost so many deals to the rival firm that he’d resolved to hire their sales leader. But during the interview, his prospective employee explained that sales executives at the SOE were not judged on profitability, but instead on the goal of growing the number of people employed by the company. Profitability was not a meaningful metric, since if an SOE ran into financial trouble, the government would simply give them more money. The American CEO was stunned: how can Western companies compete in China? Any product or service that can be replicated by a Chinese company will be and the foreign company beholden to Western shareholders and ethics standards cannot sustain.

HT:  April

Wednesday, October 2, 2013

Are single parents causing inequality?

The Atlantic has an interesting story whose causal links go something like this:

Single parent households make less money.

This leads to less investment in kid's education which leads to lower levels of human capital which leads to lower income: 

The decline in marriage rates among poorer men and women robs parents of supplemental income, of work-life balance, and of time to prepare a child for school. Single-parenthood and inter-generational poverty feed each other. The marriage gap and the income gap amplify one another.

Better educated, higher-income men and women tend to marry each other which perpetuates the cycle:

The marriage inequality crisis creates a virtuous cycle at the top and a vicious one at the bottom. It pushes educated and non-educated Americans into entirely different worlds.