Bastiat’s Bastions

It’s funny how quickly some things change. Not too long ago, the AARP and the N.Y. Times were vehemently opposed to fixing Social Security with private accounts. This week, they’ve both decided it’s not such a bad idea (here and here).

A newly released proposal by The Heritage Foundation’s David John and Brookings’ J. Mark Iwry suggests improving retirement security with the “automatic IRA.” The paper only outlines a proposal, but the general idea is this: most employers would have to offer an automatic payroll deduction for individual workers’ private retirement accounts. Individuals would have the chance to opt out of the forced saving program, so it isn’t really “forced” savings.

I suspect that some staunch libertarians will be opposed to a plan such as this on the grounds that the government should not force this cost on employers. But how much of a cost would this really impose on employers? And, assuming that private accounts would eventually eliminate the need for Social Security, what would be the cost of not switching to private accounts?

My last question: What is in this proposal that would make the AARP and NY Times, just months after trashing any similar idea, endorse it?

Happy Mardi Gras Everyone.

NM

In light of the recent threat made by the owner of the Seattle Supersonics to move to another city, James Thayer writes an article in the Weekly Standard concerning the impact that stadiums (and profesional sports teams) have on the local economy. The Supersonics are threatening to leave unless a stadium upgrade is paid for the by the taxpayers of Seattle.

To justify spending public tax dollars on a stadium, the claim would have to be that stadiums “pay for themselves” through enhanced economic devlopment, more jobs, and all the income generated in and around the stadium. An excerpt, edited every so slightly so as not to give away the answer:

…team owners promise urban renewal and a stronger local economy…Regarding the Sonics proposed stadium refurbishment, Washington State Senator Margarita Prentice gushed, “The ripple effect defies our imagination.”

So the question is – are the politicians right? What happens when you do the math.

Thayer tells you what happens when the leading economists studying the problem add it up. You might be surprised. Read the article!

Once you read the article, can you blame the Seattle Supersonics owner?

–CT

I spent approximately four years of my life working in public policy in Washington, DC, and the one phrase that I became absolutely tired of hearing come out of politicians’ mouths was: I believe the children are our future. No kidding? How long did it take you to figure that out?

Well, now I’m back in Louisiana and out of public policy, so I need a new least favorite phrase. I don’t have it yet, but I suspect it will have something to do with Katrina. Why? Because I’m already tiring of every single thing that happens being blamed on the storm.

Your waiter is late getting hot bread to the table? Katrina. No crayons for the kids’ menu? Katrina. No plugs for that flat tire? Katrina. Chad Turner hasn’t published any articles this semester? Katrina. Actually, I haven’t either….that’s definitely Katrina.

Anyway, you can imagine my horror when I came across this post on the Times Picayune “Voices of Katrina” Weblog:

Children lined the streets playing with sticks, riding bikes, bouncing basketballs. The elderly would sit on porches, fanning a breeze, chatting about days gone by. Young men walked the streets, brown bags in hand, carrying what little hope they had left for their futures.

I honestly wasn’t going to post anything about this until the author of the post put the words “children” and “future” two sentences apart. That was enough to push me over the edge. The author goes on to discuss the lives of the children, the young men, and the young women of a not-so-nice section of the city:

Their routine rarely varied. One day ran into the next. Then a shooting would happen and the streets would clear for a day, maybe two, then return to normal. This was their future, marked out for them by a society that had forgotten its rich history. Then came Hurricane Katrina, August 29, 2005. There was no more hiding these people who had been left behind for decades. This time they were left behind for all the world to see.

I’m posting this because I hope to start a discussion (and I hope people read the entire post on the Times’ website). Here are my questions to get things going:

-How does “a society” mark out someone’s future?

-How does “a city” hide people?

-Can “society” cause one person to shoot another?

-How much individual responsibility should we attribute to one’s economic condition?

-Is there really a lack of economic opportunity for those who seek it?

NM

Everyone knows that Democrats are against tax cuts and Republicans are for tax cuts, right? Well, think again.

One of the more amusing (if your cynical) aspects of tax policy during the last couple of years has been the squirming of New York Democrats over the alternative minimum tax, the dreaded AMT. There’s been all sorts of congressional horse trading over this tax, but I think we’re finally about to reach the pinnacle of absurdity.

For more than one year, insiders have known that Republicans might try to renew the 2003 tax cuts (JGTRRA) by linking their extension to (another) one-year fix for the AMT. Why? Because the AMT hits individuals in high-tax states particularly hard…..states such as New York….with two Democratic U.S. Senators.

Normally, Democrats loathe any sort of tax cut, but when a particularly egregious tax is aimed directly at their constituents, well, that’s another story. Which brings us to the funny/sick part of the story.

New York Senator Charles Schumer and Maine’s Republican Senator Olympia Snowe want to institute a windfall profits tax on major oil companies. The tax would only last one year. Right. (We’ll be posting more on this “tax” in the coming weeks.)

I don’t suppose Schumer’s aggressive stance could have anything to do with wanting to offset the “cost” of extending AMT relief one more year? And, I guess it could just be a coincidence that the new profits tax is supposed to raise around $4 billion and the AMT relief for one year would “cost” about $6 billion? Feel free to make up your own mind.

(For Wall Street Journal subscribers, see “The Max Baucus Speed Bump,” February 9, 2006, and also see Chuck Schumer’s letter to the Journal, “Big Oil’s Reported Profits Are Kept Artificially Low,” December 7, 2005.)

-NM (I’m just following Chad’s lead.)

What do economists do all day? Some of them sit around and watch game shows.

If you haven’t seen it, you’ll love the TV show called “Deal or No Deal”. It airs next on Monday, February 27th, 7pm, NBC. Here’s a link to the the official site on NBC’s page. The commercials are right – you will be screaming at the TV.

For those of you who haven’t seen it, there are 26 prizes put in 26 suitcases. Prizes range from $1 to $1,000,000. The player picks a suitcase and has no idea what prize is in their suitcase, nor does the “banker”. The player then gets to pick a number of the other suitcases, which are opened, revaling the dollar amounts. By the process of elimination (as more suitcases are opened), the contestant has more information about what might be in their suitcase. A scoreboard the displays the remaining possibilities.

Between rounds of suitcase openings, the “banker” makes an offer to the contestant. The player can take the offer from the banker and can walk away, or open some more suitcases (and later receive another offer). If the suitcases reveal small prizes (indicating a higher likelihood that the contestant’s suitcase has a big prize), the next offer from the banker will likely be for a larger amount. If the opened suitcases reveal large prizes, the banker will likely make a smaller offer. This continues until the player takes the offer (the game ends) or if there are only two suitcases remaining. If that last offer is refused, the person opens the suitcase and wins the amount shown inside.

Imagine the conundrum of only two prizes remaining – $1 and $1,000,000. Suppose the banker offerred you $475,000. Plus your wife is nagging at you – on national TV! It’s like watching a train wreck. It truly belongs on Fox.

Those of you who have taken your QBA classes will realize that is simple to calculate the probabilties and expected value of the prize in your suitcase. In economics and finance classes, we often talk about risk aversion. The idea is, that people, in most instances, are averse to risk and will pay to avoid it. Hence markets for insurance. It is important to note, in other instances, some people are risk loving, though usually for smaller stakes. Think about going to Vega$.

Here the expected value ($500K) is higher than the no-risk alterntiave ($475K). A rather risk averse person will choose the $475K, while a risk lover would open the suitcase.

This game show is interesting because it allows economists to study the way people react to risk in a situation with meaningful stakes and to measure different degrees of risk aversion. Much of the research on these types of problems are done with college kids and (sorry folks) much smaller amounts of money.

Believe it or not, this is only the latest entry in a long line of reputable economic research analyzing choices people make while on game shows. I’ve included a link to some current research done by three economist at Erasmus University Rotterdam on “Deal or No Deal”. It’s written for an academic audience – if you’re a finance major you might be ok.

The authors have analyzed the choices people made while playing Deal or No Deal in other countries. They find people, on average, are moderately risk averse, but can become risk loving after bad outcomes.

There is an interesting table in the paper relating the bankers offer to the true expected value of the suitcase as the game progresses. They give slightly lowball offers early – perhaps to increase drama later in the show? The banker usually offers an overly sweet deal after the person gets bad news, though.

If you know what a probability distrubtion and an expected value are, watch it and enjoy. If not, put it on Tivo, and pull it out after QBA 282.

–CT

Late last week, U.S. Treasury Secretary John Snow took to the pages of the Wall Street Journal to praise the 2003 tax cut package. According to Snow, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) was one of the main reasons the slow recovery (from the 2001 recession) picked up steam. Perhaps Snow is correct.

One of the main components of JGTRRA was a reduction in the tax rate on capital. Specifically, JGTRRA lowered the maximum tax rate on individuals’ dividend income. Prior to JGTRRA, dividend payments from a C corporation to an individual would have been taxed at the individual’s top personal income rate. The bill reduced the tax rate on such income to 15 percent (for most dividend recipients).

So, the story goes, JGTRRA made it easier for a corporation to provide a return to its shareholders, thus lowering corporations’ “price” of investing in projects. Naturally, when the price of something decreases, we expect to see a higher quantity demanded. Therefore, JGTRRA should have resulted in corporations investing in more projects (new plants, new equipment, new buildings, etc.).

Why am I writing about this now? A recent post on Café Hayek discusses whether the upward trend in the corporate investment data started before JGTRRA was passed. If so, we would have to conclude that the law had very little to do with the quicker pace of the economic recovery.

The post on Café Hayek really doesn’t offer an explanation as to why the law may not have worked as designed, so I’ll offer one plausible explanation: phase-outs. To sign JGTRRA into law, Congress had to allay the fears of the federal deficit hawks. They did this by writing a law that would expire (phase out in beltway language) after 2008.

As a result, all of the pre-JGTRRA capital tax rates return after 2008. This somewhat unseen part of the bill (it certainly has not been focused on by many journalists) could have a serious impact on the way corporate managers estimate their cost of capital. For starters, corporate managers had, at most, a four-year window for which they could be certain of having a lower cost of capital.

To make matters worse, it was widely believed by the time JGTRRA passed (May 2003) that the 2004 presidential election promised to go down to the wire. Candidate John Kerry’s promise to repeal JGTRRA, therefore, would have provided an excellent reason to put off investing in some projects. If most corporate managers were still, in 2004, planning which projects to invest in, then none of the 2003 corporate investment data would include much of a behavioral response to JGTRRA.

The success of JGTRRA’s capital tax reduction depends on a behavioral response, and the bill’s phase outs certainly provided a disincentive to responding quickly. To answer the question of whether these capital tax cuts worked, I would argue we have to start our investigation after 2003. Sorry Mr. Snow.

For discussion: Can anyone think of additional reasons that the investment response to this tax cut would not show up in 2003? At least one should be rather obvious.
Also, for anyone interested, here’s a short summary of two empirical studies that looked at this issue.

Norbert Michel

In the latest issue of the Southern Economic Journal, Robert Ekelund, John Jackson, Rand Ressler and Robert Tollison write about the death penalty in their article “Marginal Deterrence and Multiple Murders.”  The effect of the death penalty on murder rates, the subject of their article, is probably not what most students would guess economists might think about all day.  What has already been shown consistently in previous economic studies of crime and punishment is that murder rates are lower where:

(1) it is more likely murderers are arrested
(2) it is more likely murderers are sentenced
(3) it is more likely murderers are executed

Each factor alone reduces the murder rate. For example, holding sentencing rates, execution rates, and other unmentioned factors constant, the higher the chance of being arrested, the lower the murder rate.

In basic economics classes we discuss why it is the marginal cost of actions – the additional cost of one more unit of the activity – that affects behavior. For the same reason, teachers wisely use a set of progressively tougher penalties against repeat offenses in their classrooms. If, as the article points out, the marginal cost of the first murder is as high as it can possibly be (death), then the marginal cost of any subsequent murders can only be zero. Stated differently, if you are likely to be executed if arrested from killing one person, there is no extra penalty for the next murder. If the punishment for a single murder is very extreme, the result is likely to be more multiple and serial homicides.

Consider applying the same logic when thinking about the movement to increase the punishment for first-time child molesters.

With one of us being the father of three children, we surely do not want the courts to hand down light sentences for child sex offenders. A 60-day sentence given to a man who had repeatedly raped a young girl in Vermont is obviously irresponsibly lenient. The people supporting Jessica’s Law, including Bill O’ Reilly of Fox News fame, would agree. Jessica’s Law, named for Jessica Lundsford of Florida, requires convicted child-sex offenders to serve a sentence ranging from a minimum of 25 years to a maximum of life for a first offense. A version of Jessica’s law was recently passed here in Louisiana.

In keeping with the theme of our posts, there are often overlooked consequences of a change. The reduction in the number of first-time child sex offenders is “what is seen.” But “what is unseen” is frightening and alarming. Consider the reprehensible dilemma facing a low-life having just committed a sexual offense against a child. If arrested and convicted of child rape in Florida or Louisiana (Jessica’s Law states), the offender will face a minimum of 25 years in prison. Might this offender consider the fact that murdering the victim (the prime witness) will likely reduce the probability of being convicted of the sexual assault?

If the offender ends up being convicted of murder he may face execution, but execution usually only occurs after 20 years or so of waiting on death row, till all appeals are exhausted. At the time of the crime, the penalty for murder does not seem that much worse than a 25-year minimum penalty for child molestation. In the language of economists, the marginal cost of escalating the crime from sexual assault to murder is quite low. Unfortunately, Jessica Lundsford’s rapist found the reduction in the chance of being convicted worth killing Jessica even before Florida passed its tough minimum sentences for child rapists.

We are not suggesting that Jessica’s Laws should be repealed. However, we are pointing out that while these laws reduce first-time child rapes, they also increase the rate at which children are murdered by their molesters. A proper discussion or analysis of Jessica’s Law should take both “the seen” and “the unseen” consequences into account.

Morris Coats and Chad Turner

Michael Sokolove writes an interesting article in the New York Times Magazine titled “From Pastime to Nap Time” on the effect that drug testing will have on Major League Baseball. This is not your tired article on steroids that points out that Mark McGwire is four dress sizes smaller since he left baseball. This article addresses how testing for amphetamines will change the game.

The claim is that the practice of taking amphetamines (”greenies”) to deal with the rigors of the daily grind of a 162 game schedule was widespread. MLB’s new improved drug testing policy includes testing for amphetamines. Therefore, testing will reduce the use of greenies and change the way the game is played. Let us make some assumptions…

(1) Players are able to play a higher level of play when taking amphetamines.
(2) Some players are taking amphetamines.
(3) Day games following night games are particularly difficult, and therefore the time where amphetamine use is expected to be highest.
(4) The testing process causes (some players) to stop taking amphetamines

A result of effective testing would be to reduce amphetamine use. Thus, we would expect…

(1) A fall off in the level of play to occur as the overall level of concentration or energy would be lower.
(2) The fall off in level of play will be largest for day games following night games.

Interesting in its own right, but there is more economics tucked away later in the article. Sokolove includes a quote from Billy Sample, a former player, who gives us some gambling advice. Hold your horses before calling your bookie (or go to the track instead). Here is an excerpt from the article that quotes Sample…

Billy Sample, who played nine seasons in the big leagues before retiring in 1986, believes the most difficult challenge in the post-greenies universe will be those pesky day games after night games. He says, “People who bet on the over-under line” — a wager on how many total runs will be scored — “they should probably take the under on those games.”

An over/under bet is fairly simple. Bookmakers determine a number of runs, called the “over/under line”, that they think will be the number of runs scored in a game by both teams combined. If the line is 7, and you bet the “under,” you are betting that fewer than 7 total runs will be scored. If you bet the “over,” you are betting that more than 7 runs will be scored. Bookmakers try to get the line “right” – so that half of betters wish to bet the over, and half wish to bet the under. Without getting into the details, the bookie takes a cut of winning bets, and as a result can earn money even with equal numbers of people betting the over and under. In fact by doing so, he earns money without taking any risk.

Sample’s argument is that everyone will be too tired to swing a bat during those pesky day games, fewer runs will be scored in these games, thus making the under bet more desirable. Sample may be right about the runs scored. (He is assuming that greenies affect hitting more than pitching and defense.) However, even if there are fewer runs scored in these games, you still should not run out and bet the under and expect to win more than half the time. Why?

Begin for a second by making the dubious assumption that bookmakers do not realize the effect of the amphetamines ban. They set the over/under at 7, thinking this is the correct line. However, suppose some “informed” bettors realize the “true” line should be less than 7. They would see a profit opportunity, as betting the under would win more than half of the time, perhaps often enough to pay the bookie’s commission and still come out ahead. The large bets being placed by informed betters on the under will result in more money being bet on the under than the over. Bookies are sure to notice this imbalance and try to induce more betting on the over. How? By lowering the over/ under line. How far will the line have to adjust before the betters are evenly distributed? Until the line is set at the “correct” level. The point is, eventually, the market settles on the correct line.

If this sounds like the story you heard in your microeconomics class about “excess quantity demanded” and how prices adjust to equilibrium, it should. You can think of the betting lines as prices.

As economists, we believe gambling markets (and financial markets in general) are wonderful aggregators of information. Related is the idea we call “market efficiency.” A person that has superior information will indeed find profit opportunities. These profit opportunities provide incentives for many people to seek out superior information. People finding this information and acting on this information (a bunch of people betting on the under in our case) causes the information to be transmitted to markets. As economists, we say that all publically available information is quickly “priced into the market.”

While profit opportunities may occur for short periods, they disappear quickly. You cannot consistently “beat” the gambling market (or the stock market), unless you have truly “insider information” (information not publically available), and lots of it.

Do not think that bookies are slouches. They are in the information business, and it pays for bookies to adjust the lines quickly. Those who do not quickly adjust soon find they are paying off a lot of bets and may end up selling furniture before too long.

While Billy’s story might be right, this information is publically available and is already priced into the market. If Billy was the only one who knew this, he should not have had this information printed by the New York Times! Rest assured, if you bet the under every time a day games follows a night game this season, you will win about 50% of the time.

Epilogue:

An enterprising student could collect the lines and the time of days of games to see if lines for day games following night games were, on average, lower than other day games for past seasons. In fact, if amphetamines were important, and testing is effective, we should see this gap increase for this coming season.

Also, I once went to a Cubs game with my sister. She told me during the game that she was rooting, not for the Cubs, nor the hated Cardinals, but instead for the pitchers! I thought she was a moron. Now I wonder if she had money on the under!

A hat tip to the folks over at The Sports Economist for pointing out the article.

–CT

Shortly after hurricane Katrina, U.S. Representative Richard Baker (R-Baton Rouge) introduced a bill that would allow the Federal government to step in and buy homes damaged by Katrina. The actual buying would be done by the Louisiana Recovery Corporation (LRC), a new federal agency created by the Baker Bill (latest version here).

Congress did not vote on the bill before its Christmas recess, so the bill died. Actually, it’s probably more accurate to say it was put on life support. After Congress adjourned, Baker quickly announced “No matter the circumstances, we must try again.” And, shortly thereafter, U.S. Senator Mary Landrieu (D-LA) introduced a Senate version of the bill. The Bush administration – in an apparent attempt at fiscal restraint ?? – has refused to support the bill from the very beginning. You can find their latest position on the bill here, via the Washington Post.

One reason the White House gives for opposing the Baker bill is that they do not want to create another government agency. After reading just the first two pages of Baker’s bill, it’s easy to see what will happen if the bill is signed into law. For instance:

The principal office of the Corporation shall be located in the State of Louisiana, but there may be established agencies or branch offices in the District of Columbia and in any municipality or parish in Louisiana to the extent provided for in the by-laws of the Corporation.

Multiple offices….And, multiple divisions:

(d) CORPORATE DIVISIONS.— (1) IN GENERAL.—At a minimum, the Corporation shall establish and maintain separate divisions for the following subjects:
(A) Environment and Land Use Management.
(B) Economic Development.
(C) Property Acquisition.
(D) Property Management.
(E) Property Disposition.
(F) Urban Homesteading and Community and Faith-Based Organizations.

Just what we need. I would certainly prefer to save the money it would cost to run this new agency – oh, sorry, corporation – but I dislike the bill because of the unhealthy incentives it creates.

The newly created (LRC) would pay owners of damaged homes no less than 60 percent of their pre-hurricane equity. And the “corporation” would give lenders up to 60 percent of the money they were owed. Then, to “cover some of its expenses,” the LRC would sell the homes (or giant tracts of land ?) to private developers.

So, homeowners that did not have flood insurance (or insufficient flood insurance) can get most of their equity back from the taxpayers, many of whom did actually pay for sufficient flood insurance. And it’s these taxpayers that will be forced to bail out the lenders of the uninsured/underinsured. Why, exactly, have I been paying for flood insurance?

It certainly is difficult to not feel sympathy for those most affected by the storm (I lost a house too), but that doesn’t change the fact that Baker’s bill produces perverse incentives. In general, this phenomenon is referred to as a moral hazard – homeowners will no longer want to pay for flood insurance because they expect to be compensated for their losses. And lenders will not perform due diligence to ensure that homeowners in low-lying areas purchase flood insurance (which, by the way, they were required to do by law).

I would not be too surprised to learn that some of the homeowners in LA fully expected to receive some compensation from the government in the event of a disaster such as Katrina. And I would even argue that one reason many lenders did not require sufficient flood insurance is because they fully expected the same thing.

Historically, moral hazard and flood insurance go together so well that many economists have used homeowners’ lack of flood insurance to explain “moral hazard.” One example is in Mankiw’s popular Principles of Economics (1st edition, page 581):

A family lives near a river with a high risk of flooding. The reason it continues to live here is that the family enjoys the scenic views, and the government will bear part of the cost when it provides disaster relief after a flood.

I guess Mankiw can include a Katrina/Rita analogy in his next edition.

For discussion:
What impact could the moral hazard associated with the Baker bill have on future flood insurance rates?
Could this type of moral hazard have caused over-building in flood prone areas?
Baker’s bill passed the House Financial Services Committee 50-9. Could this be a sign of rent seeking?

Norbert Michel

The College Board (CB) released a report and a press release celebrating the 50th anniversary of the Advanced Placement (AP) program.  For those of you not familiar with the program, students take rigorous high school classes in any of a number of topics.  Upon completion of their coursework, they take an AP exam.  If they pass (a score of 3 or better depending on the college), they earn college credit.

It seems clear from the release that the CB is interested in increasing AP participation.  I think that is a desirable goal.  I can think of at least two ways to improve participation.  

One way would be to take a group of highly motivated high-aptitude students who are already in a classroom with a great teacher.  They are not taking an AP course per se, but perhaps the curriculum could be adjusted and their course could become an AP class.    Students will not learn any less (hopefully even more) and many students will pass the AP test and earn cheap college credits.  The CB will smile as participation rates rise (progress!) while pass rate will remain constant (standards!).  This is a winner.

A second way would be to take a group of students who are whittling at the third grade level and change the name of their course to AP English.  Here, the participation rate would surely increase, but the pass rate would fall dramatically.  Keep in mind it is not free to make this change. 

Here is an excerpt from the press release.

“…new programs must be initiated to build schools’ capacities to offer AP courses to all student populations, especially underserved minority students and young people from rural America.”  Such initiatives…have been successful in many states.
 
In Arkansas last year, policy legislation resulted in record-breaking improvements in AP participation…Beginning with the 2008-09 school year, Arkansas legislation mandates that all school districts provide AP courses in each of the four core areas of mathematics, English, science, and social studies…Arkansas is covering the cost of the AP Exams for all students and is providing schools with professional development funds.

The results of Arkansas’s initiatives are unparalleled; in just one year’s time, Arkansas doubled the number of students participating in AP…”

I am always a bit skeptical when Arkansas breaks any record.  In 2000, 1166 out of 2208 Arkansas test takers (53%) passed their exams.  Not bad for Arkansas, but below the national average of 62% and even the 59% pass rate of Louisiana students.  In 2005, there were many more test takers indeed, 6393.  However, only 2058 of them (32%) passed.  If we look at the “extra” 4185 people that showed up in 2005, only 892 (21%) passed the test. 

You may be pleased.  An extra 892 people have passed tests under their belt.  At what cost were these gains achieved?  Perhaps these “professional development funds” are better spent elsewhere?  Do non-AP classes in Arkansas get larger?  Are other resources diverted from non-AP classes?  Or from lower grade levels?  Are these smart choices? 

Indeed, the increase in access in Arkansas is best in the nation.  Where in the press release does it mention that the reduction in the pass rate in Arkansas is the worst in the nation?

Chad Turner