Relevant and even prescient commentary on news, politics and the economy.

## Wang and Silver on electoral projections

I learned a lot from his post due to my incredible ignorance. I go to www.fivethirtyeigth.com often enough that Firefox proposes it first when I type www, but I had never bothered to read the description of the method used to calculate the probabilities.

In case others are as lazy as me (unlikely) or have lives (likely) I will discribe my ignorance below after discussing issues of interest to the non pathetically ignorant.

Today I’d like to outlline the basic contrasts between this calculation and a popular resource, FiveThirtyEight.com. That site, run by Nate Silver, a sabermetrician, is a good compendium of information and commentary. However, both our goals and methods differ on several key points. The biggest difference is that this site provides a current snapshot of where polls are today, while he attempts a prediction. His approach also has a conceptual problem…

I think the conceptual problem is that Silver calculated probabilities from 10,000 simulations and Wang uses an analytic formula.

Silver’s approach is to carry out thousands of simulations, then tally the simulations. That method reflects the fantasy baseball tradition, in which individual outcomes are often of great interest. However, such an approach is intrinsically imprecise because it draws a finite number of times from the distribution of possible outcomes. The Meta-Analysis on this site calculates the probability distribution of all 2.3 quadrillion possible outcomes. This can be done rapidly by calculating the polynomial probability distribution, known to students as Pascal’s Triangle.

Wang claims that Poblano (AKA Nate Silver) should have obtained a normal distribution for electoral college votes. I don’t agree. This is only true if there is no correlation between shifts in support for Obama and McCain in different states. As usual, I argue using an extreme example. Assume no sampling error (each poll is of the whole population) and perfect correlation of changes in support in different states. If this were true then the ranking of states by Obama minus McCain would not change and there would be only 50 different possible outcomes in the electoral college. That’s not a normal distribution. I think that the argument is valid unless changes in support in different states are independent. This is a very implausible assumption. (note young Ezra who is neither a statistician nor a political scientist made this argument before I did).

Now Wang also argues that 10,000 simulations aren’t enough. I agree. I recently calculated something using 1,000,000 simulations for each of several different parameters (actually just 2 sample sizes). This was a distribution which I think I derived analytically. The millions of simulations were to check my reasoning, my algebra and, especially, my typing when writing the program which calculates the analytically exact distribution (the fact that I fail to reject the null that it is accurate with 1,000,000 simulations convinces me that I typed write for wunce).

The convention that simulations are repeated 10,000 times is a historical artifact of the slow pc age. I would like to ask Silver how long his computer takes to simulate. I would guess that his simulations are quicker than some of mine and waiting for 1,000,000 simulations was barely a nuissance.

Just to go back to my other obsession. I blame microsoft. I don’t think people fully realise just how much faster cheap pc’s have become, because microsoftware is designed to run intollerably slowly on any but the latest generation computers so computers take as long as ever to boot up, open a word file, open excel or well all that stuff even though they also take as long to do 1,000,000 simulations as they used to take to do 10,000.

I’d guess that 1,000,000 simulations won’t change Poblano’s calculated probability much and I would bet that he does them and reports the result.

OK what I should have known already.

I knew that Poblano (AKA Nate Silver) used old polls as well as the latest polls. His success during the primaries shows that true shifts in opinion were of limited importance. I did not know that he used a weighted average with the weight decreasing exponentially so that they fall by half after 30 days (weight = 0.5^(age/30days)*(other stuff) and that in past elections this calculation predicts better than others he tried. I see that just as I finally read the old faq (the link above) Silver wrote a new one (still doing 10,000 simulations)

Worse I didn’t even know that he considers the correlation of future changes in support for different candidates in different states.

It can reasonably be argued that I’m essentially double-counting the amount of variance by accounting for both state-specific and national movement. That is, some of the error in state-by-state polls is because of national movement, rather than anything specific within that state. However, I have chosen to account fully for both sources of error, because (i) this is the more conservative assumption, and (ii) I suspect that 2004, where voters divided into Bush and Kerry camps early, was inherently a more stable sort of election than 2008 is likely to be.

I had assumed that he did something like what Wang did, so the 67% was a snapshot not a forecast. I am pleased and reassured.

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## What’s dumb about a windfall profits tax?

The always smart Kevin Drum writes

The windfall profits tax is a dumb idea, and I wish Obama didn’t support it, but I guess politics is politics. It’s not the biggest deal in the world.

I asked in comments what’s so dumb about a windfall profits tax. I haven’t checked how many commenters responded to me, but some which I’ve found are after the jump.

My thoughts on a windfall profits tax on Oil companies (I consider an additional rebate a separate issue).

I start with the simplest assumptions so it is assumed that the tax won’t affect incentives, because it refers to the past and it is assumed to be a one off move (starting simple). Also assume the very old theory of the firm which acts in shareholders interest and is not liquidity constrained. In that case, the tax is a tax on oil company shareholders who are (including people with 401(k)’s) relatively rich. So I like it.

It seems, see below, that oil companies are passing their profits to shareholders through share buybacks. I think this helps support the old theory of the firm assumption. However, if they insistend on reinvesting profits, I would consider that an additional reason for the windfall profits tax. Last time they had a windfall (the second oil shock due to the Iranian revolution and the Iran-Iraq war) they decided to diversify and made some of the least productive investments in US history. Have you ever heard of Exxon office systems ? Big investment in smart typewriters which were like pc’s but dumber and ten times as expensive. Oil companies handle oil. They are not suited to act as investment bankers and, still less, as venture capitalists. generally high profits are a sign of skillful management which maybe can improve firms they take over. In this case, it was dumb luck. I’d say stock buybacks are the lesser waste, but reducing the deficit would be much nicer.

Now what if they assume that this is the first in a series. Often confiscation now and never again would be good policy if the promise were credible. The belief that there will be more windfall profit taxes in the future seems to me to be desireable. It means that Oil companies don’t gain as much when the price of oil goes up. Since they are imperfectly competetive, it seems to me that this would drive their actions twoards the social optimum. For example, if they aren’t helped with oil prices go up, they won’t oppose a carbon tax so fiercely. Also actual investment in alternative fuels now has the cost that production of alternative fuels causes the price of oil to decline. The threat (or promise) of further windfall profits taxes would increase their incentives to invest in alternative fuels. If designed rationally (see below) it would also increase their incentive to look for oil (which isn’t so key if there really isn’t so much left to be found).

I’d propose making a forecast for Oil holdings (inventories including proven reserves underground, crude in tankers and tanks and unsold petroleum products) and tax alpha times the price times this quantity from oil companies (with alpha positive but less than one). If the forecasts were exact, this would make the oil companies act as if they were perfectly competative. They won’t be, but so long as they are not so optimistic as to drive a company bankrupt, the costs of forecast errors will be a transfer plus something second order in the forecast errors. No such policy is like making a forecast of zero which is worse even than my forecasts.

OK at least one flame war from Drum’s site

The problem with a windfall profits tax is that it is the kind of ad hoc solution that Obama criticized when it took the form of a gas tax holiday. It may be a more effective gimmick, but it’s still a gimmick: pure pander.
Posted by: lampwick on August 4, 2008 at 12:21 PM | PERMALINK

Huh ? more like the opposite. Given that Oil refining and pumping are close to capacity, a gas tax holiday is similar to a windfall profits subsidy not tax. Both are ad hoc, but they have opposite effects. I would consider an argument that there is something wrong with a windfall profits tax to be an argument that something bad will happen if one is imposed.

[snip]
Big Oil’s profits by percentage are far less than Google’s, for example. Google’s profit is around 25%. Now there’s a windfall. Why aren’t we taxing them extra heavy? No way they should be making that much money when there are starving people out there.
[snip]

Posted by: SJRSM on August 4, 2008 at 12:23 PM | PERMALINK

This is interesting. First many of my arguments apply to an increase in price and not to increase in production (searches for google I guess). Second the windfall was a windfall (the behavior of inventories suggest that Oil company executives didn’t even see it coming as, say, Kevin Drum did). The google guys have demonstrated an ability to create wealth. I really like the idea of google venture capital. They got money by being very smart. I suspect that they will do smart things with it and won’t capture all of they wealth they create.

The only thing I could support was a windfall profits tax where the companies get to deduct from their payment every dollar they spend on renewables.

But as a general rule, resentment and vengeance are not good foundations for tax policy.

Posted by: lampwick on August 4, 2008 at 12:41 PM | PERMALINK

I’m not sure I want oil companies working on renewables. Why do we think they are better suited to manage that than other firms (I love what Shell is doing by the way) ? I am more pro market than lampwick so I think incentives to invest in renewables should be those implied by a carbon tax and not directed at any particular firms.

Remember the last time we based tax policy on resentment (hint did a plurality of Americans tell a Clinton pollster that they supported increased taxes on the rich to fund waste fraud and abuse). I’d say that the record of US tax policy based on resentment is, as a general rule, excellent.

There already is a tax on that “windfall.” It’s called the corporate income tax, and Big Oil is currently paying Uncle Sam to the tune of billions as their profits skyrocket. The proposal to effectively increase the corporate tax rate on a specific industry is unwise because consumers will pay for the tax increase in the form of higher fuel bills (as energy companies reduce exploration and development budgets). They’ll also “pay” to the extent that energy stocks are found in their portfolios.

Posted by: Jasper on August 4, 2008 at 12:47 PM | PERMALINK

a windfall profits tax isn’t just an increased tax on profits. It depends on the price times inventories not production minus costs. My proposal would, if anything, increase the incentives to oil companies to explore and develope oil fields. Someone in a thred below pointed out that average != marginal. I think Jasper really doesn’t understand that, but it could be that he assumes that the windfall part will be a fraud and will be perceived to be a fraud.

Yes, the windfall tax is a bad idea, and the energy rebate is even worse. We’re at a sad state when we count on stipends from the government to help spur the economy. What we need are policy changes that will impact how people buy and use energy in the long-term, not a panacea fix.

Posted by: MeLoseBrain? on August 4, 2008 at 2:16 PM | PERMALINK

Yes we must make the best the enemy of the good. Plus Keynesianism unbuilds character.

Someone notes that Becker and or Posner claim that the windfall profits tax was not good policy. Support for their assertion is missing. But the great part is this

.. “I was careful with my reference not to use a right wing source for the argument. Unless Becker-Posner is a right wing source.”

The scary thing is that I don’t think the commenter was joking.

I’m not done with the thread but I’m sure I’ve exhausted your patience.

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## The Company You Keep

Ah something which I actually know something about.

Dana Goldstein has found an amazing fact which, if middle class parents believed it was representative, would make the world (and in particular the USA) a much better place

So were the litigious Fairfax parents correct to freak out about South Lakes? Let’s look at the numbers.

At South Lakes High, 46 percent of students are white, 20 percent are black, 16 percent are Hispanic, and 11 percent are Asian. One-third of the school’s population qualifies for free or reduced-price lunch. In other words, this is both a racially and socioeconomically diverse school. How does this affect the most academically talented/privileged proportion of the student body? Well, more than half of white kids and almost half of Asian kids participate in the IB program, as do about 20 percent of blacks and Hispanics. An overwhelming majority of all the students enrolled in IB score a 4 or better, indicating excellent instruction and achievement. As for the SAT, the average combined score for white kids at South Lakes is 1730 out of 2400.

Now let’s look at Oakton High School, which affluent parents sued to get their kids into. Oakton is 67 percent white and only 11 percent black and Hispanic. Less than 9 percent of students there qualify for free or reduced-price lunch. Oakton has an AP program in which white students are just as successful as their similar white peers at South Lakes are on the IB exams; of the black students participating in AP though, less than half scored three or higher. Tellingly, on the SAT, Oakton’s white kids score 1734, essentially the exact same score as white students at South Lakes.

My point: The educational outcomes of privileged kids are remarkably similar across schools with similar curricula, while it is the least advantaged students who show more differentials. When parents are considering where to send their kids to school, they should look at the relevant numbers.

via Ezra Klein.

Sad to say, the whole world isn’t Fairfax county (well that would be a very boring world, ethnicly diverse but culturally a bit focused on US politics). In most developed countries, average educational attainment of mothers of students is positively partially correlated (positive significant regression coefficient) with individual student performance (on the PISA test) even if the educational attainment of the student’s parents is included in the regression.

see this (mainly for the references if you can get to them).

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## Politically impossible health care cost sharing

This is odd. Matthew Yglesias just excerpted a bit of a post at my personal blog, which I didn’t think was up to AngryBear standards. Far from it for me to question the judgment of a man who recently reached half my age. Here is the bit he liked

One politically unfeasible approach to this would be to assign people randomly to HMO’s and pay the HMO’s based on their health but have the HMO’s pay for their health care. Then the HMO decides incentives. You have to decide how much a life is worth (and eyesight and all that) but it doesn’t depend on individual income and the decisions are made by an organisation with tons of data.

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## Smart Health Care Cost sharing

Ezra Klein writes about smart cost sharing.

He wants a committee to decide reimbursement rates.

This made me think about an idea I got from Mark Thoma

Mark Thoma linked to the even more verbose version of this at my other blog. He has an interesting comment thread.

…preventative care … ought to be encouraged, and one way to help with this is … to forge an unbreakable lifetime relationship between the insurance company and the consumer so that expected lifetime costs are important to the insurance carrier.

I strongly suspect (with no evidence) that Thoma’s thoughts were influenced by
an empirical result that very small financial incentives to doctors based on their patients’ blood glucose caused big changes in those outcomes (pdf warning).
which will save huge amounts of money for medicare but small amounts of money for the HMO’s that introduced the incentives.

I think the best we can do is to charge medical costs not just to the current insurance plan but also, in part, to the one that covered the patients in the past (to give the an incentive to keep their clients healthy).

If insurance companies saw obese people with horrible eating habits who watch TV all day as a profit opportunity, the USA would be a healthier place.

Just think, sleazy insurance agent hangs around bars and then calls his boss to say “Right in front of my eyes, I have a guy who must way 300. He’s on his 4th whiskey, has emptied 2 bowls of bear nuts in the past five minutes and he’s chain smoking camels, we got to move fast before our competitors sign him”.

[line above updated for punctuation and to add details plus a homonym to celebrate the fact that Matthew Yglesias linked to this post (the homonym was honestly accidental. In fact, there were not one but to honest homonyms — I typed “too add details” two before correcting it, witch just goes to show how thrilled eye am.]

To try to explain better

My plan is the Edwards plan plus insurance companies pay for care of former clients based on alpha(cost of the treatment)*(years with that company)/(age at time of care) where alpha is well below one and for the care of current clients minus the part paid by former insurers. They get paid a constant which depends only on the region where they are located times the same alpha factors.

Thus they have an incentive to keep their clients healthy (which they can pass on to doctors).

Plus they get paid based on progress on preventive measures (patients who quit smoking, got blood pressure from x down to y, lost weight from obese to not obese etch)funded with a tax on insurance companies per patient so on average they get zero.

This means they would be more willing to sign fat lazy smokers as there is lots of room for improvement compared to things as they are.

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## Unobserved Country Heterogeneity: GDP Levels or Growth Rates

Have you ever noticed that, when considering the economic performance of different countries, people often just report the GDP growth rate without any corrections for e.g. initial GDP ? It’s as if they thought that countries generally have about the same growth rate and any deviation from the world average is interesting.

This is very odd as most growth models imply that growth rates should be very different for different countries so such a simple measure is not a reasonable assessment of performance.

It’s as if people think that there is a lot of heterogeneity in GDP levels but not so much in GDP growth rates. Marco Alfò, Giovanni Trovato and I, decided to ask a computer if that’s what it saw in the Heston and Summers data set. The computer (on Gianni’s desk top) said “absolutely”. The paper is here (subscription required for download. If you are using a work IP address or mirror you can hope to get it without paying (please try if you are interested)).

update: Greg in comments has kindly translated the post into English. I pull his comment up here.

[snip]

Perhaps an English summary:
a) Standard Economic Theory, the shibboleth we will be destroying today, says that GDP levels will converge, that is, poor countries will get richer, and rich countries will get richer … slower than the poor countries. (Apocalyptic Econ allows for us all converging at some substantially lower level, of course). This will result in all countries being smarter than average.

b) We’ve run some Fancy Number Analysis that shows this is not true. The Usual Analysis says this because two things confuse the numbers: i) within groups of similarly poor (rich) countries, there is some convergence, and ii) this within-group convergence tends to look like overall convergence.

c) This is Real Important because lots of analysis doesn’t correct for this, and hence draws conclusions that are, um, stupid.

d) Using a short-form analysis (asking your neighbour) may have been more accurate by being less clever (“it’s a fine line between clever and stupid”).

Of course, one might best avoid using Shibboleth in the simplified version.

Grateful comments/clarification if I’ve gotten anything fundamentally wrong.
Greg | 07.24.08 – 5:15 pm |

Thank you Greg.

All of my F-fort to right plane English is now below the jump (jump at your own risk).

The idea is to take a minimal model for GDP levels or Growth (basically the Mankiw Romer and Weil equation for levels applied to growth too by Bernanke (yes that Bernanke) and Gürkaynak and to allow the computer to look for remaining heterogeneity in levels and/or growth rates with minimal parametric restrictions. We used a semi parametric finite mixture random effects model in which the distribution of the unobserved disturbance to the growth and/or level of per capita GDP is drawn from a finite number of points. As the number of such points goes to the number of countries in the sample, all heterogeneity can be explained, so the approach is, in some sense stressed by Heckman, non-parametric. Like everyone we used information criteria (including Akaike they all agreed) to choose the number of points (results are not too sensitive to the number).

The result is that the computer decides that there is huge unobserved heterogeneity in levels and virtually no heterogeneity in growth rates (the unobserved points in level growth rate space have extremely different levels and the similar growth rates). There is no hint of convergence in GDP per capita levels of the different groups of countries which are, therefore, convergence clubs.

So why has every variable and it’s cousin (except for tax rates) proven to be significant in at least one cross country growth regression ? The initial GDP per capita level is always included in these regressions. It has a negative coefficient because of convergence within convergence clubs. Thus the silly computer is convinced that countries in different convergence clubs should converge (that is the one in the poorer club should have higher growth). The other variables help to explain growth by undoing this error. Regressions of just the growth rate on variables *not* including initial per capita GDP are much less likely to be significant.

The bottom line is that a computer with no hints as to the conventional wisdom very firmly told us that there is a huge amount of heterogeniety in per capital GDP levels and very little heterogeneity in growth rates of per capita GDP, just as everyone who doesn’t run regressions tends to assume.

Now the whole experience reminds me of something Zvi Griliches said long long ago (in a presidential address to the AEA I think). To understand economies better we need more information as in data not new and fancy analysis of the same old data. This was a very popular line in the Harvard ec department back when I was there. In particular, he said there was not point in the zillions analysis of the Heston and Summers data set no matter how econometrically rigorous and original. Back at the time I nodded my head and wispered the un-religious analogue of “amen”. Irony of ironies I find my most recent publication to be … the ten zillionth analysis of the Heston and Summers data set and I honestly think it adds something new. I maintain my almost perfect 0% record as a prognosticator.

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## Tax Policy Center calls McCain campaign out for cheating.

by Robert

Brad DeLong has a hot tip from Jason Furman

I quote a bit of Brad’s quote of Furman

Today, the Tax Policy Center released a new analysis of the McCain and Obama tax plans, which provides a comparison between what each of the candidates says on taxes (their actual plans) and what their campaign advisors claim. It finds that the true cost [over 10 years] of Senator McCain’s tax proposals is \$2.8 trillion larger than what his advisors have acknowledged. And most of that \$2.8 trillion is the cost of yet more tax cuts for corporations and the wealthy. The plan still offers very little for ordinary Americans.

I think the key bit of the tax policy center report is (emphasis mine)

In several important ways, the candidates’ speeches and web sites differ from the plans as we’ve outlined them above, and, in several cases, descriptions of proposals provided by campaign advisors strike us as implausible. Senator McCain has said repeatedly that he would repeal the
individual AMT, allow businesses to expense all investments in equipment immediately, double the deduction for dependents, and give individuals the option to pay tax under a simplified alternative tax system. The campaign advisers say that the AMT will be patched but not eliminated except under the simplified alternative system, that only short-lived investments (for which expensing is not worth much) would qualify for immediate deduction, that the larger deduction for dependents would phase in slowly (and never equal twice the current-law deduction), and that the simplified alternative tax system would be revenue neutral. The last assertion is particularly questionable: few taxpayers will choose to pay an alternative tax if it does not reduce their tax bill, so an optional alternative is only revenue neutral if almost nobody elects it, which is probably not what the candidate has in mind. We estimated the cost of Senator McCain’s plan as described on the stump, assuming that all the provisions are fully effective immediately and that the optional alternative tax system is similar to the one proposed by the Republican Study Committee. Under those assumptions, the revenue loss attributable to the Senator’s plan increases to almost \$7 trillion over the 10-year budget window.

I think that Len Burman Surachai Khitatrakun Greg Leiserson Jeff Rohaly Eric Toder
Bob Williams are heroes. I also think that this line about how an alternative tax option would be revenue neutral help provoked them into calling the McCain campaign out. That is not just a lie, it is an insult to their intelligence.

Below their thoughts on what Obama really has in mind.

Senator Obama’s proposal to exempt seniors with income below \$50,000 from income tax but continue full taxation starting at \$50,001 also strikes us as impractical and undesirable. Any actual legislation would have some kind of phaseout to avoid a “cliff” at \$50,000. Also, Senator Obama has spoken often about subjecting high-income taxpayers to additional taxes to help shore up Social Security, although his campaign advisers insist that there is no specific proposal. We estimated the cost of Senator Obama’s proposals assuming all of the provisions are fully effective immediately, that the seniors’ exemption would phase out over a \$10,000 income range, and that the Social Security proposal would impose a 2 percent income tax surtax on adjusted gross incomes over \$250,000 and a 2 percent payroll tax paid by employers on employees’ earnings above that threshold. Under those assumptions, the Senator’s proposals would reduce revenues by \$2.4 trillion over 10 years, or about \$367 billion less than the proposals as described by his campaign advisers.

I really have no idea what Obama’s advisers “insist” that there is no such plan. I think a tax increase on the very rich dedicated to the social security trust fund would be very popular. I certainly love it and have bitterly criticized the TPC for leaving it out of their earlier analysis. I note that the Obama campaign has talked about a tax from 2 to 4% so the amount raised could be much more than \$ 367 billion over ten years. I guessed that it was designed to roughly balance the making work pay tax cut (still might be at the higher level) here (search for Waldmann).

Also recall the appalling L.A. Times article which claimed that Obama’s numbers don’t add up (and barely mentioned the fact that McCain refuses to release numbers and that his mumblings aren’t in the ball park … or the solar system). At the time Kevin Drum noted that, according Peter Nicholas of the the LA Times Obama was only a few tens of billions short of adding up counting the expiry of the Bush cuts for families with income over \$200,000 and the end of the Iraq war (Nicholas actually said that Obama was vague about how fast he proposed getting out of Iraq). The math: Nicholas claims \$130 billion/year of spending increases (mostly health care reform) and \$ 80 billion/year in tax cuts vs \$100 billion in letting Bush’s tax cuts for those making over \$200,000 lapse and maybe \$ 90 billion/year saved by leaving Iraq. Oh with at least \$30 billion/year with the donut plan, Obama’s proposals are revenue neutral. I guessed so at the time in a comment on Drum’s post.

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## ARMY navy air force MARINES

Budget Peace in our Times

by Robert Waldmann

How can it be that the US military is strained to the breaking point occupying (sorry assisting) two medium sized countries when we spend about half of total world military spending? I’m not sure this post is in the Angry Bear comfort zone, but one reason is that US elected officials have allowed the services to form a budget request cartel such that increased spending on the Army and Marines must be balanced by increased spending on the Air Force and Navy which is needed so they can protect us from the Soviet Union.

I am moved to type this by Ezra Klein’s post “Clarke on Obama” and, in particular, by a comment.

IIRC, Obama is talking about expanding the number of “men under arms” and shifting a bit from expensive metal stuff to a more “labor intensive” military.

While McCain wants more soldiers AND more expensive metal stuff.

Posted by: joe from Lowell July 18, 2008 3:41 PM

I agree with Joe from Lowell’s version of Obama that the problem is the rigid rule that :

“Until now, the Pentagon has largely divvied up the services’ shares of the defense budget the same way every year: the Army receives 24 percent, the Air Force 29 percent, and the Navy and Marines a combined 31 percent. It is a delicate balance that has kept the services from moving aggressively to raid each other’s accounts to pay for their additional needs.”

leading to absurdities like emergency borrowing by the Army

That’s no way to run a republic, it also no way to run an empire. While the candidates debate empire vs republic maybe they can also debate Army vs Navy (not the football game). No prize for guessing which side McCain will be on. This is an issue where he probably actually cares and where his likely position is clearly absurd.

The one key step is to ask former secretary of the Navy Senator Jim Webb if he is on board for the anti Navy plan before attempting take off (from the Air Force too).

update: title changed because first it appeared twice (sorry I’m not aware of all Angrybear internet traditions) and second because I just realized that the headline of the www.govexec.com article is “Rising Army, Marine Corps costs may trigger budget war.” Yep there is concern that the US military might be involved in a war, not a little dustup like that occupation fraternal assistance in Iraq but a really unacceptable intolerable inter service budget war. “Peace in our time” was Neville Chamberlain’s slogan. I say stop appeasing the Navy and Air Force (check polls in Colorado on second point).

## Bailouts and Moral Hazard

Bailouts and Moral Hazard
by Robert

Here we are again, just into a Bear (sterns) market and we have to face the fact that Fannie Mae and Freddie Mac are waaaaay to big to fail. A strong case can be made that a bailout will cost relatively little and failure to come to their assistance will cost a lot even when distracted by Gover Norquist’s absurd arguments. Here is the video. In defence of the BBC, the accents have gotten a lot better since 1945, no striped trousers on the broadcast at all.

OK so we have to bail out the FM’s. However, it is irritating that the people who made this mess obtained tens of millions in compensation doing so. I can translate my populist rage into gametheoryspeak noting that bailouts create moral hazard problems. The US government can’t let Fannie or Freddie or even the medium size bad Bear fail. It shouldn’t make executives decide to run risks only because they know that if they roll snake eyes, the treasury or the fed will bail them out. So What is to Be Done ?

It seems simple to me (and many many others). The institutions are too big to fail, their officers are vulnerable to bad incentives. The correct policy is to keep the institution from failing in a way which will serve as a lesson to the officers of other institutions.

I think the optimal policy is simple. The chairman of the Fed tells the CEO of To Big to Fail Bank (tbtf bank) that the FED will pick up dodgy assets with face value X if mr CEO picks up dodgy assets with face value equal to 90% of his wealth as reported in the Forbes 500 or 5 years of his (or her hah?) total compensation. Then Bernanke can mention that he is not a shareholder of tbtf bank, but, if the CEO were to say no and the bank were to go bust and he were a shareholder he sure would sue (and presumably win).

Now the CEO can appeal to the 13th amendment and resign on the spot, but he loses if he says yes and loses more if he says no. If he says he is resigning, BB (Ben Bernanke not Big Brother) says his successor will be offered the same deal with the added proviso that CEO I not be paid anything by tbtf bank beyond what CEO I can claim is due to him in court. And so on. BB will get down to someone so poor that he is willing to put 4 years of compensation at risk in order to be CEO.

Unlike the highly compensated officers, that person might even be competent to manage a bank (stranger things have happened).

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## Milton Friedman Meets Robert Klitgaard

I encountered the writings of Robert Klitgaard twice.

I read “Tropical Gangsters” an excellent book on his experience working for The World Bank in Ecuatorial Guinea which is not to be confused with the epymenus epyminus (oh hell I’ll never guess the spelling of that word ) CD by King Creole and the Coconuts.

Years earlier, when I was a freshman I think, I saw students protesting “The Klitgaard Report” to the president of Harvard, in which he noted the fact (it’s a simple calculation) that African American students at Harvard had a lower GPA* than would be expected conditional on SAT scores. Brad DeLong, who actually read the report, says he detected no sign of racism in it.

Now obviously we all knew that average SAT scores of African Americans are lower than those of Euro-Americans so the SAT was presumably biased against African Americans (I mean if interpreted as a measure of smarts not assimilation in the dominant US cultural tradition). A justification for affirmative action which I personally liked a lot was that a reasonable prediction of performance would be standard measures (like the SAT) corrected for disadvantage. Thus I was most distressed by the Klitgaard report (not enough to go to the protest where Derek Bok talked to angry students as he often did because I mean he just did a simple calculation and the data ambushed him).

Now I understand. First lets assume that the cultural bias in Harvard grading is the same as the cultural bias in the SAT so race has the same effect on the expected value of the Harvard GPA as on the SAT score. Now note that an SAT score is the sum of the expected SAT score for that individual and a disturbance term which is specific to that test that day. The disturbance term includes did the student have a cold that day etc and also, if the student guessed on questions, did the student guess right. Fact is, if someone takes the SAT twice he or she will get different scores.

Given the fact that the distribution of SAT scores of African Americans is lower than that of Whites (first order stochastic dominance) if one has an African American and a White American with the same SAT score, one can rationally (and illegally) infer that the African American probably had a good day that day and the White American a bad day, that is that the expected value of the day specific disturbance is higher for the African American than for the White American.

Already this implies the Klitgaard effect even if the effect of race on expected SAT score and expected GPA is the same. The explanation of the Klitgaard effect is the same as Milton Friedman’s explanation of the fact that African Americans save more than White Americans with the same income (this is a fact). The same current income implies a lower expected value for permanent income just as the same success at demonstrating acculturation of whatever on a given day corresponds to lower expected level of acculturation to White America.

This is a general issue. There are many many empirical results which I found disturbing in which African Americans have outcomes like White Americans with lower incomes. All of this makes sense of important outcomes depend on permanent non current income. Of course they do. A huge amount of social science research on race and income was rendered obsolete by the permanent income hypothesis decades ago.

Of course that’s not the half of it. Even without colds and lucky guesses and such, the SAT is correlated with GPA but they are not measuring the same thing (whatever it is and whether or not either has anything to do with one’s real ability to contribute to the growth of human knowledge and the fullest flowering of humanity which they might because, hell, anything is possible). For example, in the SAT they gave us tiny little passages to read and it was wise to read every word. At Harvard professors don’t bother to winnow their reading lists so you have to quickly decide what to skip and what to actually read (unless you are Brad DeLong and read 1000 words a minute and never learned that skill and is suffering from that lack now). So for the same SAT score, one would guess that the African American student has more ability to read every word and understand compared to his or her ability to decide what to read when he or she doesn’t have time to read every word.

Ergo** Klitgaard effect.

Now even if the SAT has a particularly strong cultural bias so race has a bigger effect on expected SAT score than on expected GPA, the measurement error statistical discrimination bit can imply Klitgaard’s result if it outweighs the SAT is biased effect.

OK now sticking with GPA as our end point, I note that even if 11% of people who would get a harvard GPA over 3.9 (Harvard is different 4 is the max) are African American, this won’t be true of people admitted to Harvard if 11% of admitted students are African American. It’s that disadvantage and cultural difference and stuff makes the predictors of performance less accurate. Getting a student with an over 3.9 GPA requires that there be such a student and that one detects him or her and that you don’t have to choose between him or her and the son of a super rich alumnus who will give tons of money if you admit his son but it is neither gross class bias or bribery because Harvard is different and superior and you don’t understand and an institution struggling to get by with an endowment of only I don’t know how much more than \$ 40 billion*** has to make some compromises.

*Harvard called it something else like a “cube” because Harvard is superior and so it has a superior measure of grades)

** I never heard a Harvard student use that word except when denouncing “Ergo” a really dumb libertarian student magazine published by people who claimed some affiliation to MIT.

*** I note that the person who will start managing all that money in one week, Jane Mendillo seems to be neither male nor anglo. Another glass ceiling broken. Now she can decide whether to bail out a firm run into the ground by Jenna Bush like a predecessor of hers did for Harken energy (high treason since Bush is a Yalie).

update: This post was more than usually incomprehensible. I try to explain in comments and here (same text cut and pasted)

Sorry my post was incomprehensible. The permanent income hypothesis is unusual in economics because it explains facts which seem very odd at first glance. It is not true (has been rejected by the data) but, in this case, the glass is half full (in others it is totally empty).

One fact which it explains is that, when one regresses log consumption on log current income, one gets a coefficient less than one, yet over time, aggregate consumption grows at the same rate as aggregate income. Another is that Blacks consume less compared to Whites than one would predict given their current income.

Both can be explained if consumption depends on income averaged over a long period (as it does according to the PIH) so current income is equal to this average plus a disturbance term.

Now the bit on SATs and GPAs has nothing to do with bias in the SAT. “Biased” is a statement about the expected value of a statistic.

Let’s say there is something call it ESATGPA which causes high expected SATs and GPAs so SAT score is ESATGPA plus a mean zero disturbance and GPA s a function of ESATGPA plus another uncorrelated mean zero disturbance. Thus the SAT is, by assumption an unbiased measure of something to do with the GPA.

Now consider a group with lower than average ESATGPA. To avoid race, consider people whose first language is not English (hugely correlated with low SAT). Note I am assuming ENFL (English not first language) has the same effect on SAT and GPA so the SAT remains unbiased even if some people didn’t learn English as babies. However, given the disturbance to SAT, the best estimate of ESATGPA has a positive coefficient on SAT and a negative coefficient on ENFL (this follows mathematically from my assumptions). Thus people with ENFL will have lower expected GPAs than people with the same SAT scores and English as a first language.

Or forget GPA. Let’s say we are trying to use SAT scores from one day to predict SAT scores on a second sitting of the SAT. The SAT is certainly not a biased measurement of expected score on the SAT. However, Thus people with ENFL will have lower expected new SAT scores than people with the same SAT scores and English as a first language.

I assure the irritated reader that this is simple statistics. It also explains away a huge number of apparently interesting results in social science.

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