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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).

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.

Economics Makes for Strange Sick-Bed Fellows

Obama ready to cave in to insurance industry


‘Her Way’; Obama Health Plan Could Go In Clinton’s Direction
Teddy Davis, John Santucci and Gregory Wallace ABC News 06.29.2008

Obama’s surrogate [Dr. Kavita Patel] made her comments Wednesday while representing him at a National Journal health-policy forum moderated by Ron Brownstein, the political director of Atlantic Media.

Patel’s individual mandate remarks were made in response to an insurance industry leader suggesting at the same forum that insurers will oppose Obama’s plan as currently structured. Insurers are worried that the Illinois Democrat has not tied an individual mandate to “guaranteed issue,” the industry’s term for requiring patients to be covered without regard to pre-existing conditions.

“We’ve had the conversation about . . . guaranteed issue,” said Karen Ignagni, the president and CEO of America’s Health Insurance Plans. “But we are prepared to have that conversation in the insurance industry if the politicians are ready to stand up and say we are going to get everyone in.”

Ignagni’s words are watched closely because the organization she heads emerged from the Health Insurance Association of America, sponsors of the “Harry and Louise” ads which played a critical role in killing Clinton’s effort to reform health-care in the 1990s.”

I didn’t see that coming, but I should have. Obama’s plan has the part consumers like but has the problem that it would bankrupt the health insurance industry. Hmmm what if his plan was to terrify them into accepting universal health insurance with the public sector allowed to compete ? Current proposal sounds lovely. It would make it advantageous to the young and healthy to wait till they get sick to get insurance. The problem is that it could cause the industry to enter a death spiral.

But it sounds lovely. Do you want to bet your industry on your ability to stop the 46 year old African American major party nominee whose middle name is Hussein and who beat the police and the newly elected Democratic governor in a *unanimous* Illinois senate vote ? Better to deal I’d say. Maybe, just maybe, Ignagni really agrees with me that opposing Obama on a superficially appealing plan whose only fault is that it will destroy her industry is not a bright move.

And look at the headline from Green Change. We have Obama caving to the health insurance industry by accepting 100% universal health insurance (sort of like the time that he adopted Republican talking points by proposing his donut social security funding huge progressive tax increase, class war, soak the rich and spread it out thin plan).

I don’t know if he is is just brilliant or is also blessed.

Hello My Name is Robert Waldmann

Hi I am Robert Waldmann. rdan has very kindly invited me to guest post here some. I have a blog of my own (to which he kindly linked in the announcement). I am officially an economist, but tend to blog about politics at my home blog. Here I will try to fit the interest in, you know economics.

I wasn’t always like this. Until age 25 I was a biologist. I currently live in Rome Italy. I am irrational and like to write about irrationality. I am also egalitarian.

My latest effort, which is a joint paper with Emanuele Millemaci is about relatively rational people who have dynamically inconsistent preferences. It is strictly empirical. Our hypothesis is that people with more severe dynamic inconsistency would hold less of their wealth as checking account balances, because it is too easy to spend.

This appears to actually be true (Oh I love to blatantly split infinitives)

Dynamically Inconsistent Preferences and Money Demand

Emanuele Millemaci and Robert J. Waldmann

This research wouldn’t have been possible without CentER at the University of
Tilburg which designed the survey and collected the the data.

This paper focuses on two main issues. First, we find that, on average,
households’ discount rates decline. This implies dynamically inconsistent
preferences. Second, we calculate an indicator of the degree of dynamic
inconsistency that may help us to understand how households overcome their
self-control problems. We use a micro dataset containing households’ reports
on the compensation for receiving hypothetical rewards with delays. We find
that individuals with more severely dynamically inconsistent preferences on
average hold a statistically significantly lower share of their total wealth
in checking accounts. A possible interpretation is that subjects use
precommitment strategies to limit their temptation to consume immediately.
(JEL classification: D11, D12, D90)

Comments very welcome. If you want the pdf ask in comments.