Thanks to Bryan Caplan for his excellent post this morning. In the Comments section, people discussed the difficulty of shorting housing even if you thought it was overpriced. I'll tell two stories of two friends who saw what was happening. One didn't act on his insight and one did.
First, the friend who didn't act. He lives in about the only at-all upscale neighborhood in Detroit. In about 2005, people bought a house next to him and drastically overpaid, by his estimate, with a big mortgage from Washington Mutual. After buying, they let it sit. He sensed a scam between the buyer, the seller, and the appraiser. So he called WaMu and told them what he had observed. The person he talked to said, "Do you think we don't know how to run our business?" She had no interest in learning more.
How could he have acted? By buying put options on WaMu stock. He didn't.
In about the same year, another friend, who was a principal in a hedge fund, thought that California real estate was overpriced. If I remember correctly, he told me that 40% of all the value of residential real estate in the United States was in California alone. So he tried to get the other principals in the fund to buy puts on the stocks of banks that were heavily invested in California residential mortgages. He couldn't persuade them. He did research to find which bank or banks were most at risk. He found one: Downey Savings and Loan. So he used his own assets to buy a large number of puts on their stock. He made out. He's the only friend I know who had a substantial amount of wealth and didn't lose net wealth when the crisis hit.
I just read Foote, Gerardi, and Willen's subprime facts manifesto. Twice. In the process, I learned more about the subprime crisis than I learned in the last five years put together. If you're going to read one piece on this topic, read this one. Quick version:
1. A simple model where insiders and outsiders grossly overestimated housing price appreciation elegantly explains all the key facts.
2. The competing models - especially stories that allege an "inside job" - contradict basic facts.
I could easily write twenty posts about this paper. The authors draw on an amazing range of evidence. For now, though, let me just direct your attention to the single most striking table. In 2005, Lehman Brothers made the following conditional forecasts about the performance of subprime-backed bonds:
The significance?
Using data supplied by issuers and lenders, as well as quantitative tools designed to exploit this information efficiently, investors were able to predict with a fair degree of accuracy how mortgages and related securities would perform under various macroeconomic scenarios. Table 2, taken from a Lehman Brothers analyst report published in August 2005, shows predicted losses for a pool of subprime loans originated in the second half of 2005 under different assumptions for U.S. house prices (Mago and Shu 2005). The top three house price scenarios, which range from "base" to "aggressive," predict losses of between 1 and 6 percent. Such losses had been typical of previous subprime deals and implied that investments even in lower-rated tranches of subprime deals would be profitable. The report also considers two adverse scenarios for house prices, one labeled "pessimistic" and the other labeled "meltdown." These two scenarios assume near-term annualized growth in house prices of 0 and -5 percent, respectively. For those scenarios, losses are dramatically worse. The pessimistic scenario generates an 11.1 percent loss while the meltdown scenario generates a 17.1 percent loss...
Lehman analysts were not alone in understanding the strong relationship between house prices and losses on subprime loans. As Gerardi et al. (2008) show, analysts at other banks reached similar conclusions and were similarly accurate in their forecasts conditional on house price appreciation outcomes. (footnotes omitted)
The authors remark:
The analysis underscores investors' knowledge about the sensitivity of subprime loans to adverse movements in housing prices, and it refutes the idea that investors did not or could not determine how risky these loans were.
[...]
Despite its foreboding name, the "meltdown" scenario was actually optimistic with respect to the observed fall in housing prices that began in 2006. The current forecast for losses on deals in the ABX 2006-1 index, which largely contains loans originated in the second half of 2005, is about 22 percent (Jozoff et al. 2012). This is consistent with the relationship between losses and house prices implied by the table. The bottom line is that analysts working in real time had little trouble figuring out how much subprime investors would lose if house prices fell.
If the conditional forecasts were so prescient, why were unconditional forecasts so ridiculous?
The answer to why investors purchased subprime securities is contained in the third column of the same Lehman analysis cited above, which lists the probabilities that were assigned to each of the various house price scenarios. It indicates that the adverse price scenarios received very little weight. In particular, the meltdown scenario--the only scenario generating losses that threatened repayment of any AAA-rated tranche--was assigned only a 5 percent probability. The more benign pessimistic scenario received only a 15 percent probability. By contrast, the top two price scenarios, each of which assumes at least 8 percent annual growth in house prices over the next several years, receive probabilities that sum to 30 percent. In other words, the authors of the Lehman report were bullish about subprime investments not because they believed that borrowers had some "moral obligation" to repay mortgages, or because they didn't realize that the lenders had not fully verified borrower incomes. The authors were not concerned about losses because they thought that house prices would continue to rise, and that steady increases in the value of the collateral backing the loans would cover any losses generated by borrowers who would not or could not repay.
The hardest question is simply why such optimism arose in the first place. It contradicted all historical experience:
Relative to historical experience, even the baseline forecast was optimistic, while the two stronger scenarios were almost euphoric. A widely circulated calculation by Shiller (2005) showed that real house price appreciation over the period from 1890 to 2004 was less than 1 percent per year. A cursory look at the FHFA national price index gives slightly higher real house price appreciation--more than 1 percent--from 1975 to 2000, but still offers nothing to justify 5 percent nominal annual price appreciation, let alone 8 or 11 percent.
As far as I remember, I neglected to blog any housing price forecast when prices were rising. But the forecast I shared with friends from 2005 on was always "Prices have plateaued." Relative to the facts, I was clearly optimistic. But I was more pessimistic than Lehman's Meltdown Scenario! If I'd only understood the implications of my bearish housing price forecast, I would have made a lot of money from the crisis. Oh well.
Many will look at the Lehman forecasts and confidently declare, "What fools they were." My reaction, though, is bewilderment. How can experts nail the hard question of "What will happen to our investments given housing prices?" yet botch the easy question of "Will unprecedented increases in nominal housing prices continue indefinitely?" I wish I knew.
Thanks to everyone who offered excellent comments on my last post. Most people were thinking about it the way I do. To recap, here were the questions I someday want to ask on an exam or in a job interview:
Crying babies and loud children are among the common complaints of frequent flyers; indeed, I can say from personal experience that a screaming infant can make for a long flight. Describe the reciprocal nature of the externality. How does the private market internalize the externality? To what extent does the possibility of an upgrade to first class help mitigate the externality? What is the role of reasonable expectations in deciding on a policy? What is the parent's responsibility? What is the responsibility of the other flyers?
I'm generally in the "crying baby is not an externality" camp. If you want to escape, fly private. Your tickets are cheap because crying babies fly too.
I lean toward "not an externality" for much the same reason: the bundle of rights you purchase with a plane ticket includes the reasonable expectation that there will be a crying baby or two on the plane. Question-by-question, or direction-by-direction:
Describe the reciprocal nature of the externality.
As I told my classes when I taught micro, "it takes two to tango" (NB: one of the drawbacks of teaching principles of macro is that I don't get to teach externalities). There wouldn't be a conflict about rights were it not for the non-baby passengers who are there to hear the noise. That the baby is the source of the problem isn't obvious.
How does the private market internalize the externality?
As Finch put it, "(y)our tickets are cheap because crying babies fly too." The airline--the owner of the space temporarily inhabited by the passengers--presumably capitalizes the likelihood of amenities and disamenities into the price of the ticket. If things get bad enough at the outset, airlines can also ask especially disruptive families to get off the plane.
On long-haul flights with entertainment systems, airlines themselves address the problem by passing out headsets and by providing kids' games as part of the entertainment. Even if you don't have airline-provided entertainment, you can drown out most of the noise with your MP3 player, noise-canceling headphones (which I have yet to buy but which I will probably pick up on my way home), or even simple earplugs. This probably isn't in the fine print on your ticket, but my impression is that airlines assume passengers are the least-cost avoiders of kid-related noise.
In the last few years I've flown Delta, mostly, and I should have Gold status after the first leg of this trip gets processed. I've been amazed with just how good airlines are at price discriminating. The major carriers reward their frequent flyers with better seats on the plane (closer to the front, aisle seats, etc). Gold status will mean complimentary Economy Comfort seating and more first-class upgrades.
It's also worth mentioning that one person's negative externality can be another person's positive externality. Being around other people's kids on planes reminds me of my own, so a little bit of crying is not necessarily a bad thing (do note that this relationship is not linear or strictly positive). Fewer babies on planes would make people who don't like loud kids better off, but at the expense of those who are worse off because they are around fewer cute kids.
To what extent does the possibility of an upgrade to first class help mitigate the externality?
You can drastically decrease the probability that you're seated near a crying infant by paying to fly first class, or by upgrading your ticket with frequent flyer miles.
What is the role of reasonable expectations in deciding on a policy? What is the parent's responsibility? What is the responsibility of the other flyers?
This is where things get really interesting. It's reasonable, for example, to expect that if you fly often enough you will periodically lose the Screaming Kid Lottery. That said, parents have an obvious obligation to other passengers to make sure things don't get out of hand. When we've flown with our kids--who, praise be to God, travel well--we've tried to make sure we have enough stuff to keep them occupied. I take it that part of membership in a functioning society is putting up with the occasional indignity. The occasional loud kid on a plane probably isn't worth getting that upset about.
I've written on consumer surplus a number of times on this blog. See here. David Boaz recently posted on a 1979 talk by Nathaniel Branden to which I was the introducer. In my intro to Nathan, I applied the concept of consumer surplus so that, I think, a non-economist audience could understand it. My intro goes about 3 minutes and 20 seconds.
By the way, the friendly heckler at about the 59 second point, who yells out "Economist," is the late Roy A. Childs, Jr..
The lead in to the consumer surplus point starts at about 1:40.
I recommend Nathan's whole talk too. It's one of his best.
I agree with co-blogger Bryan that most voters are rationally irrational. My sense is that there are also a lot of voters and people in positions of influence who know just enough economics to be dangerous. As Steve Horwitz and I pointed out in a recent essay for the Library of Economics and Liberty, "market failure" is where the conversation begins, not where it ends.
A couple of hours ago, I got off a flight where I was seated near a couple of very, very loud children: before we departed, a few of my fellow passengers were craning their necks and looking for the source of the disturbance and--I hope--pitying the mother. This brings me back to a set of questions I've always wanted to ask on an exam or to a job candidate. From a 2009 post on Division of Labour:
Crying babies and loud children are among the common complaints of frequent flyers; indeed, I can say from personal experience that a screaming infant can make for a long flight. Describe the reciprocal nature of the externality. How does the private market internalize the externality? To what extent does the possibility of an upgrade to first class help mitigate the externality? What is the role of reasonable expectations in deciding on a policy? What is the parent's responsibility? What is the responsibility of the other flyers?
In a post on Tuesday, "Find the Flaw," I asked readers to find and evaluate the implicit assumption in the following passage from an economics textbook:
When physicians must be licensed and new drugs approved by the Food and Drug Administration (FDA) before they can be marketed, buyers are spared the cost of evaluating goods whose quality most of them would be unable to assess for themselves, except at prohibitive costs. By compelling sellers to obtain certification, government agencies can enable us all to make satisfactory exchanges at lower cost.
A number of people did so successfully. First was Fred Foldvary, who wrote:
The statement assumes there is no demand for information that can be supplied by consumers reports, Angies list, WebMD, and other sources. Also FDA could approve drugs without banning non-approved drugs.
Moreover, it's not just that private organizations could do this certifying. It's better than that. Private sources of information, such as U.S. Pharmacopeia and the Physicians' Desk Reference, already do do this certifying.
Brad D asks:
First, why would a passage like this come from your favorite economics textbook?
My simple answer is that it does.
The textbook from which this passage is taken is The Economic Way of Thinking, 12th ed., by Paul Heyne, Peter Boettke, and David Prychitko.
We've tried to model it. When we lived in Memphis, we lived in what a colleague called "Midtown East," near the intersection of Walnut Grove and Highland. I once timed my commute at 8 minutes from leaving my driveway to parking my car at Rhodes. We could walk to the grocery store, Starbucks, a bunch of restaurants, the main public library, and other places. It was great.
We don't have that luxury where we are now because Samford is in the suburbs (it has a Birmingham address but is actually in Homewood), but I do have a similarly short commute. We're also very close to Walmart, Publix, and a bunch of other places we frequent. We can also walk to the playground and park near our house. I miss being able to walk to Starbucks, but it's still pretty nice.
So what of the obvious retort--"that's great, but most people can't afford it"? My suspicion is that this is an example in which behavioral economics--or just Frederic Bastiat--has the most to contribute. We tend to notice what is right in front of us while ignoring what is harder to see. We emphasize the present and heavily discount the future. In a world where we have all sorts of cognitive biases, it's easy to believe people probably under-estimate the costs of commuting and, therefore, under-estimate the value of living close to where they need to be. I've read recently--I believe in Rolf Dobelli's The Art of Thinking Clearly, or in his essay "Avoid News"--that we tend to under-estimate the costs of chronic stress to our health and, ultimately, to our bank accounts. That "great bargain" on the house with the soul-crushing 40-minute commute may not be such a great deal when you factor in the increased probability of a future that involves expensive heart medication.
Is there a policy upshot? It seems like it would be easy to say "and therefore, we should quit subsidizing suburban sprawl and long commutes, either implicitly or explicitly." I definitely agree, but maybe not on these grounds. Density creates its own congestion problems and stressors For example, living close enough to walk to Starbucks was awesome. Multiple distant sirens daily was not. I'm not sure what the "socially rational" pattern would be, but holding others' actions and current policies constant, my sense is that the blindfolds of our cognitive biases are causing a lot of people to step over hundred-dollar bills.
So two questions for you, dear readers:
First, is there a policy upshot that I'm overlooking in my haste?
Second, what are other examples of situations in which we could be meaningfully "less wrong" if we worked at it?
Also, I owe some of you responses to previous posts. I haven't forgotten; I promise!
Social media is [sic] often recognized narrowly as a way to connect with friends, or to share and read the news. Yesterday it was demonstrated that social media can serve as a medium of mobilization for disaster relief, helping Americans all over the country reach out and help those affected by the tornado in Oklahoma on Monday.
Shortly after the destructive twister tore through the town of Moore outside Oklahoma City , conservative radio personality and talking head Glenn Beck used Twitter to organize a "convoy of hope" to travel to Oklahoma to provide early disaster relief. Within hours, Beck's team had used Twitter to locate trucks and supplies, and they were on their way, arriving in the Moore area bearing food, water, and diapers.
UPDATE: I neglected to give the source. It's here.
If you are a good libertarian, you will care only about your own freedom
and well being. The freedom of others is only of concern to the extent
that it enhances your freedom and well being. Any concern about the
freedom of abstract Haitians is the essence of "soft head, soft heart"
reasoning. As other posters have noted, that will get you nowhere in
convincing others. And it SHOULD get you nowhere. It's muddle-headed
thinking and not worthy of you. Make your arguments, instead, on how
more open immigration will benefit the people you're trying to convince.
This comment is mistaken on six different levels.
1. A "good libertarian" would certainly not care only about his own freedom and well-being. Egoism and libertarianism are not the same; indeed, as Michael Huemer shows in an elegant hypothetical, the two views are incompatible.
2. If I cared only about my own freedom and well-being, I wouldn't bother making political arguments of any kind. Per the logic of collective action, my probability of affecting policy is trivial. I'd be far better off milking my tenure for all it's worth, doing my bare minimum 150 hours of teaching per year to keep my paycheck, and dividing my remaining time between consulting and apolitical hobbies.
3. My concern for Haitians would only exemplify "soft head, soft heart" reasoning if my favored policies were bad for Haitians. That's the whole point of the hard/soft head/heart distinction: a "hard head" indicates concern for effective means, a "soft heart" indicates concern for other people. In slogan form: The minimum wage is "soft head, soft heart"; GiveWell is "hard head, soft heart."
5. For many important issues, libertarian appeals to self-interest are factually incorrect. All things considered, abolishing slavery was probably not in the self-interest of American whites. The best argument against slavery was ethical. Case in point:
6. For many other important libertarian issues, appeals to self-interest are factually correct but, to use Brian's word, "unworthy." Immigration is such an issue. Yes, doubling GDP by opening world borders will enrich most people in the First World. But these economic benefits for First Worlders are not the main reason why I advocate open borders. The main reason I advocate open borders is that immigration restrictions are a terrible injustice against people from Third World countries. Once someone retreats to, "Yes, immigration restrictions are a terrible injustice, but doing the right thing would be very costly," I'm happy to delve into the social science with them. Until then, they're just missing the point.
Are instrumental variables (IV) estimates really superior to ordinary least squares (OLS)? Most high-status empirical economists seem to think so. Meta-analyses often treat IV as presumptively superior to OLS. Yet when you ponder IV output, it's often simply bizarre.
Rose and Betts, "The Effect of High School Courses on Earnings" (Review of Economics and Statistics 2004) is a case in point. The paper's very good overall. But take a look at their IV estimates for the effect of coursework on earnings. (Columns 2 and 4 adjust for student ability; columns 1 and 3 don't).
Readers eager to find an effect of curriculum will eagerly point out that the IV estimate implies that algebra/geometry raises adult earnings by 9-10%. But the IV results also imply that advanced algebra reduces adult earnings by 9-10%. (This result is only statistically significant after controlling for ability, but still).
If you look only at point estimates, and ignore statistical significance, the results are even harder to believe. You get big positive effects of secondary physics and third- and fourth-year foreign languages. But you also get a massive negative effect of calculus. Calculus!
You could accuse me of cherry-picking (lemon-picking?) some exceptionally odd IV results. But in my experience, Rose and Betts is typical. And if published IV results are implausible, the unpublished results are probably far worse.
A staunch empiricist could admittedly object that we shouldn't call statistical output "bad" merely because it contradicts our theories. I'd reply, though, that "IV estimates are better than OLS estimates" is itself a theory. The main way to test this theory is to race IV versus OLS on questions where we are already confident that we know what the right answer is (or at least what the wrong answer is). By that standard, the privileged status of IV seems unjustified.
Please share your dirty laundry about instrumental variables in the comments. To avoid confirmation bias, please also share your clean laundry. :-)
Here is a passage from one of my favorite economics textbooks:
When physicians must be licensed and new drugs approved by the Food and Drug Administration (FDA) before they can be marketed, buyers are spared the cost of evaluating goods whose quality most of them would be unable to assess for themselves, except at prohibitive costs. By compelling sellers to obtain certification, government agencies can enable us all to make satisfactory exchanges at lower cost.
Find the unstated assumption and then evaluate this assumption.
If you know the name of the textbook and the authors, please don't reveal it in the comments section. I will do so in an update.
With the end of the semester and the coming demise of Google Reader, I'm going to take an inventory of my already-thin list of RSS feeds and add and subtract as I deem necessary. Since crowdsourcing is the hip, "in" thing that all the cool kids are doing, I put the question to you, dear readers: to what blogs or other RSS feeds should I subscribe, and why?
I look forward to your suggestions. I'll reveal my current subscriptions by the end of the week.
Question for people who think my views on immigration are "crazy": Would the same views remain "crazy" if I were Haitian?
Brad Trun, blogger at Libertarian Realist, wrote a direct and forthright reply. Some will condemn him as racist, and be horrified that Brad identifies with libertarianism. But his response to my Twitter challenge was better than the others I've seen. My reply is below. He's in blockquotes, I'm not. You write:
If you were a freedom-loving
American, it would be crazy for you to advocate unlimited inflows of unskilled,
crime-prone, Affirmative Action-eligible, future Democrat bloc-voting Haitians with average IQs of 80 into your country.
Suppose, however, that I was a
freedom-loving PERSON, who cared about the freedom of Haitians as well as
Americans. Would advocacy of open borders be "crazy" then?
Would you similarly say that a "freedom-loving white American" would be "crazy" to oppose the exile of black Americans who share the same undesirable characteristics you attribute to Haitians? Why or why not?
Brad then sent me the following email reply, used with his permission. I'm in blockquotes, he's not.
Bryan,
I'm delighted to get your response.
If you
valued the freedom of Haitians and U.S. citizens equally, then I suppose open
immigration for Haitians would be justified if Haitians gained more
freedom than they subtracted from U.S. citizens. To me, it's an
irrelevant question. It is not the purpose of a libertarian government to
help redistribute freedom more equally around the world. It is to secure
the freedoms of the people under its jurisdiction.
Do you
value the freedom of Islamists to impose sharia law wherever they want?
Presumably not, since it would be crazy to value a person's freedom to
take another person's freedom away.
Do you
favor more Muslim immigration into Western Europe? The Muslim influx is
having disastrous consequences for freedom there, ranging from skyrocketing
rates of rape in Scandinavian cities to sprawling polycentric Sharia zones in
London, where drinking is banned, women must be covered, and gays can't exist
openly.
Would you similarly say that a "freedom-loving white American" would be "crazy" to oppose the exile of black Americans who share the same undesirable characteristics you attribute to Haitians?
No, but
Thomas Jefferson was a freedom-loving white American who favored both the
emancipation of black slaves and their deportation back to where they were
illegitimately taken from. That opportunity has passed. I don't
favor forcibly exiling people unless they've actually committed a crime.
But the
granting of citizenship to the foreign born is the granting of positive rights
and privileges (to vote, etc.), to which the entire world population isn't
automatically entitled. Being highly selective as to who gets
citizenship is an aspect of national security. Citizenship selectivity
would be especially important for a libertarian country that exists within an
overwhelmingly non-libertarian world.
Indiscriminately
open immigration can result in rapid political and economic deterioration if
the immigrants are overwhelmingly low-IQ, crime
prone, statist, and/or culturally hostile. Imagine that Detroit
circa 1955 -- which was majority white, relatively safe, prosperous, and widely
considered to be one of the greatest cities in the U.S. -- became a sovereign
city-state. Should it have adopted a policy of open immigration? We
don't have to speculate about the consequences of such a policy. It was
in place by default. And it was catastrophic.
My informed
speculation is that Detroit's death spiral of rising crime, declining property
values, a collapsing economy, white flight, and depopulation would
have been averted with immigration restrictions. Detroit today might
still be a jewel of a city. I think you'd have to admit that it's hard to
imagine a sovereign Detroit with selective citizenship being worse off than
Detroit today actually is.
I'm not
saying that every city should be its own nation. But if the people who
reside in a given nation -- however delineated -- value their freedom, they
should favor an immigration system that selects for a population with
compatible characteristics.
I then sent Brad the following reply. He's in blockquotes, I'm not. (Except for his blockquotes of my blockquotes).
I'm
delighted to get your response.
Likewise.
If you
valued the freedom of Haitians and U.S. citizens equally, then I suppose open
immigration for Haitians would be justified if Haitians gained more
freedom than they subtracted from U.S. citizens. To me, it's an
irrelevant question. It is not the purpose of a libertarian government to
help redistribute freedom more equally around the world. It is to secure
the freedoms of the people under its jurisdiction.
If you're a
libertarian, where does this "jurisdictions" stuff come from?
I'd think that the purpose of a libertarian government would be to
respect people's freedom. And even if you think freedom in a
jurisdiction is a priority, that hardly means it's an absolute priority.
In the worst case scenario, full Haitian immigration make Americans mildly less
free. In the status quo, American immigration restrictions make Haitians
vastly less free.
Do you
value the freedom of Islamists to impose sharia law wherever they want? Presumably
not, since it would be crazy to value a person's freedom to take another
person's freedom away.
No.
But keeping out all Muslims because a few of them are nutjobs is much crazier.
Do you
favor more Muslim immigration into Western Europe? The Muslim influx is
having disastrous consequences for freedom there, ranging from skyrocketing
rates of rape in Scandinavian cities to sprawling polycentric Sharia zones in
London, where drinking is banned, women must be covered, and gays can't exist
openly.
I think
these tales are absurdly exaggerated. And remember - the main victims of
expat Sharia would be far worse at home, as I explain here.
Would you
similarly say that a "freedom-loving white American" would be
"crazy" to oppose the exile of black Americans who share the same
undesirable characteristics you attribute to Haitians.
No, but
Thomas Jefferson was a freedom-loving white American who favored both the
emancipation of black slaves and their deportation back to where they were
illegitimately taken from. That opportunity has passed.
Taking
freed slaves and sending them back to a country they've never known is an
"opportunity" that's "passed"?
I don't
favor forcibly exiling people unless they've actually committed a crime.
People, or
citizens? What's the difference?
But the
granting of citizenship to the foreign born is the granting of positive rights
and privileges (to vote, etc.), to which the entire world population isn't
automatically entitled.
Opposing
citizenship and opposing immigration are very different things. I am
saying that the entire world population is automatically entitled to sell their
labor to willing employers, rent from willing landlords, etc. If you
think people aren't entitled to more, why not complain about the welfare
state instead of immigrants?
Indiscriminately
open immigration can result in rapid political and economic deterioration if
the immigrants are overwhelmingly low-IQ, crime
prone, statist, and/or culturally hostile. Imagine that Detroit
circa 1955 -- which was majority white, relatively safe, prosperous, and widely
considered to be one of the greatest cities in the U.S. -- became a sovereign
city-state. Should it have adopted a policy of open immigration? We
don't have to speculate about the consequences of such a policy. It was
in place by default. And it was catastrophic.
What you
call "catastrophe" is, by world and historic standards, a
paradise. Would saving Detroit have justified depriving blacks of the
freedom to live and work where they like - and whites the right to trade with
them? No.
I'm not
saying that every city should be its own nation. But if the people who
reside in a given nation -- however delineated -- value their freedom, they
should favor an immigration system that selects for a population with
compatible characteristics.
Why stop
there? Exile aside, why not restrictions on who can have children, how
many they can have, etc? If you say, "Those restrictions are
themselves severe abridgements of people's freedom," I agree. But
then I have to add, "The same goes for immigration restrictions."
Brad emailed me a further reply, but I'm too busy for another round.
P.S. In the comments, please double-check that you aren't misattributing my words to Brad, or his words to me. Thank you.
1. When you claim that X is most efficient
way for the federal government to spend an extra billion dollars, you should point to a large externality you propose to fix - and argue that the supply response will be substantial. Answers of the form "Distribute the money equally to everyone" are weak, because all lump-sum transfers are neutral with respect to Kaldor-Hicks efficiency.
2. When you claim that X is the maximally utilitarian way for the federal government to spend an extra billion dollars, you should start with Kaldor-Hicks efficiency, then adjust for marginal utility of wealth. The conventional adjustment is to put higher weight on the poor, but there are equally strong cases for putting higher weight on the appreciative (people who savor better experiences) and the materialistic (people who place unusually high value on the stuff that money can buy). The true utilitarian will want to make each and every one of these adjustments.
Suppose a city's population exogenously rises. You might think that price theory clearly implies that demand for real estate will rise. But that's not so. In theory, higher population could generate a congestion externality so awful that demand for real estate actually falls.
If you're having trouble picturing this, imagine how much you'd pay to live in Manhattan given current conditions. Now imagine how much you'd pay to live in Manhattan if the streets were so crowded you had a 10% chance of being trampled to death every time you left your apartment. A sufficiently massive population could drive Manhattan rents down to zero.
Theoretically, then, the effect of population on real estate prices is ambiguous. In the real world, though, I've never come across a credible example of an real estate market where crowding has blatantly reduced rents. My bleg: Has anyone got a credible candidate for me? I'll accept examples from any part of the world in any time period. I'll even accept cases involving a sudden influx of destitute refugees into an area.
Jacob Levy directs readers to the Mission Statement of the Freedom Center at the University of Arizona. I agree that these are values to be emulated. While I sometimes allow the perfect to become the enemy of the good, I am constantly revising my class notes in light of things I learn, successful (and unsuccessful) pedagogical experiments, and the ongoing conversation I have with my colleagues and my students. As Professor Levy does, I reproduce them here along with the mission:
Mission
The Center's mission is to promote the understanding and appreciation of the ideals of freedom and responsibility along four dimensions: published research, undergraduate education, graduate education, and community outreach.
Core Intellectual Values
These are core values that we will not compromise.
1. Growth
We aim to stand up from our desks at the end of every day knowing something that we did not know when we sat down that morning. We do not teach from old lecture notes. With our students we will share what we know, along with our uncertainties & struggles. Our students will know the joy & trepidation of exploring the intellectual frontier.
2. Seriousness
We are in the business of theorizing, but when we theorize, we draw maps whose worth stands or falls with their accuracy in representing reality. We draw distinctions not to obscure differences but to sort them out. When we make empirical claims, we back them up not by turning them into empty tautologies but by offering the kind of data that are relevant to the testing of scientific hypotheses. In short, if your definition makes it unnecessary to check the facts, then you need to check your definition.
3. Independence
We realize that if you want to maintain your passion for work, & want people to be better off for having read your work, or for having been your student, you have to stand for something. But whatever you stand for, you have to stand for honest scholarship first. Truth comes first. If and when the truth turns out incompatible with our beliefs, we change our beliefs.
4. Diplomacy
We will not demonize those who disagree with us. Our engagements will be constructive.
In the cost/benefit analysis course i teach, one of the actual cost/benefit analyses we work our way through--and one that I present as a reasonably good CBA--is a study done by two St. Louis Federal Reserve economists on adding another runway at St. Louis's airport. The authors are Jeffrey P. Cohen and Cletus C. Coughlin.
When I taught it this quarter, I was unable to convince one of the students that congestion is an externality. We had discussed earlier in the course the fact that when you have private property, there is not an externality because the owner takes into account the gains and losses to various people. But I pointed out that the airport is government-owned.
This was not his objection, though. His objection was as follows:
When I show up at the airport, that's a choice on my part. I know that if I show up at a busy time, I will have to wait longer, but I take that into account. So does everyone else who shows up.
My answer was, and is, that, yes, you take into account the amount of time by which you are slowed down, and everyone else takes into account the amount of time by which he or she is slowed down, but no one takes into account the amount of time by which he or she slows others.
That still didn't fly (pun not intended.)
So I gave a numerical example. Let's say there are two people: A and B who arrive at the airport. (It's hard to imagine that two people would create congestion, but if we complicated it with way more people, the essence wouldn't change.) A will lose $10 worth of time by arriving at the airport at a congested time but he values being there at that time, versus the uncongested time, at an additional $15. He also causes B to lose $10 worth of time. Vice versa for B. So A looks at the extra cost he will bear--$10 due to B slowing him down--versus the extra benefit--$15--and decides to arrive at the congested time. B likewise.
Now let's tote up the costs and benefits. The benefits to A and B add up to $30. The costs are $20 each, or $40 total. Why $20 each? Take A. A's cost that he bears is $10--it's imposed on him by B. A's cost that he imposes is $10--it's imposed on B and he doesn't take it into account. They total $20.
This is the first time I've written this down rather than just said it and now I'm feeling implausible. Am I double-counting the $10 that each imposes on the other? I'm getting the uncomfortable feeling that I am. It's funny how writing things down can expose flaws in thinking.
So here's the help I want. First, is my numerical example good or flawed, and why? Second, what's a good way of showing the student that there really is a congestion externality?
Jim Flynn's latest book has fascinating info on age and intelligence. But Sternberg, Wagner, Williams, and Horvath, "Testing Common Sense" (American Psychologist, 1995) suggest that Flynn misses an important part of the story.
There's a widespread perception that "common sense" improves with age:
Older adults commonly report growth in practical abilities over the years, even though their academic abilities decline. Williams, Denney, and Schadler (1983) interviewed men and women over the age of 65 about their perception of changes in their ability to think, reason,and solve problems as they aged. Although performance on traditional cognitive ability measures typically peaks at the end of formal schooling, 76% of the older adults in the Williams et al. (1983) study believed that their ability to think, reason, and solve problems had actually increased over the years, with 20% reporting no change and only 4% reporting that their abilities had declined with age. When confronted with the fact of decline in psychometric test performance upon completion of formal schooling, the older sample said that they were talking about solving different kinds of problems than those found on cognitive ability tests--problems they referred to as "everyday" and "financial" problems.
And this perception is probably correct:
The idea that practical and academic abilities follow different courses in adult development finds support in a variety of studies. For example, Denney and Palmer (1981) gave 84 adults between the ages of 20 and 79 years two types of reasoning problems: a traditional cognitive measure, the Twenty Questions Task (Mosher & Hornsby, 1966); and a problem-solving task involving real-life situations such as, "If you were traveling by car and got stranded out on an interstate highway during a blizzard, what would you do?" or, "Now let's assume that you lived in an apartment that didn't have any windows on the same side as the front door. Let's say that at 2:00 a.m. you heard a loud knock on the door and someone yelled, 'Open up. It's the police.' What would you do?" The most interesting result of the Denney and Palmer study for the purposes of this article is a difference in the shape of the developmental function for performance on the two types of problems. Performance on the traditional problem-solving task or cognitive measure decreased linearly after age 20. Performance on the practical problem-solving task increased to a peak in the 40 and 50 year-old groups, then declined.
Ronald Coase famously advised economists to "look out the window" every so often. It's advice I (try to) take to heart. Here's an example. On Monday afternoon, I was standing behind our building waiting for a few people and "enjoying" the smell of the dumpsters behind the cafeteria next door. An obvious externality that calls for a Pigovian solution if a Coasean solution is unavailable, right?
Not obviously. I can't dig up the cite at the moment, but I recall David Friedman being insistent about making sure the accounting is complete. It's probably rare that an activity produces only positive or only negative externalities. While walking from my car to my office, I noticed something else: the air smelled like bacon. The negative externality of the dumpster smell has to be balanced against the positive externality of the bacon smell. Perhaps that's the implicit Coasean bargain: put up with a slight stench if the wind's right and you're standing right behind your building in the afternoon, and you'll get the pleasant smell of tasty bacon in the morning.
The upshot for public policy is this: we can't make policy designed to fix externalities without taking all the relevant externalities into consideration. For more, here's John Nye's essay in Regulation on "The Pigou Problem." And, while Googling David Friedman and externalities, I was reminded that the Concise Encyclopedia of Economics article on externalities was written by none other than our very own Bryan Caplan.
Arthur Breitman and I have hammered out the following inflation bet:
If the 12 month change of the CPI-U as reported by the BLS is greater
than 5% for any sliding window between today and December 2015 in monthly
increments, I pay Arthur $100. Otherwise, he pays me $3.
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