The N.C.A.A. has a rule in place that sets the market price of a college athlete as one year’s tuition, provided in kind to the student-athlete. The controversy centers around the question of whether the cost of tuition is a fair salary for “student-athletes.” However, economic theory generally ignores the question of whether or not a price is fair – it is assumed that a price is fair if two parties agree to trade at that price. Despite all the complaints about compensation from commentators, no one forces student-athletes to play. If they really are being exploited, they always have the option to walk away. Thousands of student-athletes sign on every year to play knowing the terms a university offers. Many play in non-revenue sports or have no hope of ever playing professionally. For most student-athletes, an athletic scholarship, if they are lucky enough to have one, is compensation enough.

So rather than asking if student-athletes are fairly compensated, we should ask whether or not the N.C.A.A. regulation prevents athletes and universities from exchanging athletic and educational services at a mutually agreeable price. That is, does the regulation prevent some potential athletes from playing for a university because the regulated price is set too low? It’s certainly possible. Stories about players who can’t afford trips home for break or have difficulty scrounging up a good meal (though most college students subsist on a diet of ramen anyway) show that some athletes can just afford to attend, which suggests that extra costs could prevent some players from accepting a scholarship. Removing the cap on student-athlete salaries could provide more students with access to higher education and higher compensation for their athletic talents.

Additionally, the regulation prevents some colleges from hiring their most preferred athletes. As Schwartz points out, the N.C.A.A. universities act as a cartel, working together to push down salaries for student-athletes. The numerous bribery scandals over the past few years show that some universities would prefer to violate the cartel agreement and pay some athletes more than the value of a scholarship. Therefore, removing the N.C.A.A. cap on player salaries could improve the welfare of both players and universities. A free market for student-athletes would ensure that the most desired players end up at the universities that most strongly want them.

Paying players in cash shatters the noble idea of a “student-athlete.” But I maintain that the concept of a student-athlete, at least in sports where there is a significant amount of money involved, is dead anyway. It’s time that we recognize that fact. The N.C.A.A. does a poor job of policing offending schools, and when it does, its punishments are applied unfairly. Athletics departments spend resources trying to game the system. Schools that agree to follow the rules face a competitive disadvantage. Opening up the range of competition for athletes levels the playing field by making the recruiting rules the same for every school. Unfortunately, that means that small schools will be unable to secure the necessary funds to compete with the larger universities. Some schools would need to scrap their teams entirely.

Such an unpalatable notion leads many people to conclude that the N.C.A.A. should still maintain caps on player salaries, but tinker with the amount of the cap. Yet, the end of many collegiate athletics programs is a feature, not a bug, of my proposal.

Universities and colleges exist to preserve old knowledge, develop new knowledge, and pass that knowledge along to the next generation. In no way could you construe the central mission of a university to include operating a minor league sports franchise. Athletics departments perform auxiliary functions for a university – they raise money for the university, maintain connections with alumni, and promote the university to the wider public. That is, universities use athletics for marketing and fund-raising. Yet, a university can market itself and raise funds without an athletic department. They say you have to spend money to make money, but surely there are cheaper ways to garner alumni donations than operating a Division I athletics department. College sports do get a lot of attention, but is it the type of attention that attracts the best qualified students?

Alumni of a school that care about its athletic program would understandably be disappointed if the program were to disappear. But, if they want the athletics program badly enough, they should pay for it. I propose that universities should sell off their athletics programs to a separate trust (or a more appropriate legal form) owned by the alumni. Manchester United fans started a similar trust to buy a share of the club when Rupert Murdoch offered to buy it. Alumni could by shares in the new trust. The trust would gain all sources of revenue that currently accrue to the school. From those revenues, the trust could pay out salaries as necessary to players. Students could still play for the trust’s teams without accepting a salary. Any money left over could be donated to the associated university. Such a system allows universities to maintain academic integrity by leaving the unseemly business of paying athletes to the alumni.

Of course most athletic departments lose money as a whole, so the trust would have to decide which teams to fund and which teams to drop. Most likely the trust would continue to operate only the major revenue sports – men’s football and men’s basketball. But once you recognize that the concept of the “student-athlete” is dead, and remember that universities exist to produce research and education, not entertainment, losing some smaller athletics departments doesn’t seem like a loss. Yes, it’d be a shame to lose sports such as men’s wrestling and women’s field hockey, but I maintain that money spent on those sports are better spent on research and education, for example, lowering tuition.

Small schools, such as my alma mater, Washington and Lee University, should scrap their athletics programs altogether. The absence of an athletic department would not have changed my experience at W. & L. at all. I went to the football games, but mainly as a social event, and even then I never stayed past halftime. My fiancee played for the women’s tennis team; she would have had a drastically different experience. But if she wanted to continue playing tennis in college, she could have still had the opportunity with a student club. I rowed at W. & L. as part of a club team that was financed by the student body rather than the athletic department. Yes, it’s a different experience because there is less money available for the team. But since she’s the recipient of the supposed educational benefits inherent in the student-athlete experience, should other students’ tuition dollars go to support her experience? She still would have had the opportunity to play tennis in college for a team comprised of students representing Washington and Lee, but she would have had to pay for that herself.

While I pointed out earlier that there are possible welfare gains from opening up the market for student-athletes, we see that there are possible welfare losses, too. We need to determine whether or not the gains outweigh the losses to decide whether or not the N.C.A.A. should open up the market for athletes and colleges and/or alumni trusts eliminate some sports programs. Properly done, we’d come up with a numerical answer, but this is an essay, so I’m not going to take the time with the calculations. Obviously students that receive scholarships for non-revenue sports would lose out. But their loss could be offset by providing scholarships to students on the basis of academic merit rather than athletic prowess. I think that’s a net win from a societal standpoint. Universities would gain by the amount that they could raise by selling off athletic facilities and broadcast contracts to an alumni trust. Smaller universities wouldn’t be able to capitalize as much from their facilities since their teams would presumably attract less attention in a competitive market. But losing the athletic department allows smaller universities to divert alumni donations toward educational services. Alumni are worse off by the amount of money that needs to be raised to cover expenses of the athletic department, including new potentially higher salaries for players. Not all players would receive salaries and not all players would receive scholarships, so the total cost may not need to be much higher. By shifting the costs of an athletic program as entertainment out to those who receive the benefits, the market ensures that teams that are truly wanted by their alumni and fans survive and eliminates all others. Players in revenue sports are made better off by the increase in salaries they could receive.

So yes, there will be both winners and losers if the changes I propose are implemented. But current N.C.A.A. policies restrict the price system’s ability to send signals that ensure scarce resources are directed to their most productive ends. The gains from opening up the market will outweigh the losses. I believe that we will all be better off it universities focus on education and research, students focus on learning, alumni focus on maintaining their relationships with each other and their alma mater via athletic contests, and athletes focus on playing.

View the printable version here.

However, neither Congress nor the president have drafted any plan to prioritize payments in the event that the debt limit is not raised. A partial shutdown would not occur in an orderly fashion. The federal government borrowed an amount equivalent to 9.6% of GDP in the first quarter of 2011. In fact, it borrowed more than it contributed to GDP through consumption and investment. Nine percent of the economy cannot just stop one day. Yet, we can’t keep borrowing to fund about one tenth of the economy either.

Most of the proposed deals have involved a large, immediate increase in the debt limit. I suggest that Congress raise the debt limit in stages. Using the 2011 Q1 GDP numbers, the federal government spends about $75 billion each week; $28 billion of that is borrowed. Congress can enact a bill that raises the debt limit by $28 billion in the first week, $27 billion in the second week, and so on. Hey, they can cut it a half a billion each week and that would balance the budget in a year. The government would continue to function without a great disruption. It would send a signal to the markets that the government has a plan to reduce spending. Constituent groups that might lose funding would have time to prepare for an eventual loss. Congress can get the support to cut a half a billion dollars in a week much more easily than it can get support to cut $4 trillion over ten years.

In the union lawyers’ world, every player would enter the league as an unrestricted free agent, an independent contractor free to sell his services to any team. Every player would again become an unrestricted free agent each time his contract expired. And each team would be free to spend as much or as little as it wanted on player payroll or on an individual player’s compensation.

Oh, no! N.F.L. teams would have to operate just like … every other major company in America. That would certainly change how the league allocates new talent, but I’m not sure it would be for the worse. The N.F.L. has excellently promoted its annual draft, expanding it to a three-day event with prime time coverage. The draft and off-season roster moves are a game within a game, where general managers compete to assemble the best teams. Eliminating the draft wouldn’t rob fans of the drama surrounding competition for talent. Owners and managers would still need to evaluate talent. Fans would still get the drama of discussing which team acquired talent most efficiently, regardless of whether new players come in via a draft or free agency.

I really doubt that letting teams buy talent in a market will skew the competitive balance towards wealthy teams. Major League Baseball teams can stack the deck with as much talent as they like (though they have to pay a luxury tax), yet baseball hasn’t seen the domination by a few teams that Goodell warns about. In the past ten years, nine different teams have won the World Series, with the Boston Red Sox winning two championships three years apart. Billy Beane and the Oakland Atheletics showed that a team with a small budget could compete and win by exploiting inefficiencies in the market for talent.

But suppose an owner’s objective isn’t to maximize wins, but to maximize profit. He could still field a competitive team without paying maximum salaries for superstar talent. As long as his team is competitive enough that it still has fans, the owner can sell tickets, advertising, and merchandise. I’m sure that the profit-maximizing roster is less expensive than the championship-maximizing roster.

Moreover, if the N.F.L. really wants to distribute talent easily, the draft might not be the best means to that end. Massey and Thaler showed that teams overvalue high draft picks. That means that teams with high picks would do better to trade away their picks. Berry and Schmidt note that quarterbacks taken with picks between 51 and 90 were as productive as quarterbacks taken with one of the first ten picks.

Of course, players would benefit from maximizing their salaries. I doubt that the average N.F.L. player would see a drastic difference in salary, but the top players would certainly come out ahead. Bench players, whose market salaries would probably be lower than the current leage minimum of $250,000, would lose out in the shift away from collective bargaining.

So it’s fair to the players, profitable for the owners, and exciting for the fans to get rid of the draft. Yet, I doubt the N.F.L. will actually do it. That means I’m stuck having to watch Cam Newton struggle to lead the Carolina Panthers through next season, if there is one.

They should have traded down.

Catch the first round here.

Companies that few people would associate with Wall Street benefited through the Fed’s program to ease the market for commercial paper, a form of short-term debt used by major corporations to fund their daily activities.

By the fall of 2008, credit had frozen across the financial system, including the commercial paper market. The Fed then purchased commercial paper issued by GE 12 times for a total of $16 billion. It bought paper from Harley-Davidson 33 times, for a total of $2.3 billion. It picked up debt issued by Verizon twice, totaling $1.5 billion.

In other words, the Fed fulfilled its duty as lender of last resort. It lent to healthy companies in times of stress in the financial markets. Not one of the more than 21,000 loans has lost money. I understand the scepticism surrounding large amounts of Federal Reserve lending, but I don’t think that should be the case here.

But the release now makes me wonder what else is going to come to light in the next few months and whether any more releases will affect the way in which the Fed does its job. I doubt these records will hamper the Fed at all; any politician who has a bone to pick with the Fed now had already made up his mind a while ago. Will the releases put any minds on the Hill at ease?

Update: Frank Partnoy writing in the Financial Times notes that the Fed charged low rates on its loans, sometimes as low as 0%, which casts doubt on my interpretation above. The Fed should charge a sufficiently high interest rate on emergency loans such that insolvent firms aren’t tempted to take a no-downside gamble with taxpayer money.

• “QE2: Meh” by Paul Krugman
• “Milton Friedman vs. the Fed” by Alan Meltzer
• “QE 2″ by Bill Woolsey
• “Empirical Questions About the Anticipation Effects of QE2″ by John Taylor
• “More Monetary Cowbell” by the WSJ Editorial Board
• “Full Speed Ahead” by The Economist

But banks aren’t interested in making loans at the moment. The above chart shows that excess reserves, the amount of dollars banks hold in their accounts with the Federal Reserve above what they are required to hold, has exploded since the start of the financial crisis. Normally, banks don’t want to hold more money than they have to, because money in a bank vault doesn’t earn interest (technically it’s 0.25% now, but it’s still a lot less than a loan).

The large amount of excess reserves shows that banks want to hold an asset with a value of which they can be certain. Banks already hold billions of mortgages and mortgage-backed securities that are difficult to value if homeowners are likely to default. The Economist reports the U.S. has $766 billion in negative-equity debt. One in five homeowners may default on their mortgages. Housing prices may fall further as banks foreclose on more mortgages. Any additional money pushed into the banking system is likely to sit in a bank vault until banks know the full extent of their losses. Sorting out the housing market will have the same stimulative effect on lending as another round of quantitative easing, while returning the monetary base back to typical levels.

Tyler Cowen writes today that the vacuous nature of corporate-speak exists to smooth disagreements between rival factions within a corporation. I think that’s certainly one benefit to vague language. But I surmise that empty words exist mainly for the benefit of those outside the corporation. Consider a company that advertises they “provide unique solutions for their clients.” Who doesn’t need a unique solution to their problems? Vacuous phrases allow companies to appeal to as many potential clients as possible when spending money on broadcast advertising. The potential clients then fill the empty words with whatever meaning best suits them.

Dr. Cowen brings up politicians and CEOs (speaking in public) as examples of leaders who use vague language in order to prevent conflict. In those cases, I think viewing those figures as salesmen rather than leaders gives more insight to the situation. When Eric Schmidt speaks to the public he isn’t trying to mobilize people to use Google services in the way he would mobilize his employees. He’s selling Google and their “don’t be evil” ethos. When Sen. Barack Obama spoke on the campaign trail, he tried to sell us on the “hope” and “change” his presidency would bring, without ever defining the terms. Good leaders, by contrast, address conflict head on and assuage large egos within an organization in order to keep everyone on target. Note that President Lincoln didn’t fill the Gettysburg address with emply platitudes about “common purpose,” nor did President Roosevelt encourge Americans to develop “out-of-the-box solutions” to the Depression.

Additionally, dressing up ordinary actions, such as a conversation with a client, in fancy terminology and jargon creates an air of exclusivity. If it works, then a company has shrunk the percieved size of the market for its services, enabling it to charge a higher price. Note that this strategy has the highest payoff if a company doesn’t actually do anything unique – otherwise, it would just explicitly say what it did.

Economics teaches us that when there is huge uncertainty about catastrophic risks, it is dangerous to rely too much on the price mechanism to get incentives right. Unfortunately, economists know much less about how to adapt regulation over time to complex systems with constantly evolving risks, much less how to design regulatory resilient institutions. Until these problems are better understood, we may be doomed to a world of regulation that perpetually overshoots or undershoots its goals.

When has any regulatory body perfectly set regulations? I never understand the power that some people ascribe to government agencies who oversee markets. No one person or one agency can ever know enough information to perfectly regulate an industy. Rogoff, who just wrote a book on eight centuries of financial folly (which is on my reading list), knows as much. Still, that doesn’t mean we should do away with the regulators. We’ll never get regulations exactly right, but we can get them as close to right as possible. Some regulations are generally better than none.

Mark Thoma at Economist’s View notes that “If the risks of too little regulation are very large — … much larger than the potential costs from too much regulation stifling innovative activity — then there should be a bias toward erring on the side of too much rather than too little regulation.” While that’s true, we aren’t faced with a binary choice between regulating away innovation and accepting large catastrophes. We should accept that regulations will fail, but then put plans in place to limit the damage when incidents do occur.

For instance, an offshore drilling policy that accepted that some oil rigs would occasionally create spills, but focused on methods to quickly contain the spill, would both remove the catstrophic danger and allow for the benefit of increased domestic oil production. Opening up costal areas closer to shore, where the sea bed is shallower and rigs are easier to maintain, would help oil companies contain any spils that do occur.

Do you think the bailouts were good or bad? Should the U.S. be bailing out Greece, or other countries, with money we don’t have instead of trying to limit our own spending? I think that banks continuing to get bigger and bigger is bad, just as I think other businesses or agencies that swell till they burst if they don’t have taxpayer help is bad. Am I wrong?

Well, it’s not a clean right or wrong issue. Our economy can grow so well because of fractional reserve banking. When people have money that they don’t need to use now, they put it in a bank. The bank lends that money to businesses, who use it to purchase new capital and make new goods or services. Once they make a sufficient profit, they repay the loan. The depositor can then withdraw his money as if it never left. The whole system works, so long as the business is profitable and the depositor doesn’t need his money while the business has it. For a certain amount of money that’s used by banks, businesses, and depositors, only a fraction of it is in tangible bills; the rest are just marks on bank ledger.

When a business can’t repay its loan, the bank still owes the depositor his money, so the bank suffers the loss. If the bank makes enough loans that don’t get repaid, then the bank goes out of business and may not have enough money to repay all of its depositors. If depositors see a bank lose a lot of money, they may try to withdraw their deposits before the bank goes under. If too many depositors ask for their money back, then the bank runs out of money. Think back to the bank run in It’s a Wonderful Life — George Bailey explains, “You’re thinking of this place all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house; that’s right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others.”

Bank runs used to be a regular feature of American life, at least until the FDIC was established and the Federal Reserve got an idea of what it needed to do (Milton Friedman argued that the Federal Reserve actually made the Great Depression worse). Financial crises usually precipitated recessions. When banks go out of business, other businesses can’t access credit. They either put off plans to expand, contract their operations, or go out of business. Financial panics call the lie that is our monetary system; not all money is “real.” Everyone hoards as much of the “real” money as they can and puts off trading. Some firms are so large and interconnected, that their failure would trigger a financial panic. So bailouts are in part good, because they prevent the entire economy from tanking because of the actions of one particular firm.

But the insurance of “too big to fail” creates what economists call moral hazard: the government encourages banks and investment firms to place risky bets by covering their losses. It creates a “heads I win, tails you lose” bet. In an efficient economy, the threat of loss prevents businesses from pursuing risky endeavors and generating losses. Moreover, it’s not fair to stick taxpayers with the bill for something over which they have no control and from which they could never gain. So bailouts are in part bad, because they encourage wasteful spending.

In March of 2008, the Federal Reserve provided financing for the sale of Bear Stearns, and investment firm that suffered heavy losses in the subprime mortgage market. Six months later, the Fed declined to do the same for Lehman Brothers, letting the firm file for Chapter 11 bankruptcy, the largest in history. The Fed justified its disparate treatment of the two firms by noting that problems in the mortgage market took Bear Stearns by surprise, but that Lehman and other firms had plenty of time to right their finances and could have avoided their losses. The Fed hoped that other firms would realize that it would no longer encourage risky investments and take steps to fix their own finances. The firms got the message. After Lehman failed, wholesale lending markets stopped. Anyone with money held on to it, for fear that if they lent it out, it would never come back. It took the creation of TARP and several other lending facilities to calm the markets and allow them to function while the large financial firms got their affairs in order.

Greece, along with several other European and American states, has spent lavishly on social programs and benefits for public sector employees, all of which depended on revenue from the private sector. With the downturn in the economy, the money just isn’t there anymore. They need to get their financial houses in order. But what’s the best way to help them do it, carrots or sticks? A bailout gives Greece time to cut spending here and raise taxes there, but it doesn’t force them to own up to the fiscal imbalance that is the root of the problem. If Greece were to fail to repay its debt, it would force more reorganization, but would harm the global economy.

So I’ll leave you with the thoroughly unsatisfying answer of “it depends.” In an ideal economy, people who make good decisions would get rewards and people who make bad decisions would suffer losses. But we don’t have a perfect economy. Those who act in the public interest must decide whether a bailout prevents short term economic harm more than it encourages long term economic harm. And that probably changes depending on the company, the time, and the economic situation.

There isn’t anything inherently wrong with large companies. In fact, large companies can lower costs by using economies of scale. But we need the legal framework to deal with the failure of large companies. A good framework would allow for the continued operation of the firm during the bankruptcy process, while ensuring that a failing firms’ equity holders and debt holders suffer losses, not the public.

I don’t have the General Theory in front of me, but I was under the impression that Keynes suggested the government run a surplus during expansions, then draw down the surplus during contractions. I think Keynes would have acknowledged that this business of borrowing for stimulus is like trying to raise yourself up by your bootstraps. The amount of money in the economy at a given time is fixed; by borrowing, the government puts no money into the economy that it doesn’t first take out, leaving the net result unchanged. Perhaps it makes a modest increase in the level of spending by borrowing from someone with a lower marginal propensity to consume, but the value of that increase in spending is counterbalanced by the inefficiency of the transfer.

However, when the government runs a surplus, it transfers money across time. By “borrowing” money saved from the previous expansion, the government can add to the economy during the contraction without detracting from economic activity in the current time period. Thus, the government would act as a counterweight to the business cycle; it would moderate expansions by spending less, but moderate contractions by spending more.

Of course, this assumes that the government can perfectly ascertain the current state of the business cycle and adjust fiscal policy accordingly. If policy is out of phase with the business cycle, then the government increases spending when the economy has recovered and no longer needs help and decreases spending when the economy has peaked and needs help the most, which actually exacerbates the severity of the business cycle.

But then I realized that I didn’t pay for my education entirely with loans; I got scholarship money to cover as much as I could, then used loans to cover the rest. Sure, I went to big organizations with established, well-funded scholarship programs to ask for my money instead of setting up a PayPal account. But what’s the difference except for the size of the donation? Allen shouldn’t care whether she gets a $40,000 scholarship from a foundation or 1,000 donors to give $40 online.

The internet has reduced the costs of financial intermediation. Now, most political campaigns turn to the internet to solicit donations. In his special Senate election victory, Sen. Scott Brown raised $7.8 million of his $14.2 million total in the final three weeks from small donors. Groups like Kiva and the Grameen Foundation match lenders with small business owners in the developing world who need loans of less than $1,000. What’s to stop people from financing education the same way?

A flexible market for scholarship money should match up students and donors much more quickly and efficiently than the current institutional system. Students, instead of depending on a handful of institutions for scholarship money, could appeal to hundreds of thousands of potential donors, which make it more likely that they could each raise a little money. Donors, particularly ones with esoteric interests, could fund the study of subjects of their choice, without getting limited to the interests of institutions.

Fed up with requests for bribes and equipped with a zero rupee note, the old lady handed the note to the official. He was stunned. Remarkably, the official stood up from his seat, offered her a chair, offered her tea and gave her the title she had been seeking for the last year and a half to obtain without success. Had the zero rupee note reached the old lady sooner, her granddaughter could have started college on schedule and avoided the consequence of delaying her education for two years. In another experience, a corrupt official in a district in Tamil Nadu was so frightened on seeing the zero rupee note that he returned all the bribe money he had collected for establishing a new electricity connection back to the no longer compliant citizen.

Is the zero rupee note money? It’s not official in any way, and, by definition, it isn’t worth anything. Does it function as a store of value when it is intended to store no value? (Think about that one for a while.)

Yet, I say that it does function as money, at least in the case above. The old woman presented a object worth the advertised price of the service she wanted and exchanged it for that service. I doubt that she could have gotten the same effect out by writing “zero rupees” on a piece of paper and handing it to the official.

Economists typically posit that people act in their own interest — they maximize their own utility, or happiness. It explains why studies have shown that economists free ride — get others to pay for things from whcich they themselves benefit — and contribute less to charity. A purely self-interested person would never give to charity; yet people give to charities all the time.

All of which give rise to the question: are economists cheap because they assume people are self-interested, or do self-interested people gravitate to studying economics?

Unfortunately for the government, a subsidy affects the quantity of coconut harvesting in two ways. The government meant for the substitution effect, the increase in the cost of fishing, to discourage the island’s residents from fishing. Instead, the substitution effect was dominated by the income effect; coconut farmers could obtain the same level of utility with less work, allowing more time for leisure. And in their leisure time, the farmers went fishing. Rather than decreasing, the level of fishing increased 33%.

Whether the substitution effect or the income effect dominates depends on the preferences of the island’s residents. Since the farmers prefer leisure to work, they will consume more leisure with a subsidy. If they had preferred the extra income from work over additional leisure time, then the substitution effect would have dominated.

Congress should consider both effects when deciding whether or not to continue subsidizing unemployment, now two years after the start of the recession. If Congress wants people to get back to work, it might be better to stop writing checks for unemployment benefits.

(h/t Freakonomics)

Cerf offered Rand an alternative: if she gave up 7 cents per copy in royalties, she could have the extra paper needed to print Galt’s oration. That she agreed is a sign of the great contradiction that haunts her writing and especially her life. Politically, Rand was committed to the idea that capitalism is the best form of social organization invented or conceivable. … Giving up her royalties to preserve her vision is something that no genuine capitalist, and few popular novelists, would have done. It is the act of an intellectual, of someone who believes that ideas matter more than lucre.

In fact, I see this transaction as the ultimate expression of capitalism at work. Capitalism isn’t about maximizing profits; it’s about maximizing utility or, more colloquially, happiness. Rand decided that she wanted to express her ideas completely more than she wanted seven cents per copy in royalties. She bought the ability to express her ideas with her foregone royalties, thus making her better off than she would have been otherwise.

On one level, I think this is a good idea.  Compensation policies for bank employees should reward activity that increases the long-term profitability and soundness of a bank.  They should not encourage employees to pursue profits in the short-term at the expense of the long-run.  For instance, paying employees on the amount of loans they write encourages them to make loans without regard to the credit-worthiness of the borrower.  If an employee turns down riskier loans, he may have helped the long-run stability of his company, but at the expense of a portion of his annual salary.  Why would he do such a thing, especially if he only plans to stay at the firm for a few years?

But in order for this government policy to be helpful, or even necessary, we first must assume that bank shareholders are incapable of setting up contracts that secure long-term growth in the value of their stock.  If it’s easy to set up such a contract, I see no reason why bank shareholders would not do so themselves.  If it’s not easy to write such a contract, what makes Federal Reserve more capable to write those contracts than the shareholders themselves (or rather, than any consultants with expertise in agency theory, which invites yet another agency problem, but that’s another story).

In the previous paragraph, I assumed that bank shareholders rationally choose the maximize long-run profits instead of short-run profits.  Might bank boards act rationally by pursuit of short-term profits at the expense of the bank’s long-term stability?  It certainly makes sense when they have an implicit guarantee of their liabilities from the government.  Then, if the bank makes big profits, they go to the shareholders, but if it makes big losses, they get foisted off to the government.  Such a guarantee encourages bank owners to play a game of “heads I win, tails you lose.”

It makes more sense to me to remove the implicit government protection from failure rather than simultaneously operate two policies that both encourage and discourage risky behavior.  However, operating both policies give the Fed a measure of control over the growth of the economy that it would not have otherwise.  Unless it is managed perfectly, such control will reduce the variability in the cyclical fluctuations of the economy at the expense of a lower long-term growth rate.  If regulations push bank executive compensation below their fair market values, then the financial sector will struggle to get the resources it needs to provide the amount of credit it would have without regulation, which will hamper the growth of small businesses.  The Fed’s move to examine pay structures indicates that it thinks the cumulative economic loss from a lower growth rate is less than the potential loss that could occur during a collapse.  That, or it overestimates its own ability to correctly determine compensation for bank employees.

Ultimately, the success of this new policy depends on how heavily the Fed applies.  If used sparingly, with an eye to the health of the overall financial system, the pay policy will help the Fed nudge the financial sector into a region of stability.  If used often, then it will restrict the proper functioning of the credit markets, interfere with the freedom of individuals to agree to contracts, and do little to protect the health of the financial system.

However, personal consumption expenditures grew only by $25.1 billion, or 0.3%. The larger rise in income compared to the change in consumption means that personal savings must rise. Sure enough, personal savings increased $160.3 billion, from $608.5 billion to $768.3 billion, or 26.3%.

Therefore, as the government spreads around money in an effort to get consumers to spend again, consumers respond by placing that extra money in the bank. The stimulus to date has been about as effective as President Bush’s 2008 tax rebate – 80-90% of those dollars were saved. With tough times likely down the road, who could blame consumers for wanting to keep some cash on hand, just in case?

Milton Friedman’s permanent income hypothesis suggests that consumers only increase consumption in response to permanent changes in income. Accordingly, the government should institute a permanent tax cut. Paul Krugman recently turned Friedman’s logic on its head and argued that the government should instead permanently raise taxes and institute a new permanent spending program to spread the wealth around. However, such a program would increase income for some people in precisely the amount that it decreased it for others (actually, it would be just a little less in order to cover the administrative costs), leaving the economy as a whole, at best, with the same level income. Moreover, such a program assumes that its administrators can allocate resources more efficiently than consumers in a market.

We cannot spend our way out of this recession; eventually the government’s borrowed money will run out. Instead, the federal government should cut taxes, especially capital gains taxes, and let the economy build a recovery on a solid, permanent foundation.

“In a small town in the United States , the place looks almost totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.

Suddenly, a rich tourist comes to town.

He enters the towns only hotel, lays a 100 Dollar Bill on the reception counter as a deposit, and goes to inspect the rooms upstairs in order to pick one.

The hotel proprietor takes the 100 Dollar Bill and runs to pay his debt to the butcher.

The Butcher takes the 100 Dollar Bill, and runs to pay his debt to the pig farmer.

The pig farmer runs to pay his debt to the supplier of his feed and fuel.

The supplier of feed and fuel takes the 100 Dollar Bill and runs to pay his debt to the town’s prostitute that in these hard times, gave her “services” on credit.

The hooker runs to the hotel, and pays off her debt with the 100 Dollar Bill to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.

The hotel proprietor then lays the 100 Dollar Bill back on the counter so that the rich tourist will not suspect anything.

At that moment, the tourist comes down after inspecting the rooms, and takes back his 100 Dollar Bill, saying that he did not like any of the rooms, and leaves town.

No one earned anything………. However, the whole town is now without debt, and looks to the future with a lot of optimism.

“And that, ladies and gentlemen, is how the United States Government is doing business today.”

Nice, right? However, the anonymous author of this story neglects two important facts. First, he assumes a 0% savings rate and a 0% interest rate. In reality, the $100 loan would allow the hotelier to pay something like $80 to the butcher, the butcher to pay $64 to the farmer, the farmer to pay $51 to the feed supplier, the feed supplier to pay $41 to the hooker, and the hooker to pay back $33 to the hotelier. Meanwhile, the rich tourist would expect $105 in return for his loan.

Second, and more importantly, the story works so neatly because the hotelier both begins and ends the circle of debt. That means at the outset of the story, the hotelier owes $100 to the butcher, but also holds $100 of the hooker’s debt, for a net liability of $0. The hotelier does not need the rich tourist’s $100 to pay off the butcher; he could just sell the hooker’s debt to the butcher (again assuming an interest rate of 0% and that the butcher prefers to hold the hooker’s debt equally as well as the hotelier’s), so that the butcher has a net liability of $0. The town’s citizens can continue to buy and sell each others’ debt until the feed supplier pays off his debt to the hooker with $100 of her own debt. Both before and after the rich tourist comes, each citizen of the town has a net liability of $0; his presence does nothing to alter that fact.

However, that circular debt structure is extremely unlikely. It’s more likely that some citizens will hold others’ debt without issuing any debts of their own. Thus, I offer a more plausible story: In a respectable society, social opinion would frown upon illicit activities. The hotelier, as a pillar of the community, would not provide any services to the hooker. In that case, the hooker would just keep the rich tourist’s $100 as payment for services she provided in an earlier period. Meanwhile, the hotelier, who was in debt $100 to the butcher, would then owe $100 to the rich tourist and have no way to pay him back.

I suppose the original author meant for his story to show how the government “helps” the economy by borrowing money and then spending it. In this case, the hotelier represent the U.S. government and the rich foreigner giving money to the government represents the Chinese. The more plausible version of the story illustrates that government’s deficit spending doesn’t reduce the total amount of debt in the economy; it just shifts who actually holds the debt. Eventually the government has to repay that debt and it has to get the money from somewhere.

When a business takes on debt, it uses other people’s money to purchase assets.  The amount a business uses other people’s money is called leverage, because debt multiples profits (and losses) like a lever multiplies the force exerted at one end in order to exert a greater force at the other.  Financial analysts commonly use the debt-to-equity ratio to measure a firm’s leverage.  For example, a business with $1,000,000 in assets but only $100,000 in equity has $900,000 in debt — a debt-to-equity ration of 9.  A business with $100,000 in equity and $50,000 in debt has a debt-to-equity ratio of 0.5.  

Furthermore, suppose the business can make a 10% return on assets.  The highly-leveraged business generates $100,000 of revenue using only $100,000 of equity — a 100% return.  The lowly-leveraged business generates $15,000 of revenue using $100,000 of equity — a 15% return.  When the economy is good, leverage can help increase profits.  But when the economy is bad, that 10% return on assets could just as easily be a 10% loss.  In that case, the lowly-leveraged firm suffers only a 15% loss, whereas the highly-leveraged firm is bankrupt.

Inflation, or rising prices, diminishes the real value of debt because the amount of money initially borrowed can buy less goods when it is repaid.  A higher rate of inflation would stabilize highly-leveraged firms, but at the expense of creditors, the people who made highly leveraged firms’ profits in the first place.

Think about how creditors would respond if the official government response to financial crises were a deliberate inflation.  In that case, the firms taking on the debt make great profits when the economy is good, but the government, through a deliberate inflation, transfers the great losses to the creditors.  A deliberate inflation is a deliberate transfer of wealth from the responsible to the irresponsible. Given the options of modest profits or huge losses, creditors will either ask for higher interest rates or stop making loans altogether.  Neither option helps the economy as a whole.

Constantly changing prices make it hard for businesses to plan long-term projects.  Inflation increases uncertainty.  And just look at what the uncertainty regarding the value of mortgage backed securities, the ad hoc application of the TARP, and the continued threat of further government intervention has done to the economy.  In the face of uncertain decisions, people just stop trading.  They wait to make a decision until they have a better idea of what might happen.  Higher inflation might help in the short run, but it does not help sustainable economic growth.

DO: Spend the money on investment.  GDP consists of four items: consumption (consumer and business spending on goods and services), investment (business spending on plant and equipment), government spending, and net exports. The government, just like households and businesses, can choose to spend money on public consumption or public investment. Investment spending purchases tools that workers can use to produce more goods and services. It’s like a two-for-one deal; buy investment and get consumption for free.  

DON’T: Spend the money on consumption. Some economists use the idea of a Keynesian consumption multiplier to justify an increase in consumption spending. An increase in spending from a government stimulus should increase total spending on consumption by a multiple (the inverse of the savings rate) of the initial amount. For example, suppose the savings rate is 20%. If the government spends $100,000 on new fighter planes, then Boeing has $80,000 to spend on guidance systems, and Intel has $64,000 to spend on silicon for new chips, and so on. Add up the total amount of new spending that follows from that initial increase and you will find that $100,000 of government spending stimulated $500,000 in total spending in the economy. However, this strategy depends on consumers and business spending all of their money instead of saving it.   Unfortunately, with most Americans heavily indebted already, the government should encourage saving (more on that later).

DON’T: Give a lump sum payment, such as a tax rebate. The first round of tax rebates in early 2008 were a dismal failure. Consumers, worried about difficult times to come, smartly saved the rebate for a rainy day. This is about the worst thing the government can do; it transfers money from some people to others with no real economic benefit.

DO: Cut income tax rates. Consumers will only start spending again once they feel their income stream is secure.  Cutting income taxes increases consumers’ current take-home pay, just like a rebate program, but it also increases their future take-home pay.

DO: Cut capital gains tax rates.  Just as the government should look to purchase capital, it should encourage saving by cutting the capital gains tax rate.  Increased savings will lower the interest rate and encourage business to finance more capital investment. 

DO: Invest in public transportation.  Population trends show more Americans moving to metropolitan areas.  The cities are the natural location for the information jobs of the new economy.  Most middle class workers who can afford to do so choose to live in the suburbs and exurbs and commute to work.  Unfortunately, there is a physical limit to how many people and cars can fit into a crowded downtown business district.  The congestion from a traffic jam at rush hour imposes a cost on everyone stuck in a car wasting time.  Expanding the current light rail and rapid transit in America’s most congested cities would provide commuters with a viable alternative to driving that would take cars off the road and decrease traffic delays.

DON’T: Invest in new roads and bridges.  If we want to build roads, improving the roads around metropolitan areas to reduce traffic gives us the best value per stimulus dollar.  But mass transit systems in these areas will produce an even greater return.  We don’t need to improve the highway system, as most open roads in between cities are still free of congestion.  Let’s try other stimulating other transportation possibilities first, like railways for freight shipping, and leave building roads to the New Deal.  

DO: Invest in broadband Internet access.  If information technology is the future of the American economy, we need to create the modern-day equivalent of the Interstate Highway System.  Currently, the United States rank 16th in broadband Internet access per capita.  Increasing access to the Internet will open up new online business opportunities.  The fact that certain people can make an honest living playing online games such as Second Life shows that online access can create new jobs and even new industries.  To compound the benefits, spending should go to help cities create large wi-fi networks, eliminating the costly need to lay cables and providing access to anyone, anywhere.

DO: Resupply and refurbish the military.  After two wars in Iraq and Afghanistan, the American military is worn out.  Maintaining our defense capability should be a no-brainer.

DO: Invest in research and development for energy-efficient technologies.  R&D provides another two-for-one benefit: the initial spending creates jobs while those jobs create technologies that reduce the cost of business across the economy.  Energy is still a major factor of production.  Sharp increases in the price of oil or other forms of energy can still raise the operating costs of every business, and therefore the prices of every consumer good.  Increasing energy efficiency will not only insulate businesses and households from fluctuations in the supply of and demand for energy, it will also lower the fixed costs of production and increase real GDP.

DON’T: Forget to trim spending once the economy recovers.  Politicians usually forget the second half of the Keynesian prescription: the government should run a surplus during the good economic times.  This means cutting back the emergency spending programs once the emergency has passed, not incorporating them into the baseline CBO projection for spending.  In this post, I’ve advocated spending money on public capital, which has a lasting benefit long after the stimulus spending has stopped.  Social welfare programs and direct job creation by the government require continued spending in order to maintain their effects.  With a projected budget deficit of $1.1 trillion for FY 2009 and an additional $3.1 trillion over the following ten years, we can’t continue to spend money indefinitely.

DON’T: Rush to push a stimulus through Congress. A quickly passed bill or series of bills will ensure that stimulus money goes to the groups with the best political connections instead of the groups with the most productive projects. If future generations are ever to pay off the massive debt generated by this stimulus, they need to have the ability to make money above and beyond the interest payments on the debt. Yes the economy is in a rough spot now, but a little patience will ensure that the stimulus money is not wasted and this recession will not continue indefinitely.  

And last but not least, DO: Remember we don’t have to spend the money.  It’s better to do nothing than to waste $800 billion.

A Pigouvian gas tax is an unpopular policy, which makes any politician reluctant to endorse it.  In general, I (and I’m sure I’m not the only one) prefer lower taxes.  That’s why I endorse a gas tax with a twist – a increase in taxes on gasoline offset by a reduction in payroll taxes.  Since the average driver buys 14 gallons of gas per week, an increase in taxes at the pump by $1 (or more) should be offset by a $14 (or more) payroll tax cut.  If driving habits don’t change, then the net tax effect is a wash.  But if the tax has its intended effect, drivers will reduce their consumption of oil and pocket the difference between the payroll tax cut and the gas tax hike.  Such a change does not raise the overall tax burden in the middle of tough economic times (it will likely reduce the burden) and it has the added benefit of removing a number of negative externalities currently borne by the public:

1. Oil as political power  –  The list of the world’s top oil producers features several anti-American states — Russia, Iran, and Venezuela most prominently.  The worldwide spike in oil prices has provided dictators in these countries with an easy means of financing their aggressive foreign policy and given them little incentive to invest in a productive economy.  As oil prices have fallen from about $140 a barrel to only $40, Russia’s government has switched from invading neighboring countries to scrambling to prop up its domestic economy, and Venezuela’s dictator has cut back on buying anti-American support across Latin America.  OPEC colludes to reduce supply and keep crude oil prices high; the United States should lead a group of nations to collectively raise gas taxes in order to suppress demand and keep crude prices low.  

2. An imbalance of payments – The current account deficit has grown from $215 billion to $731 billion over the past decade, an increase that corresponds to the rise in crude oil prices from $14 to $85 per barrel.  We’ve been sending dollars abroad at a faster rate than we’ve been producing new things for foreigners to buy in order to send their dollars back to the U.S.  Correspondingly, the dollar has fallen in value against a trade-weighted basket of currencies.  Countries like China and Japan with large current account surpluses used their savings to purchase the safest investment possible: United States Treasury debt.  The corresponding high demand for American debt helped the government to finance projects like subsidies for home loans to low-income borrowers.

Long story short, a continued imbalance of payments is not good for the world economy.

3. Pollution  –  I’m not sold yet on the idea that humans are responsible for changes in the planet’s weather, but I can’t argue with getting rid of the pollution that comes from our nation’s fleet of automobiles.  I enjoy breathing clean air, especially when I exercise outdoors.  I think it’s only fair that someone who makes a mess pay for the costs of cleaning it up.  We tax cigarettes because secondhand smoke has adverse health benefits; the same logic should apply to car exhaust.  

And for those who want a reduction in emissions to prevent global climate change, a Pigouvian tax on gas utilizes market forces far more powerful than any congressional decree, such as CAFE standards. 

4. Cars nobody wants – Speaking of CAFE standards, the switch to more fuel-efficient cars precipitated by a tax on gasoline would eliminate distortions in the automobile market caused by federal regulations.  Under CAFE, the average fuel economy of an auto manufacturer’s fleet must be under a certain amount.  So car companies make the fuel-guzzling trucks and SUVs, for which there is a high demand, and meet their average requirements by creating small, fuel-efficient cars that no one in the United States cares much for and the car companies must sell at a loss.  The Vice Chairman for Global Product Development at General Motors has likened CAFE standards to trying to reduce obesity by requiring tailors to only make clothes for skinny people.  In order to get rid of this inefficiency in the car market, we should either get rid of CAFE or implement a gas tax that gives car buyers an incentive to prefer fuel-efficient cars.  Such a change would not entirely make the big three car companies profitable again, but it would certainly help.  

Now is the perfect time to implement a gas tax that, on the surface, will be very unpopular.  The incoming Obama administration has approval ratings of nearly 70%; if anyone in Washington has the political capital to pull his off, it’s the President-elect.  Additionally, the memory of $4 per gallon gas is still fresh in consumers’ minds.  Consumers had just started to adjust to the idea of permanently more expensive gas by the end of the summer and are still unsure that gas prices will remain low.  The tax should be implemented now before consumers can readjust their expectations.

So to recap, this is a win-win-win-win-win for everyone involved.  The Obama administration gets to provide a net tax cut when it needs to provide economic stimulus for everything under the sun.  Consumers get the extra money that comes with the tax cut, provided they can adjust their driving habits.  Our foreign policy gets a boost by enlisting fiscal policy in the war on terror.  The economy will pick up again as the recovering dollar attracts capital to the United States.  Greens get reduced emissions to slow down global warming.  Car companies can stop begging the government for money and start making it on their own again.  I’ll bet the only people who won’t be smiling will be these guys:

Let's wipe that grin off their faces.

 Further reading: Hot, Flat, and Crowded: Why We Need a Green Revolution — and How It Can Renew America by Thomas Friedman

How the Balance Sheet Works

The Fed controls the supply of money by buying and selling securities, a process known as open market operations.  When the Fed buys a security from a bank, it lists the security as an asset on its balance sheet, and credits the bank’s account with the corresponding dollar amount, increasing its liabilities because the bank can withdraw currency from its account at any time. When the Fed sells a security, the process works in reverse; it takes an asset off of its balance sheet and receives a payment from the bank, which reduces its liabilities.  In short, when the Fed buys securities it increases the money supply and when it sells securities is decreases the money supply.

The same logic applies to the Fed’s other main type of asset, loans to the banking system.  The loans are an asset for the Fed because it expects banks to repay the loan funds.  Correspondingly, the loaned funds are either placed in reserves or exchanged for currency, so they incease the Fed’s liabilities and the monetary base.

Expanding the Balance Sheet

The chart below shows data from Federal Reserve Statistical Release H.4.1 — Factors Affecting Reserve Balances.  I’ve selected dates from August 2007, right before the initial liquidity crisis; July 2008, the first appearance of loans to Maiden Lane, LLC, the corporation set up to dispose of assets from Bear Stearns; September 2008, after the collapse of Fannie Mae, Freddie Mac, and Lehman Brothers; November 2008, after the Fed announced and implemented many of the new lending programs; and the most recent release on December 18, 2008.

Over the time of the crisis, the Fed has created new lending programs — the Term Auction Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility, the Maiden Lane LLCs, the Primary dealer credit facility, and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility — with $840 billion in loans, worth about as much the the Fed’s holings of securities before the crisis.  The Fed’s primary credit facility has grown from $2 million in August to $88 billion in December, a 4,240,150% increase.  The Fed’s total assets have grown from $909 billion to $2.3 trillion, a 153% increase.  Ordinarily, an increase in assets like this on the Fed’s balance sheet would lead to a correspondingly large increase in currency in circulation or new loans from banks.  Any increase in the monetary base leads to roughly a 10% expansion in the money supply.  Yet currency in circulation is only up 7% from August 2007 to December 2008 and the price level, as measured by the Personal Consumption Expenditures (PCE) index, is only up 3% from August 2007 to October 2008.

The Fed Giveth, and the Fed Taketh Away

That’s because Fed has been just as creative in finding ways to pull money out of the banking system at the same time it has pumped extra funds in with new loans.  Part of the Emergency Economic Stabilization Act of 2008 included accelerating the implementation of a rule that lets the Fed pay interest on the excess reserves that banks hold.  Notice how reserves have grown from $12 billion in August 2007 to $800 billion in December 2008, a 6,471% increase.  The new rule lets the Fed minimize both the inflationary effect and the increased risk associated with the new loans.

The Fed has also used its standard method for pulling money out of the banking system, selling securities, to prevent a rapid increase in the money supply. It has sold 38% of its securities holdings over the length of the crisis.  But the $790 billion portfolio the Fed had at the start of the crisis wasn’t nearly enough.  To make sure the Fed held enough in securities, the Treasury created a Supplementary Financing Program in which it issues new debt and deposits the proceeds in an account with the Fed.  As of December 2008, the balance in the account stood at $364 billion.  The general account has also expanded from $4 billion to $79 billion.

The Hidden Bailout

The good news is that credit is flowing again.  The new actions by the Fed and the Treasury take excess funds from the public, route them through the Treasury and then to the Fed, who provides them to the financial institutions who need them.  Funds move from those who have an excess to those who need them, just like they should in any properly functioning financial market.  In fact, since Treasury debt is in high demand now because of its safety, the Treasury can borrow at a low interest rate and deposit that money in the Federal Reserve, who is loaning money to banks at a high interest rate.  Since the Fed remits most of its profits to the Treasury, the taxpayers stand to make a good profit on the spread between the two interest rates.

The bad news is what might happen if some of the borrowers default on their loans and the money doesn’t flow back in the proper way, from the borrowers, to the Fed, to the Treasury, and back to the original lenders.  The United States government is not going to default on its debt, so that means that any losses that occur from these new loans go to the taxpayers.  The government will recover losses will either through increased direct taxation in the form of higher tax rates or indirect taxation though printing new money and deprecating the value of the dollar.

In The Know: Should The Government Stop Dumping Money Into A Giant Hole?