Financing the Olympic Games--Posner's Comment.

When a sport or other game is played all over the world (chess for example, or soccer), it is natural that there should be international competition. The oddity of the Olympics is that they are presented as athletic competitions between nations, rather than between teams each of which presumably would have a permanent residence in one nation yet might recruit team members from other nations as well. Nations in the grip of nationalist emotion or wanting to advertise their power to the world (nations such as Hitler's Germany, which made the 1936 summer Olympics, held in Berlin, a major propaganda event; East Germany and other communist countries; and now China) invest heavily in training their Olympic athletes. China is estimated to have spent as much as half a billion dollars to train their athletes for the Olympic games now underway in Beijing. The heavy investments that nations that regard Olympic competition as a propaganda opportunity in turn spur other nations to invest heavily in training their own Olympic athletes.

The nationalistic fervor and great-power aspirations that Olympic competition stimulates seem to me a negative externality. In addition, some unknown but doubtless large fraction of the expenditures on training athletes have no social product, but are in the nature of "arms race" expenditures. If one nation spends very heavily on training its Olympic athletes, other nations, if they want to win a respectable number of medals, have to spend heavily as well. The expenditures are offsetting to the extent that the objective of competition is to win rather than to produce an intrinsically better performance. Economic competition produces better products at lower quality-adjusted prices, and this effect dominates the costs of competition in duplication of facilities and offsetting advertising. The balance in athletic competition is different, because the main product (as in war) is winning, and it makes little difference to the consumer whether the winner ran a mile in 3.05 minutes or in 3.01 minutes. Moreover, Olympic competition is inherently lopsided since, as Becker explains, success is largely determined by a nation's population, per capita income, and (in the winter Olympics) climate. Why should Americans feel good if an American team beats a team from Costa Rica?

Since the United States is acknowledged to be the world's most powerful nation, it has nothing to prove by doing well in the Olympics, and so we are sensible not to allot any tax revenues to financing the training of our Olympic athletes. Doubtless we would were it not for the private donations that generously support the United States Olympic Committee. Since other countries do not have the same tradition of charitable giving as the United States, and so rely on tax revenues to finance activities that in the United States are financed by private charity, our charitable support of Olympic competition actually places pressure on other nations to support their Olympic teams out of tax revenues.

Becker raises an interesting point by asking whether Olympic competition creates a positive externality that might warrant public subsidy, though he recommends against subsidization. The Olympic games are immensely popular, but, given advertising-supported television, it is apparently impossible to finance them (and in particular the training of the Olympic athletes) out of television-advertising revenues. There are, however, as he notes, other (private) sources of revenue of Olympic participants, such as endorsements by champion athletes. Moreover, were there no public subsidies of Olympic competition, this would not doom the Olympic games; it would just reduce the amount of training that Olympic athletes received (the arms-race effect). This would reduce the number of new world records set, and marginally reduce the quality of play and hence the pleasure that the audience for the Olympic games derives, but would actually tend to sharpen Olympic competition by reducing the effect of a nation's per capita income on its Olympic prospects.

Determinants of the Olympic Success of Different Countries-Becker.

Hundreds of millions of men and women all over the world have been tuned to their television sets and clued to their computer screens as they followed the Olympic extravaganza in Beijing. The pride taken by people of different countries in their own athletes as they compete against the best from other countries is truly remarkable. To Americans, the main interest this year has been Michael Phelps' pursuit of a record setting 8 gold medals in swimming-which he accomplished- the gold and silver medals won by two young American girls in the all around gymnastic finals, and the new basketball "dream team" that so far has easily won against China, Spain, and elsewhere. The Chinese have been thrilled by their successes in gymnastics and diving, the Australians by their swimmers, and the Rumanian's by the victory of their 38 year old mother in the women’s marathon. Pictures were shown of how in 2004 the almost all black country of Zimbabwe with a history of significant racial conflict gave a wildly enthusiastic parade to a white Zimbabwe swimmer who won a gold medal during the Athens Olympics. And so it goes in other countries whose athletes have won medals.

All the accolades given to Olympic medal winners-especially to those who get gold- provides plenty of incentive for young and talented athletes to train hard for the Olympics in the hope of becoming a medal winner. When practically all participants in the Olympics are working hard in their training regimes, and since various random factors, such as illness, injuries, and psychological state are extremely important, it becomes difficult to predict individual winners in many of the competitions. Yet it is rather easy to predict quite well the total number of medals won by different nations.

The article "A Tale of Two Seasons: Participation and Medal Counts at the Summer and Winter Olympic Games", published in 2004 in the Social Science Quarterly by Professor Daniel Johnson of Colorado College and a co-author, examines the determinants of how many medals were won by different countries in the summer and winter Olympics since the end of World War II. Their regression analysis shows that two very important variables are the total population and per capita incomes of different countries. Also important are whether a country has an authoritarian government-such as communism- a country's climate, and whether a country is the host country for a particular Olympics. These five variables taken together predict closely the total number of medals won by different countries in the winter as well as summer Games.

It is surely no surprise that population matters a lot since there are many more athletes to choose from in large countries. This is why the breakup of a big country, such as the Soviet Union, had a large effect on the number of medals won by Russia, if Russia is identified with the Soviet Union. Climate is also no surprise since, for instance, the warm climates of African nations makes it highly unlikely that they will be contenders during the winter Olympics in skiing and other cold weather sports. Yet countries with colder climates, such as Russia and Scandinavian countries, do well, given the other variables, in summer as well as the winter Games. Host country effects are somewhat more surprising, but they might be explained by greater familiarity of host athletes with the weather and other conditions of the Games, by the extra incentives provided by the cheers of their fans in attendance, and possibly by the greater preparation efforts of host country athletes.

It is further entirely reasonable that countries with higher per capita incomes, other things the same, do better in Olympic and other international competitions. Parents of promising athletes have more resources to hire coaches, buy equipment, and get other help in their quest to improve the performances of their children. High schools and colleges have more resources to spend on their athletic programs. Private groups establish Olympic and other committees with generous resources to help in the training of the most promising athletes. Companies sponsor athletic programs and offer other incentives- such as the $1 million that Speedo promised Michael Phelps if he succeeded in winning 8 gold medals at the Beijing Olympics.

The importance of communist and other single party countries on the surface is more surprising. It is not that these countries send more athletes to the Olympics than other countries with similar populations, etc- they do not- but authoritarian countries do better per athlete that they send. The reason appears to be that governments of these countries spend considerable resources and energies in finding young promising athletes, and in providing systematic training and equipment in centralized facilities. According to the NY Times' editorial of August 17th, China has spent billions of dollars on its state sports program since the 2000 Sydney Games. These countries also can sometimes use their authoritarian structure to force parents to let their children be taken to centralized facilities, and have refu'ed to allow athletes who win medals to retire. Such activities clearly help explain China’s rapid rise to athletic prominence, but the same considerations were behind East Germany's success in earlier Olympics, and in the great success of the Soviet Union prior to its breakup.

Democratic governments would not be able to employ some of the techniques used by authoritarian governments, but still must decide on the proper role of their governments in preparing athletes for Olympic and other international athletic competitions. The strong interest of countrymen in cheering on athletes representing their countries seems like a positive "externality", especially from Olympic success. However, in private market economies, these so-called externalities from Olympic and some other international athletic achievements are internalized to a considerable extent by endorsements, requests for well-paid speeches, job offers, and other private advantages given to successful athletes. Many of these private advantages are not possible in government-controlled economies, which might explain why their governments are much more active in financing and training athletes.

Perhaps some externalities remain that justify considerable government involvement in democratic countries. Indeed, recently countries, such as Germany, have indicated that they plan to spend more in preparing their athletes for future Olympics. The Times' editorial opposes further government spending on the US Olympic program mainly because the government budget is in deficit and the economy has slowed down. I believe there are much better reasons for opposition to a much larger government involvement. The highly decentralized, mainly but far from entirely, privately financed approach to athletics found in countries like the United States and Great Britain is the right way to attract and train Olympic and other athletes in democratic countries with strong decentralized private economic and philanthropic sectors.

Hollywood and Liberals-Becker.

For every Ronald Reagan Arnold Schwarzenegger, Jon Voight, Charlton Heston, and a few other prominent conservative Hollywood stars, there are probably more than 50 strongly liberal actors, directors, producers, and other "above the line" categories of filmmakers. The top "below the line" categories of cinematographers and production designers are also heavily liberal.Less creative crew members, such as grips, have political views that are closer to those of the general American voting population.

Posner gives several explanations of the liberality of filmmakers, including their engagement in fantasy projects, their irregular employment, and the prominence of Jews, who are mainly liberal, in the industry. There is an additional consideration of great importance. Whereas most actors and other filmmakers have little interest in tax policy, approaches to Medicare and social security, other domestic economic and political questions, and even in many foreign policy issues (except wars), they are very much concerned about policies regarding personal morals. I believe the single most important reason why so many of these Hollywood creative personnel are opposed to the Republican party, especially to the more conservative members of this party, is that the personal morals of many filmmakers deviate greatly from general norms of the American population.

Creative contributors to films divorce in large numbers, often several times. Many have frequent affairs, often while married, they have children without marriage, they have significant numbers of abortions, have a higher than average presence of gays, especially in certain of the creative categories, who are open about their sexual preferences, they take cocaine and other drugs, and generally they lead a life style that differs greatly from what is more representative of the American public. By contrast, an important base of the Republican Party is against out of wedlock births, strongly pro life and against abortions, against gays, especially those who adopt an publicly gay lifestyle, against affairs while married, and very much oppose the legalization of drugs like cocaine and even marijuana.

It becomes impossible for Hollywood types who adopt these different lifestyles to support a political party that is so openly and prominently critical of important aspects of their way of living. That the majority of the relatively few conservative filmmakers lead more ordinary lifestyles confirms this hypothesis: they tend to be heterosexual, married, have children while married, are less into drugs, and in other ways too have more conventional lifestyles. True, some of the most prominent conservative member of Hollywood, such as Reagan and Voight, have been divorced, but divorce is now more accepted even by most conservative Republicans. After all, Ronald Reagan was a darling of conservative Republicans, and John McCain also has been divorced. Note that below the line members of crews lead more conventional life styles, and so they are less likely to be anti conservatives and against Republicans.

When other issues affect filmmakers more than attacks on their morals, their views often become very different. So while many of the more creative filmmakers consider themselves to be socialists, filmmakers, writers, and other creative types in communist countries were typically very strongly opposed to their governments. The obvious reason is that these governments imposed substantial censorship on the type of films that could be made, and so directly interfered with what filmmakers and writers wanted to do.

Another important factor stressed to me by Guity Nashat Becker is that members of the print and visual media who generally have strongly liberal political views surround actors and other creative contributors to films. Since it is well established that political views are greatly affected by the attitudes of people one interacts with closely, it is not surprising that some of the liberality of the media rub off on actors and others in the filmmaking industry. In addition to their concern about political approaches to personal morality, their association with the media helps make filmmakers anti-business, especially big business, and strongly pro-union.

Do the liberal views of Hollywood stars and leaders have a big affect on the opinions of others? I do not know of any evidence on this, but I suspect they only have a small indirect effect. This is not the result of speeches or other statements of their views-since they usually are not articulate in their extemporaneous comments- but their entertainment at various political functions can help generate enthusiastic audiences. More important probably is that whereas audiences do not go to films unless they enjoy them, anti-business and other liberal views will often be an underlying message of popular films. I doubt of these messages have a large permanent effect on the opinions of the audiences, but some affect is surely possible. So all in all, I believe Hollywood is a very minor contributor to general political views, but I do not think their influence can be fully dismissed.

Why Is Hollywood Dominated by Liberals? Posner.

A recent article in the Washington Times by Amy Fagan, entitled “Hollywood’s Conservative Underground,
www.washingtontimes.com/news/2008/jul/23/hollywoods-conservative-underground/ (visited Aug. 23, 2008), is a reminder of the curious domination of the American film industry by left liberals. The industry’s left-wing slant drives the Right crazy (if you Google "Hollywood Liberals," you'll encounter an endless number of fierce, often paranoid, denunciations by conservative bloggers and journalists of Hollywood's control by the Left). Fagan's article depicts Hollywood conservatives as an embattled minority, forced to meet in secret lest the revelation of their political views lead to their being blacklisted by the industry. The conservatives' complaint is an ironic echo of the 1950s, when communists and fellow travelers in Hollywood--who were numerous--were blacklisted by the movie studios.

We need to distinguish between actors, actresses, set designers, scriptwriters, directors, and other "creative" (that is, artistic) film personnel, on the one hand, and the business executives and shareholders of the film studios, on the other hand. (Producers are closer to the second, the business, echelon than to the creative echelon.) The creative workers, I think, are not so much magnetized by left-wing politics as drawn to political extremes--for there have been a number of extremely conservative Hollywood actors, such as Ronald Reagan, John Wayne, Charlton Heston, Mel Gibson, and Jon Voight--Voight recently wrote a fiercely conservative op-ed in the Washington Times, where Fagan's article was published. The left end of the political spectrum in this country is still somewhat more respectable than the right end, and so if one finds a class of persons who are drawn to political polarization, more will end up at the far liberal end of the political spectrum than at the far conservative end, yet it will be polarization rather than leftism as such that explains the imbalance. No one has a good word for Stalin and Mao nowadays, but socialism is not a dirty word, as fascism is.

But why should actors and other creative workers in the Hollywood film industry, and indeed "cultural workers" more generally, be drawn to political extremes? The nature of their work, which combines irregular employment with high variance in income, an engagement with imaginative rather than realistic concepts, noninvolvement in the production of "useful" goods or service, and, traditionally, a bohemian style of living (a consequence of the other factors I have mentioned), distances them from the ordinary, everyday world of work and family in a basically rather conservative, philistine, and emphatically commercial society, which is the society of the United States today.

The choice of a political ideology, which is to say of a general orientation that guides a person's response to a variety of specific political and ethical issues, is less a matter of conscious choice or weighing of evidence than of a feeling of comfort with the advocates and adherents of the ideology. An ideology attractive to solid bourgeois types is unlikely to be attractive to cultural workers as I have described them. So we should not expect those workers to subscribe to the conventional political values, and apparently a disproportionate number of them do not. Moreover, though most actors and other creative film workers are not particularly intellectual, as cultural producers much in the public eye they have a natural affinity with public intellectuals, who I found in my book Public Intellectuals: A Study of Decline (2001) split about 2/3 liberal 1/3 conservative.

The situation of Hollywood's business executives, including investors in the film business, is different. They are not cultural workers, and one expects their focus to be firmly on the bottom line. It is true that the Hollywood film industry was founded largely by Jews and has always been very heavily Jewish, and that Jews of all income levels are disproportionately liberal. But if Hollywood based its selection of movies to produce and sell on the political views of the studios' owners and managers, that would be commercial suicide, as competitors would rush in to cater to audiences' desires. The idea that Hollywood is a propaganda machine for the Left is not only improbable as theory but empirically unsupported. Hollywood produces antiwar movies during unpopular wars and pro-war movies during popular ones (as during World War II), movies that ridicule minorities when minorities are unpopular and movies that flatter them when discrimination becomes unfashionable, movies that steer away from frank presentation of sex when society is strait-laced and movies that revel in sex when the society, or at least the part of the society that consumes films avidly, society turns libertine. The Hollywood film industry follows taste rather than creating taste, as one expects business firms to do.

What troubles conservatives about Hollywood is less the promotion in movies of left-liberal policies than the breakdown of the old taboos. Those taboos were codified in the Hays Code, which was in force between 1934 and 1968 with the backing of the Catholic Church. The code forbade disrespect of religion and marriage, obscene and scatological language, sexual innuendo, and nudity. The code was abandoned because of changing mores in society rather than because leftwingers suddenly took over Hollywood. If conservatives bought the studios and reinstituted the Hays Code they would soon be out of business. But what is true is that when movie audiences demand vulgar fare, then given that conservatives are more disturbed by vulgarity than liberals are, the film industry becomes less attractive to conservatives as a place to work in. This may be an additional reason for the left-liberal slant of the industry. But as long as the industry is an unregulated competitive industry, market forces will prevent studio heads and owners from trying to impose their own values on audiences, rather than trying to create movies that are in sync with those values.

Notice.

Professor Becker and I are on vacation this week in honor of Labor Day, and will not be posting. We will resume next Sunday.

Competition, Discrimination, and Law--Posner's Comment.

Becker points to India as an example of a society in which competition has been more effective than law in reducing discrimination in employment. As with most analyses of historical phenomena, determining causation is rife with uncertainty. Had the Indian government not abolished the caste system, would discrimination against untouchables have declined as much as it has?

The question is of more than academic interest from an American standpoint because we have laws against so many forms of employment discrimination--discrimination on racial grounds, of course, but also on grounds of ethnicity, religion, sex, disability, and age. We also had a caste system in the South until relatively recently. So do we need discrimination laws, or can competition be relied on to eliminate discrimination?

The answer I would give is that competition cannot be relied upon to eliminate discrimination (nor has Becker ever argued that it can be), but that, even so, laws against discrimination may not be desirable on balance, at least from the standpoint of economic efficiency, as distinct from making a political or moral statement. They may also not be very effective. I will confine my analysis largely to employment discrimination.

If an important class of customers does not want to be served by, say, black employees, or if an important class of workers does not want to work with black employees, then the tendency in the absence of a discrimination law, as Becker explains, will be segregation of the workforce: the market will be served by a combination of all-white and all-black firms. If, however, segregation raises employers' costs by more than the increase in wages that they would have to pay their white employees to induce them to work side by side with blacks, plus the loss of net revenues from white customers who do not want to be served by black employees, there will be competitive pressure on the employers to integrate their work forces. The pressure will depend in part on how strong the whites' aversion to working with or dealing with blacks is. There is no reason for competition to affect that aversion, other than by bringing the costs of it home to employers and through them to their white workers and customers.

Although law can try to eliminate employment discrimination, it is unlikely to be very effective and if it is effective it may not be efficient. Take the second point first. Suppose white employees have a strong aversion to working with blacks. Then forbidding discrimination will impose a heavy cost on the white employees. If there are more of them than there are blacks, the cost to the white employees may exceed the benefits to the black employees. Of course, an antidiscrimination law may rest on a political or moral judgment that costs imposed by thwarting a taste for discrimination should not count in the social calculus, but that is a judgment outside of economics.

Now as to the efficacy of such laws: it is bound to be limited unless enforced by savage penalties, which our discrimination laws are not. There are three reasons for their limited efficacy. The first is that an employer who wants to continue discriminating against blacks can (within limits) reconfigure his work force to reduce his demand for skills likely to be possessed by black applicants for employment, can substitute capital for labor, and can relocate to areas in which the applicant pool contains few blacks. Second, felt legal pressure to hire blacks results in "affirmative action," which both creates resentment among whites and casts some doubt on the average quality of black employees and so in effect stigmatizes the entire class. And third, because a discrimination law makes it more difficult to fire a member of the class protected by the law, it increases the cost of hiring members of the class and so increases the incentive to discriminate in hiring. There is some evidence that the passage of the Americans with Disabilities Act, forbidding discrimination against the disabled, led to an actual decline in the number of disabled persons employed.

Although an employment discrimination law is thus apt to be of limited (though not zero) efficacy, other bodies of law can play a large role—larger even than market forces—in reducing employment discrimination. Much employment is public, and public bodies can decide to incur the costs of eliminating discrimination in their work forces and hire many blacks. In addition, laws that reinforce a caste system, such as the Jim Crow laws in the southern states that persisted into the 1950s, can reduce employment opportunities for blacks beyond what private discrimination would do, for example by limiting their educational opportunities. The repeal or invalidation of such laws can thus indirectly increase black employment opportunities.

Deregulation is a minor but interesting legal change that tends to reduce discrimination. A regulated monopoly is constrained in the amount of monetary profit that it can obtain, but unconstrained in nonmonetary perks, including indulging a taste for discrimination.

Neither legal nor market forces have brought employment parity between whites and blacks in the United States. Parallel with the struggle of blacks for parity, Jews, East Asians, and immigrants generally, have made rapid economic progress and indeed (at least in the case of Jews and East Asians) largely overcome discrimination, yet without significant help from the law. An open economy provides opportunities even to victims of discrimination, especially if the victim group is large enough to achieve economies of scale in trade within the group. As members of the group grow modestly affluent and thus achieve a standard of living that enables them to assimilate to the larger culture, as by consuming similar goods and services and sending their children to good schools, discrimination against them declines because they cease to seem “different” from the majority. When members of a minority group talk and think and act like the majority and have the same tastes and in short share the same culture, the fact that they may have a different physical appearance ceases to count greatly against them, as indicated by high rates of intermarriage in the groups I have mentioned. Assimilation to the dominant culture, as yet incomplete for a great many blacks, may thus be the major force in reducing discrimination, with competition and law playing lesser roles.

Competitive Markets and Discrimination Against Minorities-Becker.

An eye-opening article in the New York Times on August 29th discusses the effects of India's economic reforms and subsequent economic growth on the poverty and progress of the untouchables. This is India's lowest and poorest caste whose members have been shunned by the other castes for centuries. They have been confined to the dirtiest and least desirables jobs. The article is built around the views of a successful untouchable, Chandra Bhan Prasad, a former Maoist revolutionary who is married to another untouchable. His observations and interpretation of the effects of India's economic liberalization that started in 1991 on progress of some untouchables converted him to the belief that competitive and open markets is the only hope for his caste.

The Indian government early after it became independent in 1947 officially abolished the caste system, and especially the horrible position of the 160 million untouchables. Nevertheless, this caste experienced limited progress during the 40 years of socialism and slow economic growth that followed independence. Prasad became an economic liberal after seeing what he interpreted as the dramatic effects of 15 years of economic reform on the economic opportunities of the untouchables.

The economic theory of discrimination adds analytical support to Prasad's observations (see my The Economics of Discrimination, 2nd. ed., 1973). An employer discriminates against untouchables, women, or other minority members when he refuses to hire them even though they are cheaper relative to their productivity than the persons he does hire. Discrimination in this way raises his costs and lowers his profits. This puts him at a competitive disadvantage relative to employers who maximize their profits, and hire only on the basis of productivity per dollar of cost. Strongly discriminating employers, therefore, tend to lose out to other employers in competitive industries that have easy entry of new firms.

This is why minorities typically do better in new industries with young and initially smaller firms. Both Jews and American blacks were accepted more readily in Hollywood in its early days than in other established industries, like steel making and banking, although blacks were limited primarily to entertainment roles. Contrast this with American baseball, where the major league owners had a virtual monopoly of the industry. They did not accept any black players until Branch Rickey broke the color bar in 1947 by promoting Jackie Robinson from the minor leagues to the Brooklyn Dodgers. This long delay in accepting blacks by the baseball monopoly occurred despite the fact that for decades many outstanding black players could be observed playing in segregated Negro leagues.

Employee discrimination against minority fellow workers-such as a male worker who does not want to work for a female boss- cannot be so easily competed away by non-discriminating employers. For they have to pay discriminating employees more, perhaps a lot more, to work with minority members. A similar argument applies to consumers who do not want to be served by particular minorities. Yet in these cases too, competition can blunt the impact of prejudice. For profit-maximizing employers will attempt to avoid the cost of discriminating employers by segregating minorities into separate companies. For example, women bosses may have mainly women employees, or untouchable foremen will supervise untouchable workers.

Segregated minority workers in competitive markets may get paid just as much relative to their productivity as do majority workers in these markets. In a fundamental way, segregation can serve as a way to bypass the prejudices of other workers, consumers, and employers. When Jews could not get work in the banking industry at the turn of 20th century, they began to open their own banks that hired mainly other Jews. African -American doctors and dentists in the old South catered to other blacks as their patients.

Globalization and the growth of world trade have added another competitive force against discrimination, one that is surely helping Indian untouchables and other minorities. As I mentioned earlier, costs of production are raised when employers discriminate against various minorities in their country. Employers in other countries not burdened with costs of discrimination will be able to undersell discriminating employers in the international market for goods. This too acts as a force lowering the impact of discriminating employers, and reduces the international competitiveness of countries where discrimination in employment is dominant.

The slow growth of the old American South is a good illustration of the effects of international and interregional competition. Discrimination against former slaves was rampant in most parts of the South. Private desires to discriminate were supported and often enforced by discrimination by state and local governments. Blacks were denied access to schools of equal quality, and local governments sometimes retaliated against local companies that promoted blacks to higher-level positions. As a result, Southern manufacturing companies were at a disadvantage relative to companies from the North and West, and also to those from other countries. In good measure because of this systematic government discrimination, and private discrimination enforced often by government pressures, the South performed poorly for a century after the end of the Civil War.

The rapid growth of world trade during the past several decades, and the increasing market orientation of different economies, sometimes raise rather than lower income inequality, as least for a while. However, trade and competition has made this inequality more dependent on differences in human and other capital, and less directly on skin color, gender, religion, caste, and other roots of discrimination. This is an unsung but major consequence of greater trade and globalization.

Political Prediction Markets-Becker.

Prediction markets are pervasive in finance, especially in modern derivative markets. Someone who is long on the S&P 500 Index is betting that average stock prices in the United States will be going up, while those who are short in this market are betting that they will go down. Price movements in these markets are a good measure of aggregate sentiment, where the aggregation process gives greater weight to those willing to risk larger sums.

The aggregation in online political prediction markets, such as the Iowa Electronic Market (IEM), is more democratic because these markets usually place sharp limits on how much can be bet- the IEM limits bets to no more than $500. Yet as Posner indicates, this and other online political markets have been successful in predicting the outcomes of American elections-more successful than various polls. In the present election, the IEM odds in favor of the Democrats winning the presidency hovered around 60 per cent From May of 2007 to the end of August, but these odds have narrowed considerably since then to about 51-52 per cent for the Democrats to 48-49 per cent for the Republicans. Narrowing has also occurred in various polls. The IEM market is indicating that Senator Obama now has a small lead over Senator McCain.

Since bets on political online markets are small, the motivation of bettors can hardly be the amounts they win or lose. Nor can the usual economic theories of risky choices be of much relevance since the risks to bettors' wealth are rather insignificant. These gambles are made because of utility derived from the gambling itself, not because of the amounts won or lost. This has the very important implication that the positions taken by bettors-for example, whether they bet that the Democratic rather than the Republican presidential candidate would win- is not necessarily determined by which one they expect to win. On the contrary, their betting behavior may be in good measure determined by whom they want to win rather than whom they expect to win.

Studies of betting on sports events show a home team "bias" in the sense that the odds tend to be skewed in favor of home teams relative to the actual winning percentages of home teams. This may be because many local residents bet on their home team, such as Chicagoans betting on the Chicago Cubs, at odds where objectively they should be shifting their bets to visiting teams, and also because individuals in home cities are more likely to bet on games in their cities.

This home team bias is likely to be even more pronounced in political betting markets like the IEM since bets are small. However, if biases of Democratic and Republican bettors are about equally strong, and if a non-negligible fraction of all bettors are making prediction bets, then aggregate betting would tend to give on the whole accurate predictions about who will win, although these predictions would be quite noisy. Predictions rather than hopes may be of relatively large importance in the IEM and other online political prediction markets because the main bettors have been academic economists and financial experts rather than the general public. This type of wishful betting presumably is quite different in betting on other types of events, such as the unemployment rate shown by data to be released on a certain date.

I believe that online political prediction markets, and other online prediction markets as well, should be legal in the United States and elsewhere, even if the amounts bet were quite large. There is no important substantive difference between such online betting markets and the Chicago Mercantile Exchange and other exchanges that allow individuals and organizations to take positions on movements of stock indexes, housing price indexes, and prices of other derivatives. A distinction is sometimes made between political betting markets and derivative markets since participants in derivative markets may be hedging other risks that they face. Yet this distinction has little substance since if larger bets were allowed in online political markets, groups whose welfare depended greatly on political outcomes would make greater use of these markets. For example, if a Republican presidential win would mean greater spending on military weapons, companies in the arms business might hedge their risks by betting on Barack Obama.

If large bets were allowed, some wealthy groups may bet a lot on their candidates in order to exert bandwagon influences on public opinion through their large bets affecting market odds. If so, these markets likely would become less reliable as predictors of outcomes, and hence would have less influence on opinions. To a large extent, therefore, these markets would be self correcting, although online political markets might place various other restrictions on bets, as is common in derivative and other exchanges.

Prediction Markets and the Election--Posner.

The forthcoming presidential election has drawn attention to online predictions markets. The first, and one of the best known, is the Iowa Electronic Market (IEM), started in 1988 to bet on presidential elections. Participants can bet up to $500. The odds and hence the price of a contract are set by the bidders themselves, as in a stock market, rather than by the "house," as in casino gambling. A number of other prediction markets, some using virtual (i.e., play) rather than real money, have emerged, includingTradeSports.com, the Foresight Exchange Market, Newsfutures, Intrade, and the Hollywood Stock Exchange.

IEM, on which I'll focus, has correctly predicted the outcome of every presidential election since 1988, and its predictions have been consistently more accurate than the polls. An interesting comparison between the Gallup Poll and the Iowa market in the 1996 presidential campaign (www.biz.uiowa.edu/iem/media/96Pres_VS.html) reveals that throughout the entire campaign the Iowa market’s predicted outcome was much closer (in margin of victory) to the actual outcome than the Gallup Poll was. Studies have found that prediction markets beat polls and other prediction tools even when a prediction market uses play rather than real money.

The Pentagon planned to create a prediction market in which participants could bet on the likelihood of terrorist attacks, assassinations, and coups. The plan caused outrage and was abandoned. There was a serious objection to the plan: people planning terrorist attacks, assassinations, and coups have inside information which they could use to make a killing (pun intended) in the prediction market.

The success of prediction markets is related to though distinct from the success of the "blogosphere" in ferreting out information that eludes the mass media. Both the blogosphere and prediction markets aggregate greater amounts of information than any centralized information gatherer can obtain. In the case of the blogosphere, it is easy to see why this is so. It is virtually costless (except in time) to become a blogger, and among the millions of people drawn to blogging are people with all sorts of pockets of specialized information, which the internet enables to be pooled rapidly. This pooling resembles the economic market, in which vast amounts of information, encapsulated in prices, are pooled (the basic insight of Friedrich Hayek, and the secret of capitalism’s superiority to socialism as a means of optimizing economic activity).

Prediction markets provide an even closer analogy to the market, since they (or rather some of them, for others permit betting only with play money) provide financial rewards for correct information (as blogging rarely does), in this resembling ordinary commercial speculation. Someone who thinks he has superior insight into political processes will have an incentive to place a bet in IEM or some other political prediction market. This method of aggregating information--call it expert aggregation--is different from public opinion polling, which is based on randomness. The political pollsters quiz a random sample of likely voters for their likely vote; they do not ask them for an opinion of how other people will vote, a matter on which randomly selected respondents cannot be expected to have an expert opinion. The idea behind the prediction market is that the opportunity to make money or just the fun of betting on one's insights or hunches (the only reward that the virtual prediction markets offer participants) will elicit expert opinions--more so, certainly, than random polling, which anyway, as I have said, does not ask respondents for an opinion about anyone's voting except their own..

I don't think the success of prediction markets is due to a "wisdom of crowds" phenomenon--the idea that somehow large groups of seemingly nonexpert people are bound to "get it right." The "wisdom of crowds" is really just a matter of reducing sampling error. Suppose 100 people guess the weight of a person. Some will guess too low, some too high, but the average guess will be close to the true weight. If, however, just one person is asked to guess, the chances are great that his guess will be either too high or too low.

One problem with prediction markets, a problem that occurred on the day of the 2004 presidential election, is that a market can swing on the basis of unreliable information until the information is corrected. (That happened last week when the price of stock in United Airlines plummeted on a mistaken report that the airline was about to declare bankruptcy.) Exit polls showed Kerry winning a disproportionate number of the votes cast early in the morning, and immediately the prediction markets predicted that he would win the election; and of course he lost.

Another potential problem with the prediction-market model is that the limits of the bets that can be placed, illustrated by the Iowa market’s $500 limit, are so low. One understands why there are limits: otherwise there would be a danger of market manipulation. Expenditures on the current presidential election campaign will exceed a billion dollars. It must be that the prediction markets attract people who derive nonpecuniary satisfaction from successful bets and that among those people are likely to be a number who really do have insight into the issues bet on in the market, since their bets are more likely to be correct and therefore they are more likely to derive the satisfaction that comes from successful betting. Probably most people who bet on horse racing think they know something about horses, and probably most people who bet on the outcome of a political campaign know something about politics.

It may seem odd, though, that a stranger would have a better sense of how people will vote than a random sample of people would know, each of them, how he or she will vote. But only about half of all eligible voters actually vote in a presidential election, many people refuse to talk to pollsters, some people do not make up their mind until the last minute (but may be hesitant to reveal their indecision to a pollster), some respondents will tell the pollster what they think he wants to (or will be impressed to) hear, and the number of persons sampled is never large enough to avoid a confident prediction of a point outcome, as distinct from a range (say a 95 percent probability that one candidate's vote percentage will be between 47 and 50 percent and the other's between 49 and 52 percent).

There is an interesting question whether prediction markets should be thought of as "gambling” and perhaps prohibited. As a matter of policy, that would be a mistake, even if one thinks that gambling should be prohibited. The prediction markets are markets for speculation, rather than for game-playing or risk-taking. Slot machines, card-playing, roulette wheels, and other conventional forms of gambling do not generate socially valuable information. Speculation does. Commercial speculation serves to hedge commercial risks and bring prices into closer phase with value. Political, cultural, etc. prediction markets also yield socially valuable information. The outcome of elections is important to companies and even individuals for whom particular public policies are important; they may wish to make adjustments to avert or exploit looming political change. Politicians too need to have as sharp a sense as possible about the effects on the electorate of their and their opponents' strategies. Apparently they can get more accurate information from the prediction markets than from the public opinion pollsters.

The Financial Crisis: the Role of Government--Posner.

I agree with Becker that capitalism will survive the current financial crisis, even if it leads to a major depression (which it may not). It will survive because there is no alternative that hasn't been thoroughly discredited. The Soviet, Maoist, "corporatist" (fascist Italy), Cuban, Venezuelan, etc. alternatives are unappealing, to say the least. But capitalism may survive only in damaged, in compromised, form--think of the spur that the Great Depression gave to collectivism. The New Deal, spawned in the depression, ushered in a long era of heavy government regulation; and likewise today there is both advocacy and the actuality of renewed regulation. I would like to examine the possibility that government is responsible for the current crisis; for if it is, this would be a powerful intellectual argument against re-regulation, though not an argument likely to have any political traction.

I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity). Leverage enables greatly increased profits in a rising market, especially when interest rates are low, as they were in the early 2000s as a result of a global surplus of capital. The mistake was to think that if the market for housing and other assets weakened (not that that was expected to happen), the lenders would be adequately protected against the downside of the risk that their heavy borrowing had created. The crisis erupted when, because of the complexity of the financial instruments that were supposed to limit risk, the financial industry could not determine how much risk it was facing and creditors panicked. Compensation schemes that tie executive compensation to the stock prices of the executives' companies but cushion them against a decline in those prices (as when executives are offered generous severance pay or stock options are repriced following the fall of the stock price) further encouraged risk taking. Moreover, even when businesses sense that they are riding a bubble, they are reluctant to get off while the bubble is still expanding, since by doing so they may be leaving a lot of money on the table. Finally, if a firm's competitors are taking big risks and as a result making huge profits in a rising market, a firm is reluctant to adopt a safe strategy. For that would require convincing skeptical shareholders and analysts that the firm's below-average profits, resulting from its conservative strategy, were really above-average in a long-run perspective.

It should be noted that because of the enormous rewards available to successful financiers, the financial industry attracted enormously able people. It was not a deficiency in IQ that produced the crisis.

Becker makes incisive criticisms of the government's responses to the crisis. He points out that those responses create moral hazard, specifically a bias toward financing enterprise by bonds rather than by stock because the government's bailouts are limited to the bondholders and other creditors; create additional moral hazard because the responses include extending government insurance of deposits to money market funds; impede hedge funds by forbidding short selling, which enables the funds to hedge their risks; reduce information about stock values (another consequence of forbidding short selling); increase regulation of financial markets, which will carry with it the usual heavy costs of heavy-handed regulation; blur the role of the Federal Reserve Board by increasing its powers and duties; and increase the federal deficit.

But here is a remarkable thing about these responses. To a great extent they are not responses by government, really, but by the private sector. Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition of short selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis. In effect, the government's power to repair the crisis that Wall Street created has been delegated to Wall Street.

It is true that the top financial officials of our government have usually come from the financial industry or academia. The difference is how recently Bernanke and especially Paulson were appointed, how heavily they are relying on financial experts from the private sector rather than on civil servants, and how small a role the politicians in Congress and the White House have played in shaping the response to the crisis.

I do not criticize the delegation of the handling of the crisis to (in effect) the finance industry. I imagine that Bernanke and Paulson and their private-sector advisers are the ablest crisis managers whom one could find. I merely want to emphasize that the financial crisis is indeed a "crisis of capitalism" rather than a failure of government, though it will not and should not lead to the displacement of free-market capitalism by an alternative system of economic management. But it is already shifting the boundary between the free market and the government toward the latter.

The Crisis of Global Capitalism?Becker.

On Sunday of this past week Merrill Lynch agreed to sell itself to Bank America, on Monday Lehman Brothers, a venerable major Wall Street investment bank, went into the largest bankruptcy in American history, while Tuesday saw the federal government partial takeover of AIG insurance company, one of the largest business insurers in the world. Instead of calming financial markets, these moves helped precipitate a complete collapse on Wednesday and Thursday of the market for short-term capital. It became virtually impossible to borrow money, and carrying costs shot through the roof. The Libor, or London interbank, lending rate sharply increased, as banks worldwide were reluctant to lend money. The rate on American treasury bills, and on short-term interest rates in Japan, even became negative for a while, as investors desperately looked for a safe haven in short term government bills.

The Treasury" extended deposit insurance to money market funds-without the $100,000 limit on deposit insurance. The Fed also began to take lower grade commercial paper as collateral for loans to investment and commercial banks, and the Treasury encouraged Fannie Mae and Freddie Mac to continue to purchase mortgage backed securities.

Is this the final "Crisis of Global Capitalism"- to borrow the title of a book by George Soros written shortly after the Asian financial crisis of 1997-98? The crisis that kills capitalism has been said to happen during every major recession and financial crisis ever since Karl Marx prophesized the collapse of capitalism in the middle of the 19th century. Although I admit to having greatly underestimated the severity of this financial crisis, I am confident that sizable world economic growth will resume under a mainly capitalist world economy. Consider, for example, that in the decade after Soros' and others predictions of the collapse of global capitalism following the Asian crisis in the 1990s, both world GDP and world trade experienced unprecedented growth. The South Korean economy, for example, was pummeled during that crisis, but has had significant economic growth ever since. I expect robust world economic growth to resume once we are over the current severe financial difficulties.

Was the extent of the Treasury's and Fed's involvement in financial markets during the past several weeks justified? Certainly there was a widespread belief during this week among both government officials and participants in financial markets that short-term capital markets completely broke down. Not only Lehman, but also Goldman Sachs, Stanley Morgan, and other banks were also in serious trouble. Despite my deep concerns about having so much greater government control over financial transactions, I have reluctantly concluded that substantial intervention was justified to avoid a major short-term collapse of the financial system that could push the world economy into a major depression.

Still, we have to consider potential risks of these governmental actions. Taxpayers may be stuck with hundreds of billions, and perhaps more than a trillion, dollars of losses from the various insurance and other government commitments. Although the media has amde much of this possibility through headlines like "$750 billion bailout", that magnitude of loss is highly unlikely as long as the economy does not fall into a sustained major depression. I consider such a depression highly unlikely. Indeed, the government may well make money on its actions, just as the Resolution Trust Corporation that took over many saving and loan banks during the 1980s crisis did not lose much, if any, money. By buying assets when they are depressed and waiting out the crisis, there may be a profit on these assets when they are finally sold back to the private sector. Making money does not mean the government involvements were wise, but the likely losses to taxpayers are being greatly exaggerated.

Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.

The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.

Various other mistakes were made in government actions in financial markets during the past several weeks. Banning short sales during this week is an example of a perennial approach to difficulties in financial markets and elsewhere; namely, "shoot the messenger". Short sales did not cause the crisis, but reflect beliefs about how long the slide will continue. Trying to prevent these beliefs from being expressed suppresses useful information, and also creates serious problems for many hedge funds that use short sales to hedge other risks. Their ban can also cause greater panic in other markets.

Potential political risks of these actions are also looming. The two Freddies should before long be either closed down, or made completely private with no governmental insurance protection of their lending activities. Their heavy involvement in the mortgage backed securities markets were one cause of the excessive financing of home mortgages. I fear, however, that Congress will eventually recreate these companies in more or less their old form, with a mission to continue to artificially expand the market for mortgages.

New regulations of financial transactions are a certainty, but whether overall they will help rather than hinder the functioning of capital markets is far from clear. For example, Professor Shimizu of Hitotsubashi University has recently shown that the Bank of International Settlement (BIS) regulation on the required minimum ratio of bank capital to their assets was completely misleading in predicting which Japanese banks got into trouble during that country's financial crisis of the 1990s. Other misguided regulations, such as permanent restrictions on short sales, or discouragement of securitization of assets, will both reduce the efficiency of financial markets in the United States, and they will shift even larger amounts of financial transactions to London, Shanghai, Tokyo, Dubai, and other financial centers.

Finally, the magnitude of this crisis must be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25 percent unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. American GDP so far during this crisis has essentially not yet fallen, and unemployment has reached only about 61/2 percent. Both figures are likely to get considerably worse, but they will nowhere approach those of the 1930s.

These are exciting and troubling economic times for an economist-the general public can use less of both! Financial markets have been seriously wounded, and derivatives and other modern financial instruments have come under a dark cloud of suspicion. That suspicion is somewhat deserved since even major players in financial markets did not really understand what they were doing. Still, these instruments have usually been enormously valuable in lubricating asset markets, in furthering economic growth, and in creating economic value. Reforms may well be necessary, but we should be careful not to throttle the legitimate functions of these powerful instruments of modern finance.

The Financial Crisis II-Becker.

In considering what needs to be done to improve the functioning of the financial system, it is necessary to distinguish steps to avoid a major depression in the near term from long run reforms of the financial system. The Paulson Plan naturally concentrates on the very real short run emergency. I first discuss this plan and other suggestions, and then briefly consider long-term reforms.

The Treasury's announced insurance of all money market funds carries considerable moral hazard risks, but it has not aroused much controversy. The Paulson Plan goes much further and involves purchases from banks of up to $750 billion of assets that have uncertain worth. I say uncertain worth since there is essentially no market for many of these assets, and hence no market pricing of them. The government hopes to create this market through using reverse auctions. In these auctions, banks would offer their assets at particular prices, and the government would decide whether to buy them. This part of the Plan has been heavily criticized because it gives great discretion to the Treasury Secretary since the total value of the assets that would be purchased at this point is not known. In addition, many are repelled by the intention to bail out companies and their executives who made decisions that got the companies into trouble. There is also much concern about the moral hazard consequences for the future behavior of banks if they are led to expect to get rescued by the government when their investments turn sour.

While I find helping these banks highly distasteful, moral hazard concerns should be put aside temporarily when the whole short term credit system is close to a complete collapse. However, the proposed Plan does indicate, as I suggested in an earlier post (April 28, 2008), that the $29 billion bailout of the bondholders of Bear Stearns in March was a mistake. It probably did have a moral hazard effect by encouraging Lehman brothers and other investment banks to delay in raising more capital because they too expected to be helped if times got much worst.

The agreement apparently just reached between Congress and the White House does allow the government to purchase distressed assets up to about $700 billion- I would have preferred a considerably smaller initial limit. It does have a provision for Congressional oversight of the Treasury's use of the funds, whatever that is worth, and has several other features as well. For example, it includes pay limits for executives whose firms seek government help. That is too much micromanagement of the operations of these banks, even though no one can think much of executives who led their banks into such a mess.

I am also not enamored of the apparent provision that gives the government an equity stake in some banks that they help if these banks should prosper. It is unwise to allow governments in general to have equity interests in private companies, particularly if this equity gives them voting rights on company policies. Perhaps inevitably, this did occur in the AIG bailout. Many examples in recent history, such as the current Alitalia fiasco, show that political interests outweigh economic ones when governments have partial ownership of alleged private companies.

The agreement appears to require the government to use their new ownership of distressed mortgage-backed securities to reduce home foreclosures. Homeowners as well as bankers should have known that the insanely good times in the housing and mortgage markets could not last forever. However, consumers are less well informed about financial matters and housing pricing than are the supposed expert executives at banks. Helping homeowners also uses taxpayers money, but in a way that would generally aid people with modest to moderate incomes. Indirectly, moreover, it would also help banks by increasing the value of the mortgage-backed securities they hold.

One suggested supplement to the Paulson Plan is to require investment banks and other financial institutions to raise additional capital now, so that they have resources to start widespread lending again. Such a requirement would be unwise since banks that can raise capital readily are already doing so, as illustrated by Warren Buffet's investment in Goldman Sachs, and Mitsubishi's purchase of a stake in Morgan Stanley. Were such a requirement imposed, weaker banks might cut their lending even further in the attempt to increase their liquid capital. Milton Friedman and Anna Schwartz argue convincingly in their Monetary History of the United States that the Fed's raising of reserve requirements for commercial banks during the mid-1930s contributed to a prolonging of the Great Depression. For it induced these banks to further contract their lending in order to gain the liquid assets that were removed by higher reserve requirements.

The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have little understanding of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such ignorance of the financial system's mode of operation, it is difficult to propose long-term reforms. Still, a few seem reasonably likely to reduce the probability of future financial crises. The capital requirements of banks relative to assets might be increased, so that the highly leveraged ratios of assets to capital in financial institutions during the past several years would become less common. Possibly a minimum ratio of capital to assets should be imposed by the Fed on investment banks and money funds. As much as possible, the measure of capital should be market, not book, value, such as the market value of publicly traded shares of banks. My discussion last week indicated that book value measures badly missed the plight of Japanese banks during their decade-long banking crisis of the 1990s.

The government should as quickly as possible sell Freddie Mac and Fannie Mae to fully private companies that receive no government insurance or other help. These two giants did not cause the housing mess, but in recent years they surely greatly contributed to it, partly through Congressional pressure on them to increase their purchases of sub prime loans. They owned or guaranteed almost half of the $12 trillion in outstanding mortgages with less than $100 million of capital. The housing market already has excessive amounts of government subsidies, such as from the tax exemption of interest on mortgages, and should not have government sponsored enterprises that insure mortgage-backed securities.

Finally, the "too big to fail" approach to banks and other companies should be abandoned as new long-term financial policies are developed. Such an approach is inconsistent with a free market economy. It also has caused dubious company bailouts in the past, such as the large government loan years ago to Chrysler, a company that remained weak and should have been allowed to go into bankruptcy. All the American auto companies are now asking for handouts too since they cannot compete against Japanese, Korean, and German carmakers. They will probably get these subsidies, even though these American companies have been badly managed. A "too many to fail" principle, as in the present financial crisis, may still be necessary on hopefully rare occasions, but failure of badly run big financial and other companies is healthy and indeed necessary for the survival of a robust free enterprise competitive system.

The $700+ Billion Bailout--Posner.

There has been such a flood of media coverage of the financial crisis that it is best to begin with some very simple, basic points.

Banks (broadly defined to include investment banks and the many other lenders) borrow--bank deposits, for example, are loans to banks--and then lend out what they have borrowed. As a result, their loans are much larger than their capital assets (cash, a building, etc.). If their capital shrinks in value, they have less protection against the possibility that the loans they make will not be repaid in full. If a bank's capital is 10, and it borrows 100 and lends 100, and the persons or firms it lends to return only 90, its net worth will fall to zero (10 [its capital] + 90 [the value of its loans] - 100 [the amount it owes its depositors] = 0.

Banks in recent years have increased the ratio of their loans to their capital because borrowing costs were low and financial experts thought they had discovered ways of reducing the risk of leverage (that is, of borrowing). Many of the loans were mortgage loans, and the value of those loans fell when the housing bubble burst. (Risky, and in some cases deceptive, mortgage practices had contributed to the bubble.) What made the situation worse was that rather than retaining the mortgages that they originated, banks (especially the major ones) sold the mortgages in exchange for securities backed by the mortgages. Those securities became a part of a bank's capital. The value of the securities depended on the value of the mortgages that the entity issuing the securities had bought; those mortgages were the entity's assets. As that value fell, the bank's capital fell.

The mortgage-backed securities achieved geographical diversification of mortgage risk. But the housing bubble, though not geographically uniform, was sufficiently widespread that geographical diversification did not reduce the risk of mortgage defaults sufficiently to avert the fall in the value of mortgage-backed securities.

A complicating factor was that the value of those securities was and is very difficult to determine, because each security represents a share in pieces of many different mortgages. The bank that owns the security cannot readily determine the value of all those different mortgages, since it has no direct relationship with the mortgagor, having sold the mortgage to the entity that issued the mortgage-backed securities.

Because the banking industry (and remember that I am defining "banking" very broadly, basically as all lending) was highly leveraged, and because much of its capital consisted of securities very difficult to value, the bursting of the housing bubble reduced the capital of the banks, but by an unknown amount. The reduction and uncertainty have curtailed lending by reducing the capital cushion that a bank needs to reduce to an acceptable level the risk that some of its loans will not be repaid. That is the "credit crunch,” and it is painful because so many individuals and businesses borrow to finance their activities.

Ordinarily one would expect a credit crunch to be self-correcting. As lending dropped because of the fall in bank capital, interest rates would rise and this would attract more capital to the financial markets. We have seen this process at work in Warren Buffett's $5 billion investment in Goldman Sachs. Buffett has capital, Goldman needs it, so Buffett gives it to Goldman in exchange for preferred stock (which is really a type of bond but one that does not have a term--it is never repaid) paying a handsome interest rate.

But Goldman is pretty healthy. Many lenders have so much of their capital tied up in mortgage-backed securities or other novel forms of capital that are difficult to value that they cannot attract new capital at a price that would enable the lender to continue in business. The sale of the securities would just expose their lack of value. The federal government, however, has essentially unlimited capital because of its taxing power. It is prepared at this writing to contribute perhaps as much as a trillion dollars to rebuild the capital of the banking industry. The Treasury wants to make this contribution in the form of buying the dubious securities, but that seems to be a mistake, unless pressure of time allows for no alternative. If the Treasury pays the actual value (if anyone can determine what that is) of the securities, it will not be injecting new capital into the banking industry, but merely swapping one form of capital for another. If the Treasury pays more than the securities are worth, then it is contributing capital to the industry all right, but it is also enriching the owners and managers of the banks, which creates the familiar moral hazard problem as well as upsetting people by rewarding careless management practices. The more it overpays, the most costly the bailout plan to the taxpayer.

A more palatable approach would be for the government to drive a Warren Buffett style hard bargain, in which, rather than buying anything from banks, the government would invest in them in a form, such as purchase of newly issued preferred stock, or bonds with a long maturity, that would augment the banks' capital and thus enable banks to make more loans. That would avoid conferring a windfall on the banks by overpaying them for their bad securities; no one thinks Buffett is conferring a windfall on Goldman Sachs. After the industry was back on its feet, the government could sell the bank stocks or bonds that it had acquired.

Equities, Pay Caps, Liquidity: Structuring a Bailout--Posner.

I want to comment on Becker's post, of course, but I will also take the opportunity to respond to one of the themes in the very interesting comments that readers of our blog made on my post of last week.

I agree completely with Becker that the government should not in general have an ownership interest in private companies. The "in general" qualification is intended in part to approve of allowing the government to acquire such an interest temporarily, as part of the current bailout (for reasons I explain below); and in part to leave open the question whether the Social Security Administration should be permitted to invest some of its funds in the stock market; if the investment were spread over the entire market, so that SSA had only a very small stake in any given firm, the influence of government on firm management would be small. I would worry, however, that it would grow and turn out to be an entering wedge for socialism, but that is a story for another day.

I also agree that caps on the salaries of the executives of banks that participate in the bailout are dumb. Not only are such caps bound to be evaded, but if they were not evaded they would have the curious effect of subsidizing mediocrity. Capping the salaries of the executives in one industry will drive out (and deter from entering) some of the ablest executives, creating a space that will be filled by mediocrities. The allocation of talent across industries will be distorted and the recovery of the financial sector retarded.

Where I differ from Becker is with respect to the question whether the government should demand common stock in the banks it buys assets from. I think it should (as it is authorized to do by the bailout law just enacted).

The reason goes to the heart of the justification for the bailout. The banks are holding assets of dubious value. This makes them reluctant to lend money, because as I explained in my last post what banks do is borrow (for example, from depositors) and then lend the borrowed money, and they need a capital cushion against the possibility that the people they lend to will default. The smaller the cushion, the more conservative a bank’s lending policy must be.

If the government in executing the bailout buys the bank's bad assets at prices equal to their true, low value, the bailout will have no effect (with a qualification, concerning liquidity, noted below). A bank will be exchanging an asset worth say $1 million for $1 million; its capital will be no greater, and so neither will its willingness to lend be any greater. The bailout will work only if the government overpays. Suppose it pays $2 million for an asset worth only $1 million. Then it has added $1 million to the bank's capital. That capital is owned by the bank's shareholders. The government's purchase of the asset will therefore have enriched the shareholders.

Moral-hazard issues to one side, why should the taxpayer be enriching shareholders? The alternative is for the government to say to the bank in my example: we will pay $2 million for your lousy asset but in exchange we want you to issue us $900,000 worth of stock. (Not $1 million worth of stock, for then the bank might have no incentive to make the sale--or might, as the capital infusion could help it to stave off bankruptcy.)

I anticipate the following objections: (1) The banks will not participate. But why not? They would not only be making money on the deal; as I just mentioned, by strengthening their capital base they would also be reducing the likelihood of bankruptcy. (2) Government should not have an ownership interest in private companies. I agree, but this would be a temporary interest; the government would sell its interest as soon as it could find a private purchaser. (That was what happened in Sweden after it bailed out its banks from a crash similar to ours in thr 1990s. See Joellen Perry, "Swedish Solution: A Bank-Crisis Plan That Worked," Wall St. J., Apr. 7, 2008, p. A2.) (3) The taxpayer can recoup completely without the government's taking an ownership interest because the problem is not that the "bad" assets are so bad, as that they are illiquid; the bailout will restore liquidity without adding to bank capital.

The third point is the most important, and let me pause on it. The idea behind it is that the value of the "bad" assets that the banks hold is unnaturally depressed by the panic that has seized the financial industry. The bailout will dispel the panic and so restore the "bad" assets to their true, "good" value. The government will need only to hold the assets until their maturity and it will be able to sell them then at a price equal to or even higher than the "excess" price that it will have paid for them during the bailout.

The objection to this analysis is that if the situation is as depicted, there should be more private buying of bad bank assets than we are observing. Buffett should be investing not only in Goldman Sachs but also in hundreds of other financial institutions. There is plenty of global capital and why isn't more of it going to the purchase of bank assets whose true value is greater than their current market value? The bailout makes most sense if hundreds or even thousands of banks (there are more than 8,000 banks in the United States) really are broke or nearly broke, so that credit will dry up unless there is a massive infusion of capital into the banking industry. The fact that the required infusion is coming from the U.S. government suggests that the global capital markets are not confident that they could recoup investments in buying bank assets.

But this objection is not conclusive. It is possible that the banks' problem is not, or at least not only, undercapitalization because of the decline in the value of their assets, but lack of liquidity, which is different. Suppose you have a very valuable asset but all of a sudden the government decrees that money is no longer legal tender--that all transactions henceforth must be in bamboo shoots. Now, though your asset was valuable before the decree and will again be valuable when the decree is lifted, at the moment there is no market for it. If you do not know when the decree will be lifted, you will be very reluctant to make loans, because you will not know whether, if a loan goes sour, you can sell or borrow against your assets in order to cushion the loss and avoid bankruptcy.

If that is the problem, the bailout may restore liquidity and thereby enable banks to sell or borrow against assets on the basis of their true value, and eventually the government will recoup the cost of the bailout, because it will own those assets and can sell them, when markets return to normal, for at least what it paid for them. But probably the banks' problem is a combination of undercapitalization and illiquidity. Their assets include assets whose value is tied to mortgages, and the value of mortgages has declined because of increased risk of default as a result of the bursting of the housing bubble. Insofar as the bailout helps banks to overcome undercapitalization as well as illiquidity, it will be enriching the banks' owners--unless it demands common stock in partial compensation for its buying the banks' questionable assets for more than they are worth.

The theme in the readers' comments to which I would like to respond, and it is also a theme in the Wall Street Journal's editorial comments on the financial crisis, is that government policy, rather than the free market, is responsible for the crisis--government policy in the form of encouragements spurred in part by Congress to home ownership through the government-chartered though private Fannie Mae and Freddie Mac home-mortgage companies, low interest rates imposed by the Federal Reserve Board, and lax supervision by the Securities and Exchange Commission and other regulators. I wish it were true. And what is true is that the government, including Congress, the Federal Reserve Board, and the SEC, were complicit in contributing to or creating some of the preconditions for the crisis--cheap credit and lax regulation. But there is a difference between creating and merely exacerbating a crisis. Moreover, it is a paradox to exonerate the market on the ground that the government did not do enough to regulate it!

I believe that the basic causes of the crisis were six factors internal to the market system. The first was abundant and therefore cheap global capital--the result of private economic activity--and, consequently, low interest rates, which encouraged borrowing. The second factor was a housing bubble caused in part by those low interest rates and in part by aggressive marketing of mortgages. The third was new financial instruments that businessmen believed reduced borrowing risks and so increased optimal leverage. The fourth was the difficulty of "selling" a conservative business strategy to shareholders in a bubble environment. Borrowing more and more at low interest rates while home or other asset values are rising enables financial institutions to make higher profits, and a firm that refuses to jump on the bandwagon will as a result experience lower profits and will have difficulty convincing shareholders that they really are better off because the higher profits of the competing firms are unsustainable.

The fifth factor was sheer uncertainty--was it a bubble? If so, when would it end? Would the new financial instruments assure a safe landing if it was a bubble and it burst? And the sixth factor was that the downside risk to highly leveraged financial institutions was truncated by generous severance provisions for their executives, authorized by boards of directors that were not effective monitors of executive decisions.

Cycles of boom and bust are intrinsic to capitalism. Government can make them more serious, and sometimes less serious, but if you take away government you will still have periodic economic crises.

Government Equity in Private Companies: A Bad Idea-Becker.

The Federal government of the United States has seldom taken an equity interest in private companies, although this has been proposed sometimes, especially as a way to get higher returns on social security assets. However, the new financial bailout bill provides not only for the government to buy assets from banks, but that it also take an equity stake in the banks being helped. The purpose is to protect the government from paying too much for the many difficult to value assets that are acquired. The thinking is that if they overpay for some assets, they can make that back through a rise in the value of the stock or other equity interest that they would have.

However, the main purpose of the buyout is to increase the liquidity of the banking system and thereby reduce the banking system’s retreat from riskier investments. Yet the government's actions regarding an equity interest seem to be based on a fear that it will be outsmarted in the prices it pays for assets that are very difficult to value because they have no market. Whether the government will lose after the fact is not clear since it can afford to hold the assets to maturity. Moreover, taking an equity interest is also unnecessary in order to protect taxpayers from overpaying. Modern auction theory offers various ways to induce sellers (or buyers) of assets and other objects to "tell the truth"; that is, to bid their best estimate of an asset's worth. In using auction to buy bank assets it would be helpful if the government did not automatically take all assets offered by banks, so that banks have to compete against each other. Competition can also be increased by spreading the auctions out over time (I am indebted to my colleague Phil Reny for useful comments on optimal auction design). To be sure, the seller's estimates of the worth of their assets may turn out to be wrong, so the government would bear some risk. However, with an optimal auction mechanism design, the government need not fear grossly overpaying ex ante for the assets they acquire.

Even if the government were to lose money on this buyout, it is a bad precedent for it to take an equity interest in private companies. Inevitably, this leads to government involvement in business decisions and corporate governance. Experience shows that political rather than economic criteria tend to dominate in the pressures exerted by government shareholders on corporate decisions. This is already reflected in the bailout bill since it limits compensation for executives, including "golden parachutes" for executives of the companies helped. One can hardly have a high opinion of the executives who led such venerable institutions as Merrill Lynch and Lehman Brothers, and many other banks, into investment portfolios with such poor capacity to withstand a financial disturbance. Still, many of these executives have lost most of their very considerable fortunes since they usually owned or had options on many shares of their companies, and these shares have plummeted in price. It is appropriate that top executives suffer major losses when their companies collapse.

There is no good reason, however, for the government to interfere and impose limits on salaries and severance pay. Controls over wages and salaries have never worked well, and only encourage myriad ways to get around them, including generous housing allowances, vacation homes, easy access to private planes, large pensions, and other fringe benefits. There develops a war between the government's closing of loopholes, and the ingenuity of accountants and lawyers in finding new ones.

Governmental ownership of shares, with or without voting rights, opens up possibilities for much greater mischief than controlling executive salaries. For example, a bank or other company may want to reduce its employment in order to regain greater profitability. The government owners of these shares will be under pressure from congressman and senators who represent districts where employment would be affected to try to rescind or modify these cuts. Even without government ownership, congressmen protest corporate efforts to shift various activities overseas because labor and other resources are cheaper there. Such objections will be magnified when governments have direct equity stakes.

There are many illustrations of the bad influence on corporate governance exerted by the governments of France, Italy, Russia, and many other countries that own shares in private companies. One current appalling example is the situation of Alitalia Airlines, where the government owns almost half the stock. This has been a very inefficiently run airline that is hostage among others to powerful unions. Strikes have been common, flights frequently takeoff and arrive quite late, and baggage losses are high- experienced travelers try hard to avoid using Alitalia. Since Alitalia's command of routes into and out of Italy has market value, stronger European Airlines, such as Air France and Lufthansa, have wanted to take this airline over. However, the Italian government has resisted these efforts and continues to finance the sizeable monthly deficits of the airline. It fears the power of the unions who realize that many airline jobs at Alitalia will be lost if a more efficient airline takes charge.

This and other examples of harmful government interference in the running of companies where they have an equity interest provides a very good lesson for the United States. Avoid taking any equity interest in private companies when buying assets of banks under the bailout bill, or when investing other government revenues.