What if?

U.S. House Budget Committee Chair Paul Ryan asks a good question:

Let me ask you a question: what if your President, your Senator and your Congressman knew it was coming? What if they knew when it was going to happen, why it was going to happen and more importantly, what if they knew what they needed to do to stop it from happening and they had the time to stop it? But they chose to do nothing about it, because it wasn't good politics?


What would you think of that person? It would be immoral.

This coming debt crisis is the most predictable crisis we've ever had in this country. And look what's happening. [emphasis added]

Now, I've not been following American budget politics and am consequently agnostic about whatever budget plan he might be proposing; I'd be surprised if it made more sense to cut Medicaid, which helps poor people, than to cut cut Medicare, which helps old people many of whom are wealthy. There's more informed analysis of American budget politics elsewhere.

But I really liked the question. Recall New Zealand Prime Minister John Key's position on maintaining former Prime Minister Helen Clark's policy of zero-percent student loans:

Charging interest would bring in considerable extra revenue for the Government, but Key said he would be voted out if National did so.

"Bluntly, if you want me to be really crude about it there are 565,000 student loans out there. If we add interest back on the student loans, it doubles repayment time of the loan.

"If your loan is $50,000, and it's estimated it will take you eight years to pay it off, we effectively turn it into a loan that is about $90,000 with interest that takes you about 15 years to repay," Key said.

"That is about the only thing that will get [young people] out of bed before 7 o'clock at night to vote, but it's not politically sustainable to put interest back on student loans. It may not be great economics, but it's great politics. It is a bit of a tragedy because it sends the wrong message to young people, it tells them to go out and borrow debt." [emphasis added]

What do we think about this person? Here's what Matthew Hooton thought.

At least Key's not pretending it's good economics; politicians more typically convince themselves that whatever's politically popular is also economically sound.

But instead of leading a national conversation about the size of the deficit and ways of addressing the problem, including reintroducing interest on new loans and phasing interest back in on existing loans over time, he shuts the door on sound policy. Recall Justin Wolfers' argument against forgiving student loans; zero percent loans aren't that different - they forgive a good chunk of the proper present value of the debt.

Budget constraints do bind; Key last year suggested limiting access to loans rather than charging market interest rates. The coming budget is likely to have more restrictions on loan access: rationing the zero-interest credit. And such restrictions aren't necessarily bad economics either: if government-backed loans solve a market failure in credit markets that stems from inability to collateralize human capital, restricting people with other assets that could serve as collateral from accessing zero percent loans reduces costs without any particular policy cost. Or, if some degree programmes or student cohorts are exceedingly unlikely to see sufficiently enhanced earnings for the policy cost to be recouped through the tax system, restricting loan access there also doesn't necessarily do harm relative to a policy of loans issued at market interest rates. But it smacks a bit of government picking winners rather than letting students make their own choices after looking at the expected loan repayment burden at market interest rates.

And, there are other negative consequences for tertiary policy that flow directly from maintaining zero percent loans. The Government caps tuition increases, ostensibly for the students, but really because it can't afford to dish out loans at zero percent were tuition to rise. Similarly, the government has moved to limit domestic tertiary enrolment via capped enrolment at the universities - a policy that would be superfluous if tuition were higher and students charged market interest rates.

I sure hope the budget has something other than "Yeah, the deficit is really big. But everywhere we looked for savings would have somebody complaining, and Labour would then get elected and boy wouldn't that be worse. So we're not really going to do anything - not even commit to raising the age of superannuation eligibility two decades from now. It's horrible economics and boy the Treasury guys will get mad at me. But it's great politics."

iPredict says there's a 43% chance National wins government again in 2014. Pulling out a couple of high variance plays might not be crazy.

Goff fails my intermediate micro exam

Every year, I work to beat into my Econ & Current Policy Issues students what things get to count as market failures and what things don't. So I could ask on an exam something like:

After the earthquake, many houses became uninhabitable; the price of remaining houses went up as supply remained relatively inelastic. Explain whether this is a market failure. If it is, what kind of market failure is it? If it isn't, explain why.

The very best answer - the kind that goes a bit beyond what's asked without getting much wrong - would say:

That prices increase consequent to changes in supply and demand is not a market failure; it represents the normal functioning of markets after an increase in relative scarcity. No part of the First Fundamental Theorem of Welfare Economics has been violated. At best, there is a pecuniary externality benefiting those whose homes have been less damaged. If we worry about the inequities that result from the lottery-assignment of property destruction or property price increases, that is better addressed by insurance or other transfers to those adversely affected than by intervening in property markets to cap prices.

The government may wish to reconsider the optimality of zoning regulations that limited the supply of land for housing on the Christchurch suburbs however; even in the case that those restrictions were optimal prior to the earthquake, the very large negative supply shock likely changes things.

Now, here's Phil Goff in last night's Leaders' Debate.

At times you have to intervene. The market is a good system. But there's a thing called market failure. And when you've got 10,000 people chasing sections all at the same time, that's not the normal functioning of the market. And if there isn't the supply to meet that, then your property prices are going to be inflated.

Sorry, Phil, that gets you a C- at best. Yes, if there's a shock to demand for standing houses and supply is relatively inelastic, property prices go up. But you've bollocksed the part on market failure by taking the populist understanding of the term instead of the economic one. More on that later.

Goff goes on to recommend that the government buy up a pile of sections and sell them on at cost to folks whose houses have been destroyed. Unless that's coupled with easing up the supply restrictions on the edges of town, that does nothing to reduce the run-up in house prices. And if it is coupled with easing supply restrictions, all the work's done by that easing; the government intermediation of sales is superfluous.

Key replies to Goff that central government came in to release more sections for development. It took central government far too long to do this, but moving more quickly to kick Christchurch Council around might not have been well received.

I really hate how politicians use the term market failure to refer to any market outcome of which they disapprove. They couldn't do it, though, if the public didn't share that view of market failure. And we, as a profession, do harm in our introductory-level teaching of economics. If a student comes away from Principles with a better grasp of that government can improve outcomes in case of market failure than of the strict conditions under which this may be true, we've set the stage for later policy harm.

The omniscience constraint

Man, a bit of market failure theory can really screw you up.

Recall that the First Welfare Theorem shows that, under an idealized set of sufficient conditions, market outcomes cannot be improved upon.

Normal economists recognize that the conditions fail and that, when they do, there may be room for ameliorative government policy. Policy would still need to be assessed to see whether it's welfare improving; we need comparative institutional analysis.

Abnormal economists say that whenever one of the conditions fails, we can throw all of economics out the window. That's what Collins & Lapsley did when asserting that alcohol consumption involves only social cost with no offsetting benefit: because consumers don't have perfect information, they can't have enjoyed consumption benefits.

Here's Single, Collins et al:

Thus, if the costs of substance use are to be classified as private costs, the following three conditions must be simultaneously satisfied:

1. The users are fully informed as to the costs which the substance use imposes upon themselves;
2. The users are required to bear the full (internal and external) costs of the consumption; and
3. The users make rational consumption decisions in the light of all the information available to them.

These requirements are extremely stringent, so stringent in fact that the conventional approach of treating all abuse costs as social costs is fully justified.

Collins & Lapsley wrote as reason for counting private costs as social:

Being fully informed about the private costs of abuse requires the abuser to have access to, and have the ability to process and evaluate, epidemiological information on the effects of drug use. It also requires the drug user to be able to evaluate the probable future health and other costs resulting from the drug use. It is difficult to believe that drug users, by their nature, are fully-informed, or even well-informed, about the costs of their abuse.

Both of these are clearly nonsense. Sure, full information would require that. But that's insufficient basis for assuming zero private benefit. And, it's insufficient basis for saying that alcohol needs more regulation than anything else: no form of consumption would meet the Single et al requirements.

Don Boudreaux finds another example today from the New York Times' letters section:

In a perfectly functioning economic world, all consumers would receive perfect education about good nutrition and then simultaneously demand that fast-food companies and grocery stores start offering healthy options, thus forcing Big Food to supply what the people demand.

Until that happens, we need regulation of Nestlé, Monsanto, McDonald’s and the rest of the moguls that dictate our diets.

I suppose that's not as bad as the Collins & Lapsley assertion that imperfect information transforms all private costs into social ones. But it's worrying how often folks run the following syllogism:

1. People make choices I dislike;
2. Those people do not have perfect information; therefore:
3. Regulation must be used to make people choose the things I would have chosen for them.

No recognition of imperfect information problems in government; no notion that preference heterogeneity could underlie different choices; no attempt at comparative institutional analysis.

I think we as a profession are doing harm in our principles level teaching when we cover market failure. Far too many people seem to come away from Principles of Micro with the impression that any market imperfection is sufficient basis for throwing away the rest of price theory and revealed preference.

Intervening for the surplus

Paul Walker asks whether consumer surplus can ever justify government intervention. Arguing against Sam Richardson's contention that consumer surplus from the Rugby World Cup can justify government intervention, Walker notes:

Three question came to mind for me: 1) If CS is a reason for government involvement in a project then isn’t this a reason for government involvement in almost everything? I meant the CS generated by computer software, for example, must be huge and thus should the government not subsidise Bill Gates?! 2) If there really is enough CS to justify government involvement doesn’t this tell us that that real issue here is one of the pricing of the event? If the council priced in such a way as to capture the CS, e.g. some form of price discrimination, then evaluation of its investment would be easy, just look at the profits generated. 3) If there is a large amount of CS to be captured then why have the council involved at all? Why not just let the private sector run/build the event/stadium, pricing in such a way as to capture the CS, and let the event stand on its own economic feet? No government involvement is necessary.

What's Walker missing? If there's a market failure preventing the realisation of potential consumer surplus. Imagine that the local folks putting together a bid for the RWC set up their bid optimally with respect to maximal extraction from those who could attend games: lots of tiered pricing, lots of tied sponsorship arrangements, lots of merchandising. And the bid were just shy of making it. And, suppose further that each and every Kiwi got $10 in warm fuzzies just from pride in knowing the event were here being held. If there's no market in which they can express their preference for the event's being held, and if the event wouldn't be held absent the contribution from those folks who'd never attend a game but who would enjoy benefits, then that can be an argument for government intervention.

Now, the warm fuzzies can be internalized through sponsorship arrangements: if those not attending the game get warm glow from the games, sponsors may capitalize on that warm glow. But we'll specify that the $10 per person is over and above any amount that can be capitalized on by sponsors.

In that case, you could argue for government involvement. You need a market failure of some sort to make the CS argument for intervention hold. It's not nonsensical on first principles. But it's rather unlikely that we've been made better off by the investment. Why?

First, we'd have to know that the potential CS made it worth the cost.

Second, we'd have to ask why alternative mechanisms for solving the coordination problem among those experiencing warm glow weren't attempted. KickStarter is an awesome mechanism for this. You put up your project and your required funding threshold; folks pledge money and are only called on for funds if the collective willingness to pay is high enough. Sure, there could be free rider problems, but there are ways of turning assurance contracts into dominant assurance contracts. If RWC never even bothered trying KickStarter and went instead immediately to the guys who can use guns to force your contribution, we might be sceptical that they really believe that there are net gains to the public (or that the latter is just easier for them).

Finally, we'd have to weigh up whether the losses from bearing the market failure - the forgone benefits - really justify the costs of intervention.

I'd put 20:1 against that the NZ government's investment in RWC meets any kind of sane cost-benefit analysis. There are states of the world in which such investments can be optimal; we're just rather unlikely to be in that world.

Obvious points on student loans

John Key's suggested limiting access to New Zealand's zero percent government guaranteed student loans; folks nearing retirement age will no longer be eligible to get zero percent loans from the government for living expenses while in tertiary study.

Folks in the Labour Party have called the move discriminatory; some implausible parallels were tweeted.

Two obvious points that perhaps need spelling out.

First, there is a good market failure argument for government guarantees of student loans. Namely, asymmetric information about the likelihood that human capital investments will yield returns that would be paid to the bank combined with the bank's inability to foreclose on your B.A. in Poetry. So the banks may abstain from participating in that market without some kind of guarantee. Nothing in that argument justifies low interest or zero interest loans.

If the point of policy is to remedy the market failure, then best policy would have the government act as backstop guarantor on student loans where the government expects to be able to recoup the loan. Government can always force repayment through the tax system and by confiscating the passports of those with outstanding debt, so long as the debtors have sufficiently augmented earnings consequent to education to pay off the loan.* If it's exceedingly unlikely that someone would be able to repay the loan, it would make sense for the government to decline to extend the guarantee; it's not a market failure that a bank refuses to extend a home loan to an overvalued property where the buyer has little prospect of paying the mortgage. And, by and large, near retirees taking on student loans will be in this group. Sure, some will be retraining for a late career change. But even for those, paying off the loan will be tough. And many others will be taking courses for consumption rather than investment purposes.

So if government guarantees of student loans are meant to solve market failures resulting from asymmetric information, putting in an age cutoff doesn't seem obviously discriminatory. It's no more discriminatory than that a life insurer might refuse to extend coverage to the terminally ill.

If the point of policy is other than solving market failures, then maybe it's a bad idea to restrict access to the elderly. But we'd need to specify then what the purpose of policy is. Barring specifying some point other than meliorating market failure, I'll stick with that it's entirely reasonable to restrict government student loan access.

* Note that the alternative solution to the market failure would solve things by allowing banks to make more restrictive and enforceable contracts with folks taking on loans for human capital. Government is able to solve the problem by compelling payment through the tax system: future income streams then become collateral. Were banks able similarly to compel payment, I'm not sure there would be any particular failure to solve.