Public Choice Theory & the Current Economic Crisis

The late Professor Mancur Olsen (University of Maryland and George Mason University) was well-known for applying economic concepts to explain legislative outcomes (Yale Professor William Eskridge and Berkeley Professor Phillip Frickey have also done work on this topic.

In a nutshell, Olsen believed that if one used basic supply and demand curves — it was possible to gain insight into the political process.  If the benefits of a particular proposal (embodied in a draft law or bill) were concentrated and lucrative while the costs were diffuse — thus discouraging the expenditure of resources to organize in opposition to the proposal, those who favored the concept (i.e. interest groups”) would obtain that which they sought.

In contrast, if the benefits were diffuse and the costs concentrated, those who would have to bear the costs would have an incentive to organize to kill the measure.

The hybrid cases were where BOTH:

(i) the benefits and costs were diffuse, there would be no legislative action or “feel good” laws such as an appropriation for building a statute to a well-known poet or to have a particular month declared national “exercise” month; and

(ii) the benefits and costs were concentrated, then the legislature would adopt “framework legislation” in which some ideas acceptable to both sides might be adopted, but in general the legislature would delegate to an administrative agency the task of resolving the conflict.  With respect to a particular matter, those who would receive greater benefits or have to bear higher costs would prevail, provided the cost of organizing a coalition were not prohibitively expensive.

There are a multitude of explanations for the present economic situation.  That being said, there is general agreement that a large part of the problem was the absence of an appropriate system for regulating particular activities (e.g. the buying and selling of derivatives or securitization of mortgages) or that there were an insufficient number of trained and motivated regulators with sufficient resources and political support to fulfill the purposes for which they were hired.

How else can one explain that AIG (an insurance company) essentially had a division that operated as a hedge fund?  How is it possible that whistleblowers suspicious of Messrs. Madoff’s or Stanford’s activities were ignored?  Perhaps the whistleblowers were not sufficiently persistent, but it may have been a shortage or resources or a “dissent channel” if ones’ hire-ups are ignoring red flags.

Essentially, the political system is broken and there is little consensus or desire to fix it.  Ever wonder why if increasing the number of IRS auditors results in larger amounts for the treasury than the cost of hiring such individuals, there are not more IRS auditors hired?  Why do Congresspersons represent districts the population of which may vary significantly?

If politicians actually wanted a large share of the population to vote, why not spread voting over the course of a week, make it easier to obtain absentee ballots or make election day a federal holiday?

The absence of rules in many areas is not accidental.  The reason that a small portion of the population benefit from particular laws is not mere happenstance.  Those taxpayers who did not undertake to become informed and active have only themselves to blame.  In many cases, people get the governments they deserve and those who see loopholes in regulatory schemes to make money generally will do so.

“Rogue Traders” & Bernard Madoff

In 1995, then-Barings Bank’s employee Nicholas Leeson was a “rogue trader” who, allegedly acting on his own, caused 1.4 Million Pounds in losses by “gambling” in the Singaporean futures market.  One might have been suspicious as to his activity since he did not hold a currency trading license.  Ultimately, no other persons were found to be at fault — that is, Mr. Leeson was determined to have acted alone.

Similarly, Societe General’s Jerome Kerviel engaged in massive fraud leading to the loss of 3.7 million Pounds.  He too allegedly acted alone in perpetrating his crime.  Subsequent investigations have implicated others of either negligence or wrongdoing.

It is seldom the case with economic crimes (e.g. embezzlement, fraud, bribery, etc.) the criminal acted entirely alone or at least without the knowledge or suspicion of the relevant institution’s risk management personnel or management.  Either both were incompetent or were also engaged in some crime.  It is often in the interests of institutions to keep secret the relevant facts of the case. Law enforcement or regulatory authorities frequently do not pursue such matters.

As a general rule, the higher one gets in any organization, the less accountable they become.  It is hard to believe that both Leeson and Kerviel completely lacked supervision when they performed their jobs or that that less responsible individuals responsible for keeping the records of their activity or performing some other routine function had no knowledge of their transgressions.

One can even buy Leeson’s book that recounts his exploits. http://www.amazon.com/Rogue-Trader-Nick-Leeson/dp/0751517089.  He probably charges high speaker fees — it is not clear if those harmed by his action will somehow benefit from the sales of his book or other actions he may take in the future that will generate revenue.  He is regarded as having “paid the price” for his actions (and is now benefiting from them).

Bernard Madoff’s decision to plead guilty to all 11 felony counts currently brought against him (including securities fraud, investment adviser fraud, mail fraud, wire fraud, three counts of money laundering, false statements, perjury, false filings with the United States Securities and Exchange”) will deprive the public of a trial of one of the biggest “white collar” criminals in history.

Although Department of Justice and other U.S. governmental bodies continue to investigate the matter, it does not seem likely that NO ONE had any idea of what he was doing.  Is it unjustified to be just a little bit skeptical?  Such individuals might qualify as co-conspirators, others may have been under no legal obligation to report Mr. Madoff’s crimes.

In 1964, when 38 persons heard Kitty Genovese’s calls for help when she was being stabbed to death but did nothing including calling the police, which would not have placed them at risk, there was tremendous moral outcry.  It would be no exaggeration to say that thousands of sermons were given on this topic.

Violent crime is much easier for the average person to understand.  Financial crimes are often complex. Even though Mr.  Madoff will be sentenced to serve 150 years in prison, it is doubtful that he will live that long.  It is impossible to comparable the horror that Ms. Genovese suffered that one night in 1964 with the harm Mr. Madoff has caused thousands.  At present, we will not know the number of persons who can be analogized to the 38 persons who did not call the police even though they were aware that a crime was taking place — but just as Mr. Leeson was betting on commodities futures, there are probably many people who might be willing to wager that the guilty in the Madoff Ponzi scheme will never be punished.

The U.S. Can Be a Marihuana Exporting Powerhouse ! ! !

We should all applaud The Economist (March 7-13, 2009) for having the courage to examine a controversial public policy issue and then arriving at a patently obvious and logical conclusion.  Its cover story “How to stop the drug wars” analyzes (i) international drug trafficking and attempts to curb supply and cut demand, (ii) the workings of the cocaine trade, (iii) the impact of the prohibition on the illegal use of narcotics in Europe, and (iv) the effectiveness of drug education in America.  The Economist analogizes existing restrictions on the use of narcotics to the U.S.’s unsuccessful attempt at prohibition in the 1920s (incidentally, the main character in the British film “Layer-cake” uses this same line of thinking when he describes his involvement in the cocaine trade as that of a businessman).

The adoption of a rational public policy towards narcotics is hampered by numerous factors: (i) since almost all countries have huge number of persons engaged in the so-called “war on drugs” and are eager to protect their jobs (and promotion opportunities) they have an incentive to justify their activities — indeed, they form a very successful lobbying group with allies both inside and outside of government, (ii) the narcotics trade produces huge illicit incomes for a sizable group of people (farmers, wholesalers, corrupt law enforcement personnel and customs officials, enforcement personnel, among others), and (iii) many people see the narcotics problem as a moral issue, consequently they react emotionally to this topic rather than logically.

It would not surprise me if individuals in the first two categories immediately above are making large campaign contributions to conservative politicians to help guarantee that narcotics remain illegal to ensure that narcotic prices remain high.  Should the price of cocaine or heroin really be that more expensive than paprika?  For those involved in the narcotics commerce chain, is their position significantly different from oil producers promoting the use of automobiles that are not fuel efficient  and fighting research into alternative sources?

British Columbia’s largest export to the U.S. is marijuana — a product that could easily be grown in the U.S.  Perhaps we should end our foreign dependency and perhaps even become a marijuana supplying nation.  Marijuana could be an important source of tax revenue for the U.S., just as alcoholic beverages are — indeed its legalization might help with the country’s balance of payment problems.

Fortunately, the distribution and sale of alcoholic beverages are regulated.  For example, there is governmental quality control.  Wisely, it cannot legally be sold to minors (but creates a market for fake IDs).  A person may not drive an automobile, fly an airplane or operate certain types of machinery if the alcohol content of their blood exceeds certain levels.  These are common sense rules that few would oppose if applied to marijuana users.

The war on drugs is a war on ourselves.  It forces law enforcement to devote a considerable share of its energies to activities that pose a minimal risk to American society — and at great financial cost to the taxpayer.  Keeping narcotics illegal enriches organized crime groups.  The international narcotics trade potentially destabilizes countries.

Leading American politicians have acknowledged their drug use during their youth.  U.S. Barak Obama has shown great courage and candor to admit his own experimentation.  Al Gore, like a majority of baby-boomers, used marijuana.  Senator John McCain when asked whether he smoked marijuana as a youth amusingly remarked that since he was a POW when his fellow servicemen were experimenting with drugs, he really did not have the opportunity, but he would not criticize those who had.  Former President George W. Bush refused to discuss his former drug and alcohol use — but anyone who is interested in this topic will find a lot has been written on this subject on the Internet as well as numerous well-researched books.  Query whether the political leadership in the world’s other countries are significantly different.  An end to hypocrisy would be refreshing.

Persons with a drug dependency (including alcohol) should be encouraged to seek help with their problem.  There would be little public support to jail alcoholics in most Western countries.  In fact, some of the revenue derived from taxing narcotics should be used for drug education and rehabilitation programs.

As suggested above, if narcotics were legal, the cost of cocaine and heroin would plummet.  Drug users would be far less likely to commit burglaries, robberies, and other crimes to support their habit.  The number of persons incarcerated for drug-related crimes would plummet saving taxpayers billions — which could be used to help fund our country’s recovery program and make health care available for those who cannot afford it.  Furthermore, many inner city neighborhoods would experience an economic renaissance — boosting property values and generating more taxes.

The medical community is unanimous that smoking cigarettes contribute to health problems — cancer being the most prominent.  U.S. tobacco companies are required by law to place warning labels on their cigarette packages, not advertise on television and radio and not to target minors.  Yet these same companies export their products abroad.  These very same companies for many years have contingency plans in the event marijuana were legalized.

Even though legalizing and regulating all narcotics would be a net plus — there is a lot to be said for incrementalism.  The late New York Governor Nelson Rockefellar promoting the decriminalization of small amounts of marijuana for “personal use.”  Frankly, elected officials, voters and police officers did not want to deal with the consequences of turning future productive members of society into criminals.  Judges and prosecutors recognized the resources that were being wasted on non-violent drug “criminals” who pose no real threat to society.  Unfortunately, the New York experiment was ended before there were sufficient data to examine.  Ironically, in this regard, public opinion may be years ahead of our elected officials.

Bravo for The Economist.  It is time for us to concentrate our energy on the world’s real problems.

Performance Bonuses for Civil Servants?

In recent weeks, details have come out that U.S. government officials suspected that both Allen Stanford and Bernard Madoff were involved in major financial crimes — but for various reasons their suspicions were not acted upon.  This is indeed troubling.

It brings to mind that there were officials within the U.S. who reported “up the ladder” activities that might have led to the uncovering of the 9/11 plot.

After the fact, persons may recharacterize events in a manner to elevate their insight and importance.  In the above instances the economic and psychological costs of the harm caused are incalculable.

The U.S. military offered rewards for information leading to the apprehension of both Osama bin Ladin and Saddam Hussein.  This was done on the basis of the belief that money motivates.

Under the False Clams Acts, under certain circumstances, whistle blowers obtain the right to receive a percentage of the money they save the U.S. government from the improper actions of contractors through qui tam lawsuits.  Perhaps this market principle could be applied in other contexts — including payments to civil servants.  The absence of such a system may give rise to passivity when supervisors do not want to investigate alleged wrongdoing.

Of course, it would be undesirable to encourage viglilantism or pay law enforcement personnel bonuses for the number of persons arrested and convicted, but some though should be given to better incentivize initiative where bureaucratic intertia and group think often predominate.

Financing Public Education (Grades K-12)

In recent decades, most public school systems have been financed by taxes on real estate within the school district.  In theory, renters pay their share with the property owner acting as a “pass-through.”   With the price of real estate falling precipitously, it appears to be time for state legislators to look at alternative methods of funding public schools.

The current system produces great inequities.  Wealthier school districts can afford to spend more per student than poorer school districts.  No doubt there is great variation in the quality of education a student receives as it costs money to pay teachers, sponsor after-school activities, and maintain facilities as a result of financing education in this manner.

Owners of real estate (California excepted) typically pay property tax according to a formula based on recent “comparable sales” of properties in their locale.  This produces an unfair situation.  Traditionally, homes appreciated in value.  Thus, as the “value” of homes increase, the tax imposed on them should also increase, as if owners just bought their homes.  This is not always the case — some people inherit real estate, for example, their parents home.

The comparable sale model is blatantly unfair.  If a person bought their home 10 years ago, why should they be taxed on its theoretically current “market” value?  We are not taxed on the value of our 401-Ks, investment portfolios, etc. until the underlying asset is sold.  Why tax homes of persons who did not sell them?  In economic times such as these how is it possible to determine what the value of a home is? They may be volitiable.  The sellers and buyers circumstances will influence price.  If house prices are falling, will taxing authorities resort to increasing the tax rates at a time of falling incomes?

Many sales occur under unique circumstances.  Perhaps, the appropriate step would to increases taxes on the sale of real property that would be paid by recent buyers and sellers  (possibly adding a premium when the seller is a developer).  This would increase “closing costs” for both parties, but at least the market price at the time of sale has some basis in reality.

All homes are not created alike.  Price is not entirely a result of the building’s  square footage, number of rooms, or associated land.  One can spend $40,000 redoing a bathroom or $10,000.  The location of land is unique in each case and subject to zoning codes that can affect their value.  The use of bureaucrats determining the sale price of comparable “sales” is highly flawed, particularly if the relevant government authority does not want to see a falling tax base.

There some locales try to undo some the unfairness by phasing in tax increases, granting homeowners exceptions for persons living in their homes, and persons on fixed incomes (usually the elderly).  Of course, the elderly MAY have greater dispossible incomes than a young family.

Today, many people are seeing the value of their net worth steeply declining.  Housing prices are dropping throughout the country by dramatic amounts.  Are we going to cut the amount of money spent to educate our children commensurately?  Such a policy would have a dramatic impact on the future of our country and reduce upward social mobility.

Let me propose three ideas:

(i) State income taxes should be made more progressive by adding more brackets and treating all income, irrespective of source the same.

(ii) Luxury taxes should be imposed on the sale of items having a price above $25,000 (but only on that additional amount above $25,000).

(iii) Corporations having more than a given number of employees (e.g. 250), have been in business more than five years, and generated a profit in each of those years, might be charged a school-supporting fee since they are likely to benefit by being able to hire employees educated by the public schools.

No system is perfect.  But will states be willing to downwardly adjust real estate values?  Or will they increase the rates to offset this trend?  A new system is needed where the funds for schools should be financed principally by state governments and secondarily by the federal and local governments.