Wednesday, December 31, 2008

Guest Jake Ahmann on Moral Hazard

Do avalanche beacons cause more skiing accidents than they prevent? Do Bullet proof vests cause more officers to risk their lives? Do passengers in armored cars take more unnecessary risks? Do People with four wheel drive take more chances with bad weather? These are just a few of many Moral Hazards that I believe to be true.
Let me give you a scenario. You and a couple of buddies are at a world class ski resort for spring break. The lift line wait is at an hour and counting, and the slopes are swarming with skiers like ants on an ice cream sundae. So you decide to skip the lines and go straight to the good snow. That’s right; you and your buddies are heading out of bounds. One of your friends, we’ll call him Peter, has a little bit of common sense and says, “Hey guys, I’m not so sure about this, I mean ski patrol can’t help us if we get into trouble.” But you, being the good friend you are, ease his mind by telling him that, ‘It’s ok, we have avalanche beacons, what’s the worst that could happen?”
I believe that this scenario can and does happen, whether or not people think it through that far or if it’s further back in their subconscious. For a real life example, my friend Preston is an avid skier, as are his parents, but he also has a strong liking of adrenaline rushes. His parents don’t care for receiving the same doses of adrenaline, so Preston was stuck in a tough place whenever he skied alone because he had to stay off of all of his favorite runs. So for Christmas, his parents bought him an avalanche beacon. Now, with his parents mind at ease, he can ski all of the double black diamonds he wants, even when he’s alone. But the big question is, is he safer now than he was before he had the beacon?
Moral hazards are something we face everyday. There are thousands of them, all around us. They affect everyone, most of the time in small ways, and the benefit of many outweighs their risk. But there are cases where they can affect entire countries such as the recent market collapse in the United States. You may ask, how does a moral hazard cause the largest market collapse of the twenty first century? Insurance. Almost any case that involves insurance involves moral hazard. It causes people to become sloppy, careless. It affected the big investment firms; it caused them to become over extended because they knew that even if they couldn't’t always back up everything they did, the United States Government would.
A moral hazard is when a party or individual acts in a different way when sheltered from some of the risk, than they would if exposed to all of the risk. If the party is sheltered from part of the risk, they will act more carelessly because someone else is responsible for some of the consequences. One of the most used examples of moral hazard is insurance. Because the insurance company bears some of the risk, the person who has the insurance may drive more carelessly, knowing that if something happens, their insurance company will pay for part of the damage. The term of moral hazard dates back to the 1600s when insurance companies would use it to refer to fraud or immoral behavior, mostly in negative connotation. Then, in the 1960s, the concept of moral hazard was picked up for study again in economics, but at the time it did not imply fraud or immoral behavior, but was a term to describe inefficiencies when risks are displaced.

Tuesday, December 30, 2008

Consumer Confidence

Consumer confidence fell to the lowest point since the 1990-91 recession. Consumers are pessimistic about the future. When there's no spending, there's no income and no production growth. Looks like aggregate demand will take another couple steps away from the road creating more unemployment.

Monday, December 29, 2008

Slippery Slope of Fiscal Policy

An increase in government spending increases the trade deficit and leads to a depreciation of the dollar. Government spending in excess of tax revenues means a growing budget deficit. Paul Krugman estimates the multiplier effect of the $700 billion package at 1.1. Of course, crowding out is a problem. See Wade Rousse for an excellent discussion on government spending. Also, fiscal policy suffers from lags and bad timing. Greg Mankiw reiterates what colleague, David Backus writes, “It’s the financial system, stupid” implying that the fiscal policy is misdirected. Fiscal policy is a slippery slope. I will aver that when the government intervenes, more is lost than is gained.

Sunday, December 28, 2008

Expectations and the Stock Market

"A well-functioning stock market will have unpredictable movements in stock prices." That quote from Oliver Blanchard's Macroeconomics, 2nd edition. After reading, A Random Walk Down Wall Street, I firmly believe in efficient markets. I don't believe that the stock market should be taught in high school as part of an economics class as students often use the closing price as the purchase price. This week, I have an interview with Mark Lofgren, Lofgren Investments, to discuss technical trading using Point and Figure charts. In this blog, I want to analyze HON Industries, HNI, from a fundamental view.
Using data from the MSN homepage, the closing price of HNI was $14.89 with the stock paying $0.215 quarterly dividends for a total dividend of $0.86 yearly. Assume that investors consider the return on bonds when investing in the stock market, then the arbitrage condition would be: $PV = (.89/1.0175) + (15/1.075)or $15.61. I used the 12-month CD rate from First National Bank of Muscatine and calculated the present value of the future payments. My calculations show that if the expected price is $15, then the stock is a value at $14.89.
I will meet with Mr. Lofgren on Tuesday and apply Point and Figure analysis to see if the value of HNI goes up this week to reflect future earnings.

Energy Independence

Can developing alternative fuels relieve tensions with Iran?
Say the US developes a substitute for oil that is clean, efficient, and cheap? Now Iran will have to rely on its own natural resources to survive. Comparative advantage tells us that a country cannot provide the same standard of living by producing all of the goods and services itself. A country that trades will have more benefits. So in the absence of petrol trade with Iran, they will immizerize like North Korea. My point is esoteric. The flow of dollars into Iran would almost stop and therefore halt nuclear development.
I believe that the Iranians are people just like us, and they do not want a war. But the unintended consequences of alternative fuel might be stopping the proliferation of nuclear bombs.

Saturday, December 27, 2008

Personal Income

The Bureau of Economic Analysis reports "Personal income decreased $20.7 billion, or 0.2 percent, and disposable personal income (DPI) decreased $11.8 billion, or 0.1 percent in November."
Consumption makes up about 70% of GDP and if consumers earn less income, then there's less to spend. Macro theory says that production equals income equals spending. Spending drives investment. If consumers are making less income, growth will slow. Since January, 2008, 2 million workers have lost jobs. Personal saving is up to 2.8% indicating that consumers are fearful of a long recession. According to Wachovia Economics Group, "The core PCE deflator, the Fed’s preferred measure of inflation, is now up 1.9 percent year-over-year."

Friday, December 26, 2008

How To Make A Credit Card

Wired has an excellent article on identity theft. To really scam a credit card would take over $10,000 in investment. The investment would be a machine to print the image of the credit card on the card, an embosser, a reader to print data on the magnetic strip, a fake drivers license, and the holographic foil. The ink to print directly on the cards has to be obtained in China. I'm sure a thief would spend time and money if he or she thought that the returns were greater. A thief also has to obtain valid credit card numbers from a black market.
I will say again, criminals heavily discount the future and prefer to have the money today instead of tomorrow. The present is so important today that those engaged in criminal activity only care about today.
You can read a story of one hacker on the Wired site here.

Thursday, December 25, 2008

On Happiness

Cuba Luddities

Does a new innovation increase or decrease unemployment?
An optimistic view is that new technology enables workers to produce more output with the same resources. A pessimistic view is that more can be produced with less workers. A Luddite is one who believes in the latter. In my interview with Dan Paca [hear the podcast on my blog] Dan saw numerous inefficiencies in Cuba where new equipment lay idle while labor completed the work by hand. Clearly, the Cubans see technology as a replacement for labor.
This argument is unconvincing in my opinion. If one looks at robots used in manufacturing, higher output and higher income. Higher income leads to higher output and more employment.
There can be some creative destruction where changes in infrastructure results in the loss of some jobs. As long as Cubans think that machines are a sub for labor, they will continue to toil in poverty.
Since Cuba is a Socialist state, there cannot be unemployment--is that right?

Tuesday, December 23, 2008

Fisher Effect

Plotted are the 3-month treasury bills versus the change in the CPI. Does the evidence support that nominal interest rate reflect changes in inflation rates? I think so. You can make graphs like this one too. I found the tools at the St. Louis FED and used the FRED graphs. The link is here.

Dan Paca

This is a link to the full audio interview with Dan. If you want to add me as a friend to Facebook, you can also find all of my Livescribe interviews under my profile on Facebook.
If you are a student who wants the best method of taking notes, I recommend the Livescribe pen as a Christmas present. If you are a teacher, this will save you hundreds of hours on make up work. Best wishes for a fulfilling Christmas.

Growth Accounting

Why do some countries grow faster than others? Let's use the aggregate production function to compare growth between countries. Assume a fictitious production function of: Y/L = A(K/L)^.5 This function states that income per person (Y/N) is equal to a technology coefficient (A) times the ratio of the square root of kapital to worker(K/L.
If everything else is equal, than the country with the highest level of technological progress will enjoy more income, GDP per capita.
Oliver Blanchard in his textbook, Macroeconomics, states that "..high output growth leads to high productivity growth, not the other way around. [page 254, Second ed. Marcoeconomics, Prentice-Hall.] Since the USA enjoys a higher output than Cuba, I conclude that the USA has a higher rate of technological growth and will be richer than Cuba in terms of goods and services produced.
Since Cuba has access to the same technologies as the US, perhaps the difference between the two countries is foreign trade. This video explores Cuba's tourism. [Note: Real Player required]

Sunday, December 21, 2008


Time writes, "Poor and isolated, Cuba is crumbling." [The Sound of Change, December 8, 2008, page 46.] In a photo caption in the same article, "A vintage taxi picks up passengers at the Hotel Nacional. The capital city's glut of old American Bel Airs, Corsairs and Corvairs has less to do with nostalgia than with the crippling economics of the U. S. Embargo." [ibid.] Yet, Cuba remains a mystery to macroeconomists on growth. Visitors to Cuba say that income is divided evenly, crime is low, and they feel safe while walking down the street.
Let's get a sense of Cuba's economy by comparing it to Iowa, population 3 million, 56square miles, per capita GDP $23,340 and a GDP of 124 billion.
Cuba has an area of 43,ooo square miles, population of 11 million, GDP of 125 Billion, and per capita GDP of $11,000.
In the next couple of days, I am going to interview Dan Paca who visited Cuba on Business. His comments are compelling and worth exploration. In the upcoming blogs I will examine the many institutions such as the legal system and the government. I also want to ask what institutions are needed to sustain growth. Your comments are welcome.

Saturday, December 20, 2008

Relative Prices of Food

Here's an argument I'd like to make. I'll argue that food is almost always relatively cheap. Say that there's only two goods that a country consumes--bread and cars. The price of bread is $1 a loaf and the price of a car is $20,000. If consumers buy a car, then they give up 20K loaves of bread. If consumers buy a loaf of bread, the relative cost is 1/20,000 of a car. Thus, food is relatively cheap. Food should always be cheaper even if the price of food increases. Consumers should be indifferent to the price of food.

A White Christmas

When consumers use a credit card, they are making the choice to consume now and give something up later--in this case Christmas. The choice to consume now comes at a cost and for this family, bankruptcy and no Christmas. The kids get hurt and that's wrong. It's sad that our choices have unintended consequences. This family is putting up a nice front.
In the US, 70% of GDP comes from consumption. With consumption spending down 1% over the past year, unemployment rate at 6.5%, and consumer prices up 4.1%, this Christmas will be a "white Christmas" since consumers will be buried under the white paper of bills and layoff notices.

Friday, December 19, 2008


Competition for Resources

Besides displaying incredible artwork, this toon depicts competition. Resources are scarce and thus there's competition for those resources. The price reflects the relative scarcity of oil in this toon and so the price should be high.

Thursday, December 18, 2008

Moral Hazard/Adverse Selection Lecture

Here's today's lecture in case you missed it. The link is here. This lecture made possible from a Pulse Livescribe pen. This technology is incredible.

Tuesday, December 16, 2008

Paradox of Choice

Freedom of choice results in analysis by paralysis. Do you think that occupations such as nurses are crowded by women because of choice? Self ordering lists result because of defined preferences. No law is going to change that more women than men will take classes in child care. Mr. Schwartz uses excellent cartoons to show opportunity cost among an array of choice.

Monday, December 15, 2008

Negative Real Interest Rates

Nominal rates minus expected rate of inflation equals the real interest rate. I've plotted countries using data from The Economist. Several countries have negative real rates. Who's going to lend money when they earn a negative return?

Moral Hazard

Tim Harford has an article on Slate here.

Sunday, December 14, 2008

Pumping Up

Hayleigh Yonish made this cartoon to show how the government needs to add liquidity to the market. Does her cartoon suggest that the government is big enough to accomplish this task? Does the government's presence infer crowding out, increase national debt, and a reduction in private savings?

Paul Krugman

Tim Schilling posted this link to Paul Krugman's speech. Mr. Schilling's site is a continual source of information on economics. See his link in my blogroll or click here.

Saturday, December 13, 2008

Market Failure

Adverse Selection happens when one party has information in a transaction that another party does not. A moral hazard occurs when a party changes behavior as a result of a prior action. An example of adverse selection is a smoker buying health insurance because he knows he'll need long term health care later. The classic example of moral hazard are seat belts since drivers drive more carelessly after they click it.

My third-hour class brainstormed some fun adverse selection and moral hazards. Can you guess which one from the list?

1. A swat team wears bullet-proof vests on a raid.
2. A student buys cell phone insurance with the intention of "losing it" when a better model comes along.
3. Juan hates his stereo so he leaves the car unlocked.
4. Rachel knows her grade will be an "A" in economics so she quits studying.
5. A Binks truck speeds to get to the Federal Reserve Bank in Chicago.

Thursday, December 11, 2008


Innovation is a state of mind. Benjamin Zander gives his views on the fertility of innovation as a catylst for growth. When a company innovates they create an idea that can be shared and changed into new products.

Tuesday, December 09, 2008

Solow Residual

The Solow Residual is found by taking output, Y, divided by Kapital ^.36*Labor^.64. I calculated growth rates in income, capital, labor, and total factor productivity. My data finds that Kapital contributes the most to output and technological progress contributes the least. I was surprised to find that technology contributed the least as I thought technology was powering growth and not capital accumulation. Of course, one can always attack the metric, but I think the exogenous changes in energy might have caused the slow growth. As I have been saying, technology is slow to diffuse as people use new technology in old ways. As Robert Solow said, "Technology shows up every where but in the statistics." to view the data, click on the picture to enlarge it.

Ben Zander on the Art of Possibility

This is so inspiring.

Monday, December 08, 2008

Sunday, December 07, 2008

Diffusion of Technology

Do you Google?

Last year, 1,000,000 people learned how to use Google to search for information. The Internet has been around for a long time, yet users are just beginning to understand the tool. When computers were first introduced into the schools, the first use was as a gaming system. Users continued to use new technology in old ways. Now, some 20 years after the Internet is widely available, users are shopping online, sharing information on YouTube, learning how to search for information, and earning a masters degree. When a new technology is introduced, it takes years for the technology to diffuse and become a springboard for new products. I'll even go as far as to say that after technology has been diffused, technology is used in ways never intended by the inventor. For example, think of all the ways the Model T has been changed and all of the uses of a car besides basic transportation.

Now look at how long it takes the automotive industry to adopt new technology. Fuel cell, electric, hybrid, pollution controls, and green technology are all slow to show up in 2009 cars. As early as 1960, society's attitude toward adopting new technology was researched by Everett Rogers. The Bass Diffusion Model used to forecast in marketing is here.

Saturday, December 06, 2008

On General Theory

John Maynard Keynes wrote in General Theory of Employment, Interest, and Money, that "The wage is equal to the marginal product of labour" (See postulate I, Chapter 2. Click here to see the Chapter.) I used the Solow production function to show how an increase in the price level, P, would increase employment as shown on te graph as a movement from 1 to 2. Likewise, a decrease in the price level will cause employers to hire less as shown by point 3. The CPI has fallen while the economy lost over 5oo,000 jobs in November. Total job loss is 1.9 million since January 1, 2008. There are plenty more dynamics than just workers being paid their marginal product, but the theory is consistent with what I'm observing in the economy.


Kyle Allgood drew this cartoon of me as a warm up for our lecture on factor markets. Each student has a whiteboard in my class to interact with me.

Friday, December 05, 2008

Due Process

Cheerleaders suspended for naked photos. See Fox and Friends.

Growth Data

The recession will penetrate through next year according to this forecast from IMF Chief, Oliver Blanchard. His full speech delivered in Munich is here.

Wednesday, December 03, 2008

Wage Rigidity Across Countries

Oliver Blanchard, in his macroeconomics textbook computed Okun's law coefficients across countries based on employment fluctuations. This is this data where B, beta, represents how firms adjust to changes in employment. The coefficient captures the internal organization of the firm and legal and social conventions . A low coefficient means high job security. The US = .42; UK = .51; Germany = .32; and Japan = .20. It should be noted that job security in Japan has lessened since the 1970's.

Deflationary Spiral

Two weeks ago I visited Flowers on the Avenue to buy a dozen roses for my wife. All fall silks were on sale for 50% off. I knew if I waited a week, the silks would be 75% off the following week. so I saved my money and waited a week. That's how a deflationary spiral begins. If prices fall, then wages will fall. The spiral will find a bottom some time after millions have lost their jobs and incomes have fallen. The costs of borrowing increase since debtors are repaying loans with dearer dollars. A graph is here along with a tutorial.

Monday, December 01, 2008

Recession Officially

The NBER has declared 2007 the start of the latest recession. Unemployment was the main reason cited for the declaration. The unemployment rate of 6.5% shows that the economy is producing less that the full employment GDP. Consistent with the model, prices have fallen to 214.935 a full .1% from August 2008. When employment drops, many other macro stats follow. New Orders for Manufactured Goods, New Orders for Manufactured Durable Goods, Business Inventories, Retail Sales, Producer Price Index for Finished Goods,Wholesale Inventories, Housing Starts are all down. Given the wage rigidity of contracts that will expire in the future, wages will be slow to adjust. We are going to be in this recession a long time.