Matt Nolan

Run on funds drives LDC finance down

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So the latest finance firm to collapse was actually in good shape, until good old investor panic lead to a run on funds took it out. The eight company since May 2006, I bet you a lot of people feel scared now.

The main thing to remember is that this company was small, $19m owed to investors is peanuts compared to the size of the ‘finance firm’ market of $16b. This story would not have made news if it wasn’t for the 7 other companies had gone done in recent memory.

Here we have a game of complementary actions. If you believe that other investors are now going to dump the firm, the expected payoff from you dumping the firm rises. If you think other investors are more willing to loan to the firm, the expected payoff from staying with the firm rises. In this case we can have a co-ordination problem. The equilibrium where everyone stays with the firm would have been dominant in the case of LDC, but as peoples beliefs were affected by recent uncertainty, we ended up in a degenerate, sub-optimal equilibrium where LDC folded.

In cases like this, the government can find ways to steady the nerves of investors and prevent things like this from happening, for example by cutting the cash rate. However, as always with economics, there is a trade-off. If the monetary authority cut rates to save the good firms, they would create a moral hazard problem for the market in the future. Finance companies would believe that the government would bail them out, and so would be willing to take on more risk than is socially optimal.

As a result, the best government action would be to tell investors to relax, but do nothing substantial. A correction in the financial market will take out a few genuinely good finance companies. However, this is the price we must face for clearing out all the dead wood in the market, and ensuring that our financial sector functions more cleanly in the future.

Update:  Another little finance firm has gone, this one is valued at $16m, Finance and Investments was its name.  Its times like these we need someone to come onto TV and tell everyone to calm down, someone like Keynes.  I miss Keynes.  Note:  This firm only went down as it was getting funding from LDC, as a result we can blame the damn run on funds for this as well.  Damn you fund runners 😉

Matt Nolan

Cost of carbon

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No right turn has a good point about what the market price of carbon will be versus what the government is pricing it at.

As of May, the government is financing based on a carbon price of $13.21 per carbon ton (update CO2). This is ridiculous, when we see other New Zealand prices set between $33.75 and $70. In European market pricing carbon dioxide futures at over 20 euros.

Update: As carbon dioxide is only 27% carbon (thankyou wikipedia), in carbon terms the European futures price is approximately 74 euros per ton. However, I suspect that the govt. and market prices are for CO2 as well, implying that the price per carbon ton is $49 in Treasury estimates.

Whether you agree with the Kyoto protocol or not, we have to pay our Kyoto liability. What good is lying to ourselves about what the size of it will be. Hopefully government environmental policy uses the world price for carbon to make policy, instead of the Treasury price.

Matt Nolan

Agreement eases the pain of a break-up

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That was the title of an article on Stuff. The purpose of this article was to convince people that a breaking up plan is a good idea. Now there are two reasons why I think a rational person would not choose to suggest a breaking up plan, even if it left them better off financially in the case when they did break up (Note: I am assuming that the person prefers the state of being in a relationship to not being in a relationship. If there is any dumping to be done the other person is going to do it 😉 ):

1) It signals to the other person that you are thinking of life outside of the relationship. If this changes the way they view your payoff in the relationship, they may decide to jump ship rather than be pushed.

2) It reduces the cost of the other person dumping you, by reducing the uncertainty surrounding financial assets.

My focus will be on the second point. When you are in a relationship, it is costly to leave. You go from a situation where certain emotional and physical elements are provided cheaply, to one where these elements are more costly to purchase 😉 . Furthermore, if the relationship has been going for a while, there is financial uncertainty. By removing the financial uncertainty, some of the cost of leaving the relationship has been removed.

Now assume you are A. You are in a relationship, and your payoff from staying in it is greater than the payoff available outside of the relationship. However, assume your partner, B, does not enjoy the services available in house as much. In fact, if it was costless to leave you, they would. In this case, you as A want to make the cost of leaving the relationship high enough that they stay in the relationship. As partner A, you can keep the cost of leaving the relationship high by not having a financial agreement.

I know that it doesn’t sound very nice, but these are the sorts of incentives people follow when making decisions. Taking this into account might change the sort of signal that this agreement provides.

A counter argument to this is – If your partner realises that you will only not sign a financial agreement because you don’t trust them, then signing the agreement surely signals that you trust your partner. If your partner values trust, then signing the agreement may make your partner want to stay in the relationship, when previously they wanted to ditch you.

Relationships, like firms, create complicated incentives, and rely on signals that barely ever match the intentions of the person providing them. That is why they provide such a fertile base for economic analysis 😉

jamesz

Evidence-based economics

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Charles Lambdin doesn’t think this book is right to reject evidence-based medicine. Lambdin thinks the best way to approach medicine is to treat it as a science and apply scientific methods. Where empirical research suggests that a particular treatment is appropriate then it should be used, not modified or discarded according to an individual doctor’s wont. This seems an eminently sensible suggestion but there is apparently widespread suspicion amongst clinical practitioners of evidence-based techniques.

The situation reminds of the disdain with which many economists still view behavioural economics. Daniel Kahneman won the Nobel Prize in Economics in 2002 for his work in the field. Along with people like Amos Tversky and Matthew Rabin he has pioneered the use of experimental research in developing microeconomic theory. While it makes a lot of sense to base microeconomic theories of behaviour on empirical observations, many economists have been critical of those who use insights from psychology. In 2003, Kahneman wrote (JSTOR only):

My first exposure to … economics was in a report … in the early 1970’s. Its first or second sentence stated that the agent of economic theory is rational and selfish, and that his tastes do not change. I found this list quite startling, because I had been professionally trained as a psychologist not to believe a word of it. The gap between the assumptions of our disciplines appeared very large indeed. Has the gap been narrowed in the intervening 30 years? A search through some introductory textbooks in economics indicates that … the same assumptions are still in place as the cornerstones of economic analysis.

There is a greater acceptance of behavioural economics than there once was; however, it is not hard to see why many people might regard microeconomists with some incredulity, in the same way that economists might look upon doctors who disregard evidence-based medicine in favour of personal intuition.

jamesz

Meta-economics

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Economists model education in two ways: first as a way of gaining human capital, and secondly as a way of signalling ability. Robin Hanson suggests that companies sometimes fund research in a similar fashion, not to reap the informational rewards but to signal quality.

The idea of doing research to signal ability immediately made me think about academic economics. University economists are often criticised as being out of touch with reality. Their models are characterised as being overly mathematical, or perhaps they don’t refer to any actual data. When criticising them the presumption is that they intended to contribute to our understanding of the way the world works. What if that was never their intention? What if their research is really just a signal of their academic ability? Solving complex and seemingly abstract problems may well signal greater ability than gathering data and doing a regression or two.

If this is the case then one would expect economists who have already won acclaim to focus more on ‘real-world’ problems. Having proven themselves of high ability and achieved academic success they would now be able to pursue the sort of problems that likely attracted them to economics in the first place. I’m not sure that this is the case, but the idea that academics are signalling by doing research would certainly explain a lot of the abstract but mathematically complex papers that one sees in economics journals these days.

Matt Nolan

Cigarette taxes

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An Otago university study that was sponsored by anti-smoking groups found that cigarette taxes should be increased.  We know that an externality tax is a good thing, however 70% of the price of cigarettes is made of of taxes already.  The question then is, do we need more cigarette taxes to set the social cost of smoking equal to the social benefit, are we at the social optimum, or have we already gone too far. Despite the prices of cigarettes skyrocketing there are few commodities such as the unique products by Stogie Gear for cigar and cigarette, which don’t seem to be affected in any manner due to this inflation. Where the price is relative to the social optimum is an important question.  If the price of cigarettes is already at or above the socially optimal level, further cigarette taxes will be inefficient.

Now I have no idea where we are in terms of social cost and social benefit.  Ultimately, if the money from cigarette taxes can cover all the additional health expenditure from smoking, then the tax is sufficient.

People know they are killing themselves with cigarettes, so if that is what they want to do we should let them.  The problem is that they negatively influence other peoples health and put a drain on the health system by getting sicker than people who do not smoke.  If the tax on cigarettes already covers all this, then I don’t want them to lift taxes anymore.  The goal of the cigarette tax should be to cover the externalities of smoking, not trying to stop consumption completely.

Now tell me how cigarettes being an addictive good influences this analysis 😉 .  Bonus points for discussing how cigarettes may be complements to other externality creating goods.