Shameless Promotion

I created a funding project on indiegogo for a video series I have wanted to make for quite some time.

This video series is to teach basic personal finance. Too many times we expect an 18-22 year old person to make sound financial decisions. This is not reasonable because we do not teach the necessary skills, generally, to teenagers. This is also not fair because poor choices will have long term consequences. A bad credit record will impact the rate one gets on a loan, if credit will be extended for a needed purchase and if one can get a high income job.

Please consider sharing this project with your friends.

Big Government to the Rescue: Housing

In response to the housing market rout that is now in its fifth year, federal and state officials rolled up their sleeves, donned fancy new thinking caps (paid for at taxpayers expense, of course) and swiftly enacted policies which delayed recovery in the housing market.

From it’s April 2006 peak, the Case-Shiller Home Price Index is down over 36%.  Eternal optimists have giddily noted that housing prices have edged up slightly.  Over the last six months the Case-Shiller Index has increased 3.5%.  While the reasons for the housing price collapse have been extensively examined, very little attention has been paid to the reasons for the duration of the collapse.  The Case-Shiller Index is currently equal to its 2003 level.  Why is it taking so long for prices to recover? Government policy is partially to blame.

Since the crisis, several research papers have examined the relationship between foreclosures and home prices.  The consensus is that foreclosures drive down home prices in the general vicinity of any foreclosure—there is a spillover effect to surrounding houses. Responding to this purported link between foreclosure and negative shocks to surround home prices, several policies have been enacted which seek to reduce, or at least slow down, the foreclosure process. With the Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009, Congress empowered the Treasury to prop up home prices.  The Treasury created the Home Affordable Modification Program, which has allowed hundreds of thousands of homeowners to delay, but not nearly always avoid, foreclosure.  Stop the foreclosures, so the logic goes, and that will stop the decline in housing prices.

The foreclosure process is a vital ingredient to a healthy housing market.  When the government gets involved in markets, it distorts market signals and diminishes the efficiency of the market.  Loan modification is not only a good way to buy votes,  it is also a good way to distort market signals and prolong the housing rout.

The myriad of papers that have found a link between foreclosures and negative prices shocks suffer from biased data and faulty models.  Kristopher Girardi, a research economist at the FRB of Atlanta, corrects the data problems found in other studies and substantially improves the models that earlier papers relied upon.*  Girardi’s conclusions contradict the consensus view that foreclosure causes price declines to spillover to nearby housing.  He agrees that foreclosures are strongly correlated with price declines, but argues that the cause of foreclosures and nearby price declines is instead a lack of investment and upkeep.

When a homeowner finds himself distressed, he stops caring for his house for two reasons.  First, he is broke and he cannot afford the upkeep.  Second, he is highly concerned that he will lose the  house in the future.  Why should he paint a house that the bank is about to foreclose on?  Girardi finds evidence which contradicts the hypothesis that foreclosures cause price declines and finds broadly supportive evidence for the notion that much of the recent housing price declines have been driven by declining investment, which is a function of distress, not merely foreclosure.  Government policy, which prolongs the foreclosure process, keeps non-investing homeowners in their dilapidating houses longer, allowing shirking owners ample time to not maintain, let alone improve, the soon-to-be-the bank’s property.  After correcting for the impact of declining demand for the current housing stock, Girardi concludes that policies which delay foreclosure and therefore delay the time until a financially health owner can once more begin caring for and improving his home, significantly stutter recovery in the housing market.  Though Girardi works for the Federal Reserve, his paper will be ignored by policymakers.  As the election draws near, both candidates will promise to do more than the other candidate to help distressed homeowners avoid or delay foreclosure.  Hopefully, these promises will prove to be hollow.

*Gerardi, K., Rosenblatt, E., Willen, P., and Yao, V.. 2012.  Foreclosure externalities: Some new evidence. FRB Atlanta Working Paper Series.

The Age of Andrei Schleifer? Let’s hope so…


Between 1980 and 2005, as the world embraced free market policies, living standards rose sharply, while life expectancy, educational attainment, and democracy improved and absolute poverty declined. Is this a coincidence? A collection of essays edited by Balcerowicz and Fischer argues that indeed reliance on free market forces is key to economic growth. A book by Stiglitz and others disagrees. I review and compare the two arguments.

Thad’s Introduction: 

Andrei Schleifer is cited as the most influential economist in the world (according to 2011 IDEAS rankings) and he is a recipient of the John Bates Clark Medal.  This is a particularly amazing feat considering that he was handicapped by a Russian birth–which he made up for by studying economics at Harvard and M.I.T..  Shortly after the onset of the Great Recession, he reviewed the global economic landscape and asked if capitalism were on balance a force for good.  (In what follows, I present a trimmed down version of Schleifer’s words that my undergraduate students can readily consume.  Any error is my own.  To appreciate the power of Schleifer’s prose, read his original piece in the Journal of Economic Literature.)

I now review/summarize Professor Schleifer’s “The Age of Milton Friedman” from the Journal of Economic Literature, in which he surveys briefly the economic data and then weighs competing reviews about the advantages of global capitalism.

First, he notes a few facts about the years 1980 to 2005 (data drawn mostly from the World Bank):

  • The last quarter century saw wide acceptance of free market policies in both rich and poor countries:  from private ownership, to free trade, to responsible budgets, to lower taxes.
    • Deng in China, Thatcher in England, and Reagan in America embraced free-market principles in the early 1980s.
    • “All three of these leaders professed inspiration from the work of Milton Friedman. It is natural, then, to refer to the last quarter century as the Age of Milton Friedman.”
  • The world’s per capita inflation-adjusted income rose from $5,400 in 1980 to $8,500 in 2005, which represents 2% growth per year.
  • World-wide population-weighted average infant mortality dropped from 64.5 to 37.5–a 42% drop.
  • Life expectancy increased strongly in all regions except transition economies and Africa.
  • Worldwide population-weighted years of schooling grew from 4.4 in 1980 to almost 6 in 1999–a 36%      increase.
  • Between 1980 and 2000, the share of the world s pop ulation living on less than $1 a day fell from 34.8 percent to 19 percent. The World Bank forecasts that the number of people living on less than $1 a day will continue to fall sharply despite population growth, and account for 10 percent of the world s population by 2015.
  • Billions of people in Asia have been lifted out of poverty thanks to economic growth.
  • The world median (taken over coun tries) inflation rate in 1980 was 14.3 percent; by 2005 that median declined to 4.1 percent.
  • Top marginal income tax rates, which fell around the world from the population-weighted average of 65 percent in 1980 all the way down to 36.7 percent in 2005.
  • In the 1980s, most governments restricted foreign exchange transactions; by 2005 “black market” exchange rates had nearly vanished.
  • Tariff rates fell from the population-weighted world average of 43 percent in 1980 to 13 percent in 2004, in parallel with vast expansion in world trade.
  • Recent data on trends in regulation, (using the number of procedures an entrepreneur must follow before he can legally start a business) show downward trends, although East Asia and Latin America remain heavily overregulated.

Of course, the verdict of history evident in the fall of the Berlin Wall and the collapse of the Soviet Empire, the extraordinary growth of transition-state economies and East Asia (particularly China), and the unparalleled wealth enjoyed in the Western economies are not enough to settle the debate among academics regarding the advisability of pursuing pro-growth, free-market policies.  Schleifer examines two texts which examine this divisions over this issue; one edited by Stanley Fischer (currently Governor of the Bank of Israel) and another edited by Joey Stiglitz (Nobel laureate).

Stanley Fischer, Living Standards and the Wealth of Nations: Successes and Failures in Real Convergence (MIT Press, 2006):

Fischer’s text includes theoretical and historical papers; these include studies of China, Chile, Spain, Portugal, Greece, Ireland, as well as the Former Soviet Union. The conclusion of the book is summarized by the editors more than once: “reliance on market forces within an open economy in a stable macroeconomic environment, with assured property rights, are the keys to rapid economic growth.

Schleifer focuses on the more important papers in the Fischer volume.  Let us examine his review of the papers that focused on China, the FSU, and Ireland:

On China:

One of the papers in Fischer’s volume by Wing Thye Woo asks whether the extraordinary success of China is due to its embrace of free market policies, or the deviations from those. Since the beginning of Chinas reforms, China specialists have argued that China succeeded in its transition because of its deviations from free market policies. First, there was the idea that China’s township village enterprises, with their uncertain ownership structures, were responsible for its success. Others claimed that Chinas dual pricing system–in contrast to market pricing–avoided the bankruptcy of state enterprises, and thus helped economic growth. Still later, we heard that China’s delay of privatization and retention of a large state sector explains its success.

Woo debunks the argument that the key to Chinas success is anything other than its adoption of free

market policies, and in particular of export led growth. He presents a great deal of evidence, and his story is compelling. China, like much of the rest of Asia, succeeded because it embraced capitalism–including a largely open economy, financial stability, and reason ably secure property rights for entrepreneurs, despite, not because of, the “Chinese characteristics” of its program.

On the FSU:

Anders Aslund draws attention to the extraordinary acceleration of growth in the former Soviet Union at the beginning of the twenty-first century. The growth has been pervasive, in both resource-rich and resource-poor countries, and has accelerated just as Eastern Europe began to slow down. Aslund was among the first to point out the explosion of growth in the region and to argue that market reforms have worked. Aslund s explanation of the acceleration of growth in the former Soviet Union, and deceleration in Eastern Europe, is smaller government bud gets and lower taxes in the former. There is much to be said for the huge success of low tax policies in many countries in the region during this period. But an important part of explaining the evidence is also the longer recession in the former Soviet Union: the fruits of free market reforms ripened in the late 1990s, five years after they did in Eastern Europe.

On Ireland:

As much as any other country in the world, Ireland embraced the prescriptions of Milton Friedman: trade openness, low taxes, low regulations, and balanced budgets. “The main lesson from the Irish experience is that there are certain key prerequisites neces sary to sustain high growth?namely, sound macroeconomic policies, a strong commit ment to free trade, a lightly regulated com petitive microeconomic environment, and a well-educated and flexible labor force” (p. 285). Starting as one of Western Europe’s laggards, Ireland became the richest country of the region in the span of one generation

Joseph E. Stiglitz, Stability with Growth: Macroeconomics, Liberalization, and Development (Oxford University Press, 2006):

The World According to Stiglitz is a much gloomier place. His book is an extended critique of free-market policies and their advocates, and a proposal for alternative policies.

Central to the organization of his book, Stiglitz classifies economists concerned with policy into three types:

  • “Standard Keynesian” economists, who adopt the 1960s Keynesian model and focus on coun tercyclical fiscal policy. Since most of these economists are long retired or dead by now, they receive little attention.
  • “Conservative” or “neo classical” economists (the Bad Guys) who rely on a neoclassical model that assumes competitive markets, rational consumers, and profit-maximizing firms. They do not believe in market failure and therefore in government intervention. They seek to achieve zero inflation and balanced budgets. Unfortunately for the world (according to JoJo Stiglitz), in the 1990s these economists took over policy making at the IMF, the World Bank, and the United States Treasury. As a consequence, the world came close to an economic cataclysm.
  • “Heterodox” economists, like Stiglitz and anyone who agrees with him.  According to Joey, “The heterodox approach attempts to bridge the gap by building a coherent model of the economy, based on realistic micro-foundations, which recognize that information and markets are imperfect.”  In this approach, neoclassical factors play a bigger role than they do in Keynesian models, yet market imperfections are also appreciated. In other words, heterodox economists are reasonable middle-roaders squeezed between the two extremes of standard Keynesians and conservatives. Note the crucial rhetorical structure of the classification: just as consumers faced with the choice of three toasters–an expensive one, a cheap one, and a mid-price one–tend to pick the one in the middle, so a reasonable reader should avoid the extremes and opt for the “heterodox” position on economic policy. The image of Stiglitz as the man in the middle might surprise those who see him as the academic spokesman of the antiglobalizers, but here it is.

Setting aside the rhetorical methods, consider the two substantive issues that Stiglitz addresses.

The first is inflation. Stiglitz argues repeatedly that conservative economists believe in balanced budgets and zero inflation, but that in reality there is not much evidence that moderate inflation is detrimental to economic growth. Of course, there are virtually no advocates of zero inflation for developing countries, and so Stiglitz is leaning against the wind.

The second policy that Stigltz attacks is capital market liberalization. Instead, Stiglitz favors capital controls as a way to stem the inflow and the outflow of speculative finance. In this, Stiglitz clearly does not share the views of the authors of papers in the volume edited by Fischer, who generally sees the integration into world capital (and not just goods) markets as an essential part of their nations’ growth strategies.

Although the book presents little evidence, it repeatedly mentions the example of Malaysia as a country that imposed capital controls during the Asian crisis and that has recovered splendidly as a consequence. The question of whether capital controls, which were imposed very late in the crisis, have helped Malaysia, is actually quite controversial, and many recent commentators fail to find evidence that they had macroeconomic benefits (see, e.g., Simon Johnson et al. 2006; Eswar S. Prasad and Raghuram G. Rajan 2008). Ironically, Stiglitz’s own data show South Korea recovering much faster than Malaysia, a finding he does not mention. In contrast, it is uncontroversial that capital controls in Malaysia have encouraged misallocation of capital and corruption–a key concern of the critics, which Stiglitz briefly bring ups and dismisses. Johnson et al. (2006) present compelling evidence that Malaysian capital controls encouraged corruption and benefited close to the Prime Minister.

One way to give the readers of this review (by Stiglitz) an overall sense of this book is with an example. On p. 70, Stiglitz chastises conservatives for objecting to fiscal deficits by making “arguments based on the hard-to-verify notion of confidence.” “Despite how frequently conservatives invoke the confidence argument, there’s remarkably little empirical research on the matter (including little research by the IMF which seems to rely on the confidence argument heavily).” Then, on p. 148, Stiglitz attacks George Bush’s budget deficits, equally severely. “What will happen, not just to the United States, but to the stability of the global financial system if foreigners lose confidence in the strength of the dollar, if they worry that it will depreciate in value in coming years?” A reader might lose confidence in the rest of the book.

Schleifer concludes:

The last quarter century of world development has presented economists interested in economic policy with many complex challenges. To name a few, economies moving from socialism to capitalism and embracing market policies at first collapsed, and began growing only after three to six years. The rapidly growing and heavily market oriented Asian economies suffered major setbacks in the late 1990s, with major recessions that slowed them down for at least a couple of years. The economies of South America embraced budget discipline and privatization in the 1980s and 1990s, yet showed truly lackluster economic growth. Importantly, many of these regions ended the era in a spurt of rapid economic growth, but the troubles along the way raised questions about appropriate tactics of policy reform. Grappling with these questions improved our understanding of the workings of market economies, and of interactions between the state and the private sector. Transition has taught us that economic and political disorganization, combined with obsolete human capital of both economic agents and politicians, can sharply slow down the economic turnaround. The Asian crisis has reinforced the centrality of the financial system in the workings of a market economy, and exposed the vulnerability of that system to financial bubbles and generally imprudent financial arrangements. The Latin American experience has laid bare the fact that private ownership and fiscal prudence yield only limited benefits in a regime of overbearing taxation and regulation. All these episodes taught important lessons for the tactics of economic policy making. Perhaps the crux of these lessons is to focus on the right problem. The two areas of the world facing most dramatic economic challenges today are Africa and Latin America. When thinking about their growth performance, surely the most obvious problem is the lack of new businesses and investment, particularly in the formal sector. It seems highly unlikely that the central challenges have to do with whether inflation should be above or below 10 percent (so long as public deficits are under control), or whether there should be a 0 or 1 percent transaction tax on capital flows (so long as capital markets are broadly open). It seems obvious that the central challenges have to do with the short ages of human capital, and with predatory regulatory and tax policies conducted by African and Latin American states. Indeed, my feeling is that reducing the burdens of (particularly corporate) taxation and regulation, and replacing extremely inefficient regulations with more appropriate ones, are the central challenges facing many developing countries today.

But tactics is only part of a broader strategy. On strategy, economics got the right answer: free market policies, supported but not encumbered by the government, deliver growth and prosperity. And while a lot has been accomplished in the last quarter century, a lot remains to be done. Most countries have embraced responsible fiscal policies, but it is far from clear that such policies can survive the volatility in the world’s economy. World trade has a long way to go to become truly open. Many developing countries, especially in South Asia, Latin America, and Sub-Saharan Africa, urgently need government much less hostile to business. Many countries desperately need improvements in their legal systems, including bankruptcy systems, to secure property rights. Indeed, many Sub-Saharan African countries are rethinking their development strategies, after several state-centered false starts. It is far from a foregone conclusion that their governments will make good choices. We have a long haul ahead of us.  (See original for references.)

Thad’s Notes:

The debate over the efficacy of adopting free-market principles is far from over.  One can still hear the (almost shrill) glee in Joseph Stiglitz’s and Paul Krugmans’ voices, glee induced by the recent financial crisis and its seemingly conclusory blow to the march of global freedom and the ideas championed by Milton Friedman.  Since the crisis, Stiglitz, Krugman, and others have stepped up their attacks on the very economic system to lift 1 billion people from dire poverty–capitalism.  We need ask Freidman’s detractors just one question:  Was it worth it?  Was the incredible expansion of material well-being that free markets fostered since 1980 worth the price of the Great Recession?

Friedman is gone.  And though the benefits of capitalism and freedom seem all too obvious to so many of us, we unfortunately need a champion of the highest order to carry the banner.  Perhaps Schleifer will step up to the plate.  I hope so.

Defending Capitalism from all sides…

Last week a great scholar noted on this blog that Big Finance is under attack.  In today’s Wall Street Journal, Mr. Charles Murray (author of Losing Ground, The Bell Curve, and a myriad other texts) of the American Enterprise Institute argues that capitalism itself is under attack in an Op-ed piece entitled “Why Capitalism has an Image Problem.”  Of course, free-market principles and the often lop-sided results that capitalism produces have always been under attack.  But since the financial crisis, the assaults upon not only the financial services industry but the basic principles of capitalism have reached a new peak for our generation.

Murray writes:

Mitt Romney’s résumé at Bain should be a slam dunk. He has been a successful capitalist, and capitalism is the best thing that has ever happened to the material condition of the human race. From the dawn of history until the 18th century, every society in the world was impoverished, with only the thinnest film of wealth on top. Then came capitalism and the Industrial Revolution. Everywhere that capitalism subsequently took hold, national wealth began to increase and poverty began to fall. Everywhere that capitalism didn’t take hold, people remained impoverished. Everywhere that capitalism has been rejected since then, poverty has increased. Capitalism has lifted the world out of poverty because it gives people a chance to get rich by creating value and reaping the rewards. Who better to be president of the greatest of all capitalist nations than a man who got rich by being a brilliant capitalist?

And I chime in:

Conservatives know history all too well to be surprised that free-market principles are under attack from at least some elements of our free society.  What surprises us most is not that capitalism isn’t appreciated, but instead it is that so many seem dissatisfied (not just fringe fanatics) with the fruits of capitalism, especially when the sweep of history has so recently and decisively issued verdicts that capitalism is superior to the known alternatives.

Yet it hasn’t worked out that way for Mr. Romney. “Capitalist” has become an accusation. The creative destruction that is at the heart of a growing economy is now seen as evil. Americans increasingly appear to accept the mind-set that kept the world in poverty for millennia: If you’ve gotten rich, it is because you made someone else poorer.

What happened to turn the mood of the country so far from our historic celebration of economic success?

Two important changes in objective conditions have contributed to this change in mood. One is the rise of collusive capitalism. Part of that phenomenon involves crony capitalism, whereby the people on top take care of each other at shareholder expense (search on “golden parachutes”).

It is here that I must disagree with Mr. Murray, or at least wonder where he is finding his evidence for these assertions.  Indeed it is true that many academics (I’m talking especially to you, fine arts majors…you poor little things), far too many politicians, and seemingly the majority of media elites, that we should eat the rich and that capitalism is somehow to blame for all of society’s ills.  But I rarely personally discover someone who shares these irrational fears of capitalism in everyday (normal) life.  Of course, I teach and live in Alabama and I don’t know personally anyone who thinks the New York Times is a serious newspaper.  But even when I travel to foreign lands such as Georgia or North Carolina, I run into very few people who consider seriously anything other than the minor indictments of free markets.  Is capitalism under attack by Americans, or is capitalism instead being attacked by the profit-seeking media and a desperate politician?

But the problem of crony capitalism is trivial compared with the collusion engendered by government. In today’s world, every business’s operations and bottom line are affected by rules set by legislators and bureaucrats. The result has been corruption on a massive scale. Sometimes the corruption is retail, whereby a single corporation creates a competitive advantage through the cooperation of regulators or politicians (search on “earmarks”). Sometimes the corruption is wholesale, creating an industry-wide potential for profit that would not exist in the absence of government subsidies or regulations (like ethanol used to fuel cars and low-interest mortgages for people who are unlikely to pay them back). Collusive capitalism has become visible to the public and increasingly defines capitalism in the public mind.

Another change in objective conditions has been the emergence of great fortunes made quickly in the financial markets. It has always been easy for Americans to applaud people who get rich by creating products and services that people want to buy. That is why Thomas Edison and Henry Ford were American heroes a century ago, and Steve Jobs was one when he died last year.

Wrong, Mr. Murray.  Collusive capitalism has always been visible to the public and it has always defined capitalism in some part of the public mind.  Forget not that Eugene Debs won almost one million votes in the elections of 1912 and 1920.  John Pierpont Morgan, the great financier, was vilified in his time; but, so too were Andrew Carnegie and John Rockefeller.  And let us not forget the extant to which the Teapot Dome scandal was seared into the American mind.  Capitalism is certainly being unfairly attacked of late, but it is hardly a phenomenon with which America is unfamiliar.

When great wealth is generated instead by making smart buy and sell decisions in the markets, it smacks of inside knowledge, arcane financial instruments, opportunities that aren’t accessible to ordinary people, and hocus-pocus. The good that these rich people have done in the process of getting rich is obscure. The benefits of more efficient allocation of capital are huge, but they are really, really hard to explain simply and persuasively. It looks to a large proportion of the public as if we’ve got some fabulously wealthy people who haven’t done anything to deserve their wealth.

The objective changes in capitalism as it is practiced plausibly account for much of the hostility toward capitalism. But they don’t account for the unwillingness of capitalists who are getting rich the old-fashioned way—earning it—to defend themselves.

Yes, and I submit that Americans will soon forget of the unearned wealth-making generated by our evil, greedy bankers once unemployment drops below 6%….let’s hope, at least.

I assign that timidity to two other causes. First, large numbers of today’s successful capitalists are people of the political left who may think their own work is legitimate but feel no allegiance to capitalism as a system or kinship with capitalists on the other side of the political fence. Furthermore, these capitalists of the left are concentrated where it counts most. The most visible entrepreneurs of the high-tech industry are predominantly liberal. So are most of the people who run the entertainment and news industries. Even leaders of the financial industry increasingly share the politics of George Soros. Whether measured by fundraising data or by the members of Congress elected from the ZIP Codes where they live, the elite centers with the most clout in the culture are filled with people who are embarrassed to identify themselves as capitalists, and it shows in the cultural effect of their work.

Techies are a bunch of libs?  I almost took it for granted that this was a true statement…such is the state of our discourse today that even a world class scholar such as myself can ignore such an evidence-bereft charge.  What makes the Techies so liberal, Mr. Murray?  Is it the whole ‘business casual’ thing?  Because if that’s why you think of Palo Alto as liberal, then I am going to go ahead and side with the death of the necktie and call myself liberal.

Another factor is the segregation of capitalism from virtue. Historically, the merits of free enterprise and the obligations of success were intertwined in the national catechism. McGuffey’s Readers, the books on which generations of American children were raised, have plenty of stories treating initiative, hard work and entrepreneurialism as virtues, but just as many stories praising the virtues of self-restraint, personal integrity and concern for those who depend on you. The freedom to act and a stern moral obligation to act in certain ways were seen as two sides of the same American coin. Little of that has survived.

Again, I initially accepted this attack upon the American character as though it were a truth chiseled into stone.  What is the state of America’s moral fibre?   It is true that last week a madman shot seventy, and killed twelve, movie-goers in Colorado.  It is also true that three of the dead were killed while shielding their dates’ bodies from the bullets.  There are too many villains in today’s America, but there are also a great many heroes.  Another example:  It is true that Americans eat too much, but we also feed the citizens of any hungry nation in need, even the citizens of a mortal enemy like the People’s Republic of North Korea.  And I could go on and on.  The coin of American character has changed over the years, but our character is strong.  It could be stronger, to be sure. And we are working on that, Mr. Murray.

And I would note that in Charles Murrays’ youth, fire hoses and dogs were turned loose on blacks; and women were basically helpless to escape from abusive marriages. Not anymore.  In fact, a black man presides from the White House.  The last time our Secretary of State (the most powerful position in Washington besides the presidency) was a white man was more than fifteen years ago.   We still have a long way to go and Americans still occasionally stumble and fall, but we are generally moving in the right direction.  I am proud of America, and it seems that Mr. Murray is losing the faith.  Lack of faith in America and her people is stamped on neither side of the American coin that Mr. Murray so rightly cherishes.

I’ll let Mr. Murray take us home:

To accept the concept of virtue requires that you believe some ways of behaving are right and others are wrong always and everywhere. That openly judgmental stand is no longer acceptable in America’s schools nor in many American homes. Correspondingly, we have watched the deterioration of the sense of stewardship that once was so widespread among the most successful Americans and the near disappearance of the sense of seemliness that led successful capitalists to be obedient to unenforceable standards of propriety. Many senior figures in the financial world were appalled by what was going on during the run-up to the financial meltdown of 2008. Why were they so silent before and after the catastrophe? Capitalists who behave honorably and with restraint no longer have either the platform or the vocabulary to preach their own standards and to condemn capitalists who behave dishonorably and recklessly.

And so capitalism’s reputation has fallen on hard times and the principled case for capitalism must be made anew. That case has been made brilliantly and often in the past, with Milton Friedman’s “Capitalism and Freedom” being my own favorite. But in today’s political climate, updating the case for capitalism requires a restatement of old truths in ways that Americans from across the political spectrum can accept.

Here is my best effort:

The U.S. was created to foster human flourishing. The means to that end was the exercise of liberty in the pursuit of happiness. Capitalism is the economic expression of liberty. The pursuit of happiness, with happiness defined in the classic sense of justified and lasting satisfaction with life as a whole, depends on economic liberty every bit as much as it depends on other kinds of freedom.

“Lasting and justified satisfaction with life as a whole” is produced by a relatively small set of important achievements that we can rightly attribute to our own actions. Arthur Brooks, my colleague at the American Enterprise Institute, has usefully labeled such achievements “earned success.” Earned success can arise from a successful marriage, children raised well, a valued place as a member of a community, or devotion to a faith. Earned success also arises from achievement in the economic realm, which is where capitalism comes in.

Earning a living for yourself and your family through your own efforts is the most elemental form of earned success. Successfully starting a business, no matter how small, is an act of creating something out of nothing that carries satisfactions far beyond those of the money it brings in. Finding work that not only pays the bills but that you enjoy is a crucially important resource for earned success.

Making a living, starting a business and finding work that you enjoy all depend on freedom to act in the economic realm. What government can do to help is establish the rule of law so that informed and voluntary trades can take place. More formally, government can vigorously enforce laws against the use of force, fraud and criminal collusion, and use tort law to hold people liable for harm they cause others.

Everything else the government does inherently restricts economic freedom to act in pursuit of earned success. I am a libertarian and think that almost none of those restrictions are justified. But accepting the case for capitalism doesn’t require you to be a libertarian. You are free to argue that certain government interventions are justified. You just need to acknowledge this truth: Every intervention that erects barriers to starting a business, makes it expensive to hire or fire employees, restricts entry into vocations, prescribes work conditions and facilities, or confiscates profits interferes with economic liberty and usually makes it more difficult for both employers and employees to earn success. You also don’t need to be a libertarian to demand that any new intervention meet this burden of proof: It will accomplish something that tort law and enforcement of basic laws against force, fraud and collusion do not accomplish.

People with a wide range of political views can also acknowledge that these interventions do the most harm to individuals and small enterprises. Huge banks can, albeit at great expense, cope with the Dodd-Frank law’s absurd regulatory burdens; many small banks cannot. Huge corporations can cope with the myriad rules issued by the Occupational Safety and Health Administration, the Environmental Protection Agency, the Equal Employment Opportunity Commission and their state-level counterparts. The same rules can crush small businesses and individuals trying to start small businesses.

Finally, people with a wide range of political views can acknowledge that what has happened incrementally over the past half-century has led to a labyrinthine regulatory system, irrational liability law and a corrupt tax code. Sweeping simplifications and rationalizations of all these systems are possible in ways that even moderate Democrats could accept in a less polarized political environment.

To put it another way, it should be possible to revive a national consensus affirming that capitalism embraces the best and most essential things about American life; that freeing capitalism to do what it does best won’t just create national wealth and reduce poverty, but expand the ability of Americans to achieve earned success—to pursue happiness.

Reviving that consensus also requires us to return to the vocabulary of virtue when we talk about capitalism. Personal integrity, a sense of seemliness and concern for those who depend on us are not “values” that are no better or worse than other values. Historically, they have been deeply embedded in the American version of capitalism. If it is necessary to remind the middle class and working class that the rich are not their enemies, it is equally necessary to remind the most successful among us that their obligations are not to be measured in terms of their tax bills. Their principled stewardship can nurture and restore our heritage of liberty. Their indifference to that heritage can destroy it.

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Understanding Insurance

In keeping with my earlier post explaining what money actually was, I am going to use this post to explain insurance.


Insurance is simply the transfer of risk from one party (the insured) to another (the insurer) for a payment. The payment is called the premium. This premium is equal to the expected loss during the insured period plus some additional amount to pay administrative and operational costs of the insurer and build available reserves. The process of accessing the risk, determining the price of the risk, and deciding if to take on the risk exposure is called underwriting. When a loss occurs, the insured makes a claim and the insurer then indemnifies, or makes whole, the insured.


For insurance to “work” there need to exist insurability. There are several characteristics which will exist if a risk in insurable. If they do not exist then the risk must be transferred either through a compulsory insurance program such as workers compensation or social insurance such as social security disability insurance or through other techniques which I will address in future posts. I will use an example for each of these with the insurance company insuring $200,000 homes which have a 1% chance of a total loss due to fire and a 99% chance of no damage.

  1. Definite loss: The loss has to have a clear cause that took place at a particular time and place. In our example the cause of the loss would be the fire which occurs at the home’s location and we could clearly have a time of the event.
  2. Accidental loss: The loss has to be fortuitous to the beneficiary. That simply means that the loss needs to be outside of the insured control. In our example this would mean for instance that the fire was not arson by the beneficiary or at the beneficiary’s request.
  3. Calculable loss: The loss needs to be both of a calculable chance of occurence and of an estimated size. In our example we have a 1% chance of a loss and that loss is of $200,000.
  4. Large loss: The loss has to be economically significant. If the loss potential is too small then it is not worth the effort to underwrite the policy and administer it. In our example we have a total loss so this is not a concern because it is clearly economically significant.
  5. Affordable premium: The premium for that loss calculated above cannot be so great that the insured will not pay (for the risk of occurence is too high as an example) or so great that the insured is not at risk (because the cost is too high for the risk insured). We do not state a premium in our example but an actuarialy fair premium would be $2,000 for a year. The premium would be higher than this because of loading. This loading is how insurance companies pay for the administrative costs and generate an underwriting profit.
  6. Large number of similar insurable interests: This means that the insurer needs to insure a pool of homes that are similar in their risk exposure. This is because as the number of units grow we can use something called the “law of large numbers” to assume a normal distribution of losses. With one home the expected loss is $2,000 and the standard deviation of the loss is almost $20,000. If this were a pool of 10,000 homes, the expected loss per unit is $2,000 but now the standard deviation is just over $2,000.
  7. Limited risk of catastrophe: The individual trials should be independent. This means that there would not be a giant conflagration which burns a large number of the pool. Catastrophic losses defeats the advantage of pooling.

Role of Insurance

Insurance is one of the techniques to manage a risk. As the list above shows, insurance works well when you have rare events which result in large losses and those losses are independent of each other. If the size or frequency do not fit this pattern, then risk management is still important but other tools must be used instead.

In my next post I will look at the example of the health insurance industry in the United States and discuss if it is appropriate to consider it to be an example of insurance in our description above.

In Defense of Big Finance

Finance is under attack.   The war against Wall Street re-ignited after the financial crisis of 2007-2009.  Paul Krugman fired the first major salvo against academic macroeconomics and finance in 2008.  John Cochrane responded in kind shortly thereafter.  These critiques and counter-critiques were somewhat tame to a layman’s eyes–Krugman and Cochrane slug it out over the implications of theory that not even all economists understand.  (I will ignore the debate as it evolved in the popular press, which is best summarized as “Left hates Greedy Bankers and Right hates Occupy Wall Street and their champion, the socialist Obama regime.”  I focus instead on the debate roiling at the fringe of respectable (scientific) academia.)  The Krugman-Cochrane debate quickly devolved into a clash of assumptions. On faction assumes, essentially, that Krugman is right to indict finance theory and practice as essentially at fault for every deleterious event of the last few years.  The other faction…doesn’t exist.  No one is really defending modern finance theory and practice in academia.

I challenge readers to recall the last paper or blog that seriously defended the modern financial artifice and the fruits borne by it over the last few decades. (This is still the only country in the world where any individual with a steady job, decent credit, and a modest down payment can purchase a veritable palace after suffering through almost three or four solid hours of paper work.  I asked one of my Chinese students if such miracles were possible in his homeland.  “Yes,” he replied.  Turns out he thought I was asking if it were possible to rent an apartment.) On the other hand, the vast majority of popularly accessible papers, speeches, and blogs delivered by most academics assumes that modern finance is inherently nefarious.

These (Is Globalisation Great?) remarks appended below were recently delivered by Stephen Cecchetti at the Bank for International Settlements Annual Conference.  He is the Head of the BIS Monetary and Economic Department and he is speaking before other professional economic policymakers who perch at the highest level.  His mantra?  Finance seems benign, but really it’s harmful–he assumes that modern finance is the primary cause of the worlds’ recent backsliding.  I present his remarks below because they are representative of the “Finance is bad” critique; and, because they are such an easy target.   I present his series of arguments and then offer a critique.

He begins benignly enough:

…I am led to ask two questions, namely: how much globalisation is good and how much finance is good. Over the next two days we will reflect on these questions. Let me give you my answers to my questions up front: financial deepening is great, but only up to a point. And, this means that the globalisation of finance is great, too; but only up to a point.

Don’t be fooled.  He blames finance, not ‘too much finance,’ for most of our problems as the speech progresses.  He continues:

To see why I have come to these conclusions, I will take a minute to describe the relationship of finance to growth in general, and then draw out implications for cross-border banking; that is, the part related to the globalisation of finance. My comments build on work that has been going on at the BIS for some time.

In other words, he is definitely not offering up an opinion trumped up with loosely tailored and selectively chosen regressions.  And by the way, other people have agreed with him in the past; his arguments must be true.

For most people, the term globalisation means cross-border trade in real goods and services; something that we would all agree has brought the greatest benefits to a large number of people. Trade very clearly supports middle-class living standards, among other things putting literally tens of thousands of different products on the shelves of even a modest-sized supermarket.

Interestingly, Cecchetti notes that ‘trade supports the middle-class’ by increasing the variety of ketchup available at the local grocery and he fails to mention (purposefully?) that the globalization of trade has lifted hundreds of millions of people (who should be counted regardless of the fact that they are not middle-class) from the most dire poverty.

But this real side of globalization relies on financial intermediaries to fund the trading of all this stuff across borders. And the recent crisis showed how problems both on and off the intermediaries’ balance sheets can have very large, very real and very bad implications. Many of us have started to ask if finance has a dark side.

Cecchetti is a little late to the party.  The tradition of attacking the purported excesses and evils of finance date back at least to the Pujo Committee, which lambasted John Morgan for his shortcomings shortly after he almost singlehandedly saved the equity markets from certain disaster during the Panic of 1907.

Let the self-flagellation disguised as scholarly inquisitiveness begin:

First, can a financial system get too big? Put differently, is there some optimal size for the financial industry after which it drags down the rest of the economy? Second, how far should countries go in outsourcing the provision of financial services? Does specialisation in financial services by some countries impose vulnerabilities on others? How we think about and answer these questions will surely have an impact on the financial system’s structure and thus on the future of globalisation.

Turning to some facts, consider the relationship between the size of a country’s financial system and growth. We teach that, because it allocates scarce resources to their most efficient uses, one of the best ways to promote long-run growth is to promote financial development. And, a sufficiently well-developed financial system provides the opportunity for everyone – households, corporations and governments – to reduce the volatility of their consumption and investment.

It sure sounds like finance is great. But experience shows that a growing financial system is great for a while – until it isn’t. Look at how, by encouraging borrowing, the financial system encourages an excessive amount of residential construction in some locations. The results, empty three-car garages in the desert, do not suggest a more efficient use of capital!

Cecchetti’s words are persuasive and pick at the emotional sore spot opened up by the most recent  financial crisis–employing the same trick that every critic of every era has employed.  He assumes that the financial system ‘encouraged’ borrowing (without offering any evidence) and relies upon his audience to know what he means by ‘encouraging.’  In my deepest southern drawl, I ask myself, “Why goodness, whatever does that mean?  The financial system ‘encouraged’ borrowing?  But for those encouraging bankers, nobody would have borrowed too much money?”  Thank goodness that customers never get involved in all of this encouragement.  If borrowers had sought money to buy second homes or used their homes as ATMs of their own free will, then things might have really gotten out of control.

Financial development can create fragility. When credit extension goes into reverse, or even just stops, it can induce economic instability and crises. Bankruptcies, credit crunches, bank failures and depressed spending are now the all-too familiar landmarks of the bust that follows a credit-induced boom.

Every first-year economics student is taught the Post Hoc, Ergo Propter Hoc (‘coming after, therefore because of”) fallacy. Cecchetti is not alone in noting that asset price booms are caused by easy credit booms.  It is difficult to fault Cecchetti and others for blaming booms on easy credit (which should be distinguished from low interest rates), because of the mass of research which observes that most financial crises are precipitated by credit-fueled asset price booms.  But precedence is not causality; and, blaming the financial system for a gunman’s shooting spree is like blaming ammo makers for producing too many bullets.  The shooting spree might not have occurred if bullets were rare, but that ignores the fact that cops, soldiers, and angry ex-husbands need bullets for good reasons, and ammunition stockpiles do not cause shooting sprees.  Why blame the credit system for providing credit to those who asked for it?

What is more, financial development is not costless. The expansion of finance consumes scarce resources that could be used elsewhere. And finance’s large rewards attract the best and the brightest. When I was a student, my classmates dreamed of curing cancer, unifying field theory or flying to Mars. Those in today’s cohort want to become hedge fund managers. Given finance’s booms and busts, is this the most efficient allocation for such scarce resources? I doubt it.

Where is it written that finance is an ignoble enterprise?  That Wall Street diverts otherwise decent and competent human beings away from supposedly more noble enterprises  is pure conjecture. And he doesn’t even pretend to argue that finance professionals haven’t made the world a better place.  He just assumes that it’s true because he chooses to blame Wall Street for the recent crisis.  Cancer will not be cured, field theory won’t be unified, and humanity will never walk on Mars unless financiers help to make it happen.  I charge anyone to name a single innovation of the last century that wasn’t financed somewhere along the way.  Cecchetti think that we can will ourselves to live in a Star Trek-like universe where money doesn’t matter.  (And it doesn’t matter if finance is costly.  No one has ever claimed that it wasn’t.  The question is whether the resources devoted to finance would be more productive elsewhere.  Cecchetti never addresses this except to (again) conjecture that nobody wants to cure cancer anymore because bankers are greedy.  (That’s too bad.  I didn’t get that memo.  No one wants to cure cancer anymore apparently because someone told college students the secret that money buys things.  Shucks.  And if recent college graduates are flocking to hedge funds instead of oncology labs, maybe that’s because high finance is where those particular professionals belong.  After all, maybe these would-be cancer curers will be more adept at financing the cure than at finding it.  Maybe that’s what has held back the cure; efforts to find the cure haven’t  been properly financed!)

Cecchetti now sets out to prove that there is such a thing as too much finance:

So, when does financial deepening turn from good to bad and become a drag on the economy? Somewhat surprisingly, we get a consistent story regardless of how we measure financial development.

In our 2011 paper for the Federal Reserve Bank of Kansas City’s Jackson Hole Symposium, Madhu Mohanty, Fabrizio Zampolli and I found that the effect of debt – public, household or corporate – turns from good to bad, when it reaches something like 90% of GDP, regardless of the type of debt.  To prevent adverse developments – both natural and man-made – policy should normally strive to keep debt levels well below this line.

Yep, he really just said that.  Policy, instead of markets, should aim to properly allocate credit.  If only the government would step in and discourage lending beyond a some unknown point, then more people would want to cure cancer.  And then there is the counterfactual problem:  we don’t know what the economic environment would look like it government enacted policies to limit debt levels below that nefarious line that Cecchetti picks on.  Has this been tried?  If so, then he doesn’t mention that evidence.

If we measure the scale of the financial industry by employment or output, as Enisse Kharroubi and I do in a paper completed earlier this year, we come to the same conclusion. (Cecchetti and E Kharroubi, “Reassessing the impact of finance on growth”, mimeo, January 2012.)  When average growth in output per worker is plotted…against the share of employment in finance… a parabola summarises the scatter… Again, the conclusion emerges that there is a point where both financial development and the financial system’s size turn from good to bad.  That point lies at 3.2% for the fraction of employment and at 6.5% for the fraction of value added in finance. Based on 2008 data, the United States, Canada, the United Kingdom and Ireland were all beyond the threshold for employment (4.1%, 5.7%, 3.5% and 4.5%). And the United States and Ireland were also beyond the threshold for value added (7.7% and 10.4%).

(Disclaimer: I have not read the above cited paper…correction: I just read it, and it is just as argumentative as his remarks.)  Cecchetti claims that because he has found a parabolic relationship between the number of financial workers in a country and that country’s economic growth, that  he has “proven” that there was “too much financial development” in crisis countries.  At best, his finding fail to disprove his hypothesis; not by a long shot does his unconfirmed finding prove anything.  (On this basis alone I discount his entire paper.)

If financial development is only good up to a point, it follows that financial globalisation might only be good up to a point. Financial globalisation is about making it irrelevant to investors and borrowers where the services and the funds they draw on are actually located. But the spillovers during the financial crisis, when one country’s troubles spread to others, raise the question: does it matter where the funds are coming from? That is, how should we think about cross-border flows and financial specialisation?

This is a valid question.  Many blame the severity of the Asian Financial Crisis on the lack of capital controls imposed by the Tigers.  Indeed, Malaysia may have suffered less from the Asian crisis in part due to the quick imposition of capital controls.

As economists, we are trained to think that specialisation is great. Within an economy, we believe that when individuals exploit comparative advantage, it benefits everyone. And, we have created an entire infrastructure where, for example, I am able to write and speak about macroeconomic and financial stability policy full time, but still purchase groceries. The alternative, where I would barter my insights for food, would surely not work as well.

Agreed.  Go on…

I’ll let you be the judge of whether, in my specific case, the market is yielding the right social solution. But for the world as a whole, global welfare is enhanced when we encourage international trade in goods and services. And international trade benefits emerging and advanced countries alike when it exploits comparative advantage. And this inevitably leads to specialisation.

I, too, have taken Economics 101.  And please continue…

Trade and specialisation reach their limits where economics meets national security. As an individual, I can rely on someone else to produce my food, trusting that some combination of the market and the legal system will look out for me. But would a country want to outsource its entire food production? And what about energy?  National security concerns dictate that some amount of self-sufficiency is cultivated, simply as a precaution. Some concern about food and energy security is certainly warranted. The same is probably true for strategic technologies. But clothing or coffee security is probably not worth worrying about.

Maybe YOU don’t lay up nights sweating the possibility that our nation’s coffee supplies with be choked off in some African hell hole, but I am not that complacent.  Idea:  We need to develop the SCR:  Strategic Coffee Reserve.  Do we have any empty salt caverns left? Cecchetti isn’t really saying much…maybe he’s setting me up?

Where does finance stand on this spectrum between the essential and the superfluous? More specifically, can countries become vulnerable by excessively specialising in finance or by overly relying on people outside their borders for the provision of financial services? Has financial globalisation gone too far in some countries?

Excellent questions.  The national security aspects of financial system development have not been studied enough by our profession.  But still…what is he getting at?

Over the past 30 years, the international financial system has come to be dominated by a relatively small number of large banks headquartered in a handful of advanced counties. Their growth has coincided with a push to remove impediments to the free flow of capital. As a result, a highly concentrated banking sector dominates the international provision of capital and maintains large balance sheet positions with respect to many countries. And when these balance sheet linkages are large (relative to GDP or the capital stock or domestic tax base), problems in one country’s financial sector quickly transmit themselves to other countries and markets. In short, financial globalisation is bound up with a specialisation in financial services that makes countries much more vulnerable to each other’s mishaps.

It is true that globalization increases the risk of financial or economic contagion between countries.  So, should we pass a law that bans contagion?  I am still unsure what Cecchetti is driving at.

The experience of some countries during the crisis suggests that too much international capital, like too much debt, can be bad. For example, credit booms in the years preceding the crisis tended to outrun domestic funding and to depend on funds from abroad at the margin. Countries that relied heavily on international credit sources to finance domestic booms found themselves high and dry when these off-shore sources of funding went into reverse – which happened as soon as the foreign creditor banks ran in to trouble.

And that is his bug uppercut.  But I’m still standing.  His arguments are superficial enough and easily dismissed.  But the threat from the anti-finance movement within our community isn’t from the power of their arguments, but instead due to the deeply embedded assumption that finance is the problem.

No one put a gun to bankers’ heads and told them to make loans (that crossed borders!  Oh, the humanity!).  And no one forced borrowers to suck up credit from abroad.  (Of course, almost the ENTIRE POINT of cross-border lending is to spread risks.  If the credit system is working properly, then there MUST be some contagion in downturns.  Otherwise, risks have not been dispersed and therefore credit has been sub-optimally allocated.

And, the implication of his concern about cross-border lending is that controls should be put in place that restrict cross border credit flows.  We should trust the same officials to design a credit control system that did such a smashing job of allocating credit just a few years back?  Some of us are all too aware that the definition of insanity is doing the same thing and expecting different results.

In all, Cecchetti has a few good points and he is right to push the finance community to take a closer look at these questions.  (That is our job, after all.)  But he is much too like the rest of the most vocal in the finance community of late.  He starts from the presumption that somehow Big Finance is to blame for the recent crisis.  It may be true.  But as scientists (or even policymakers) we shouldn’t begin with a proposition and then search for evidence to prove it.  And if so many of us are going to do just that, then we need a few more people (like John Cochrane, for example) who do not see finance as the problem, but instead see finance theory and practice as a rich set of tools we can use to navigate our way to a better future.

Finance is a science and a profession that has helped usher in the greatest era of prosperity humanity has ever known.  There are shortcomings, to be sure.  But let’s continue our examination of the field with an open mind.  Scientists aren’t supposed to be advocates until all of the evidence is in.  Until that day comes, we need to stoop to the anti-finance faction’s level and champion our field.  Big Finance Rocks!

Thadford Jackson

Insider Trading – Is It As Bad As You Think?

When most of us hear the words “Insider Trading”, we feel a little chill down our spines.  It is a bad thing of course, isn’t it?  Recent insider trading scandals like the case with hedge fund manager Raj Rajaratnam of the Galleon Group reverberate through our minds.  It is something that should be punished criminally, and eliminated from the markets if at all possible.  But anyone especially interested in this phenomenon should really stop and ask again that age old question that has plagued market regulators – is insider trading truly a bad thing? 

For that matter, do we even know what insider trading really is?  In the 1980’s and 1990’s, many famous insider trading cases appeared headlining the news.  This spate of illegal insider trading renewed interest in increasing regulation of these types of trades, and the question of how to define insider trading moved to the forefront.  Previously, legal insider trading had been mostly defined as trades by top executives or beneficiaries of corporations or their family members.  But couldn’t others outside this group obtain information that could move the stock price, and illegally benefit? And how exactly would those cases be defined as illegal? Michael Milken was one of the most famous illegal inside traders in the late 1980s, but it was not always clear that what he was doing was illegal. And how could regulation possibly define all the ways that one could obtain this inside information illegally?  Congress is famous for massively long bills, but the ways to trade on inside information are almost infinite.  So in 2000 a much more practical bill called Regulation FD was passed, broadly defining illegal insider trading as “anyone who trades on material, nonpublic information”.

Ok, so now we know what insider trading is.  However, before I go further, it is important to make a more clear distinction between legal and illegal insider trading.  Insider trading is actually legal for corporate insiders and is an active part of the marketplace, but is done in a controlled, regulated fashion.  Legal insider trading is not only accepted, but is considered desirable in the markets, because it improves the chance that the stock price more fully reflects current information regarding that stock, meaning that the current stock price is more accurate (this is called in the finance literature the “price discovery” process).  Who knows better than corporate insiders if their product is selling like hotcakes and orders are increasing, or if sales are slowing down and their warehouses are filling with costly inventory?  So these insider trades send a great signal to the marketplace on which direction the stock price is likely to move in the near future, and what the current fair price of the stock should be.  And because of improvements in insider trading laws (the biggest recently being Sarbanes Oxley in 2002), insiders cannot gain much profit before revealing their information to the general public. 

Now let’s consider illegal insider trading, which is usually assumed to be harmful to investors and the marketplace.  In fact, since current laws would be expected to only allow insider trading that is not detrimental to investors, it is easier to see why these illegal insider trades might cause problems. And in contrast to legal insider trading, illegal insider trading might be assumed to make the stock price less accurate (harming the “price discovery” process).  Thus in a market with heavy illegal insider trading, the average investor would constantly be buying at an abnormally high price, and selling at an abnormally low price, with these illegal inside traders profiting off of the difference.  This behavior would discourage average investors from trading in markets like this, causing further harm to stock price accuracy, as there would be less traders doing research on stock prices, etc.  However, there is a small contingent that believes that even illegal insider trades are beneficial to the marketplace. Nobel prize winning economist Milton Friedman argued that all insider trades should be allowed for trading, even the ones currently considered illegal, as this would open the markets up to the free and unhindered flow of information from insiders to the marketplace.  Stock prices would move up or down based on this increase of insider trades, more accurately pricing the stock than what happens in our current regulated environment.  While this sounds good in theory, evidence of market manipulation prior to the 1930s when insider trading was less regulated may conflict with this opinion.  Many Libertarian think tanks argue that the market would adjust to attempted manipulation while still allowing better stock pricing, but the debate rages on.  Actually, an excellent guide to understanding the distinction between the benefits and detriments of insider trading appears in the 1987 Oliver Stone classic film “Wall Street”, in which Michael Douglas portrays a corporate raider heavily using illegal inside information.   While most of the movie focuses clearly on this undesirable illegal insider trading, there is one famous scene (often called the “Greed is good” speech) in which Douglas’ character Gordon Gekko skewers the management and insiders of Teldar Paper for not personally buying into the stock, subtly suggesting that the poor performance of the firm was because “management has no stake in the company” and was thus uninterested in actually improving firm performance.

So back to the original question – is insider trading really bad?  Always remember when answering that question to define exactly what insider trading is first.  Under the current regulatory environment, most scholars believe legal insider trading to be a good thing for the creation of more efficient markets, while illegal insider trades are considered undesirable for establishing proper stock prices.   The dividing line between the two shifts periodically with economic conditions and political parties in office, but one thing is certain – insider trading will always be with us, whether legal or illegal, so we better get used to it and try to understand it more fully.

Tony Via is a 5th year Finance PhD student at the University of Alabama, and currently resides in Tuscaloosa, AL.  He is originally from Decherd, Tennessee, and worked as a mechanical engineer before returning to graduate school.  His research specializations are in Investments and Market Microstructure, and he has done consulting work in proprietary trading and market impact models.


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