Unintended Consequences

Edward Conrad “Unintended Consequences: Why Everything You’ve Been Told About The Economy Is Wrong” Penguin, 2012, 285 pp.

Strange, strange, and stranger…yet, some intriguing points.  For instance: Who’d a thunk that Roe v. Wade brought pro-investment voters to power?  Conrad maintains that the fury after the 1978 court decision united Anti-Roe people with the minority pro-business community and this united group shifted the political center away from income redistribution toward investment.  Pro-investment Republicans then used their newfound political power to cut marginal tax rates, maintain open trade borders, keep inflation low, and minimize regulation that would have increased labor redeployment (read lay-off) costs.  At first this Roe v. Wade connection seems absurd, but upon reflection I became less sure.

The author’s aim in this book is to piece together a mosaic of academic studies to explain how the economy works; why the U.S. has outperformed its high-wage rivals, what caused the Financial Crisis; and what improvements might better protect our economy without damaging its growth. (p. 7).  Conard was a partner and associate of Romney at Bain Capital from 1993 to 2007.

My Notes:

Pg. 12: During WWII, Europe and Japan’s infrastructure was destroyed.  Meanwhile, the commercialization of television and advertising, newly built U.S, interstate highways, and automated manufacturing allowed American companies to create nationwide mass markets for their products.  Because international trade was under-developed at that time, the U.S. was essentially a closed economy and the advanced education of the American workforce accelerated the growth of its post-WWII economy.  Decades earlier, the U.S. had been the first nation to publicly educate all its citizens.  Europe and Japan were slow to follow.  In 1955, the U.S. enrolled 80 percent of its fifteen- to nineteen-year-olds in school full time compared to only 10 percent to 20 percent in Europe.  And most European students were studying for vocations that prepared them to do jobs better suited to the past rather than rigorous academic subjects that would allow them to take their economies into the future.  The U.S. GI Bill propelled the transition of the U.S. economy from simple farming to sophisticated manufacturing. (Author strongly criticizes liberal arts education as not all that useful).

Pg. 13:  In sum the U.S. was prosperous for twenty years following WWII for a unique set of reasons that are impossible to duplicate today: a decade-long depression, the destruction of the rest of the developed world’s infrastructure, a failure of potential foreign competitors to educate their people, and a highly restricted supply of workers. 

Pg. 17:  Beginning in the early 1990s and lasting through 2008, U.S. productivity increased from 1.2 percent per year to 2.0 percent per year, almost a 70 percent increase.  This increase was caused by an expansion of know-how and not from an increase in the capital invested per worker or an increase in the education of the workforce.  It’s hardly coincidental that this increase coincided with the commercialization of the Internet and email.  Most effective ideas come from novel combinations of preexisting ideas.  The Internet is today’s communication hub.  The U.S. ran the table on Internet innovations, creating companies like Google, Facebook, Microsoft, Intel, Apple, Cisco, Twitter, Amazon, eBay, YouTube and others.  Europe and Japan scarcely contributed. AS we take actions to avoid the next Financial Crisis, we must avoid damaging those things responsible for our success.

Pg. 45:  Conventional accounting, and survivor bias, obscures the cost of innovation by being based on antiquated 1940s manufacturing rules which expenses the salaries of creative thinkers and leaders as intermediate costs of production, rather than capitalizing the as investments.  Only recently have accounting rules allowed the capitalization of software development costs. 

Pg. 49:  Pundits often wonder why median wages have failed to rise in proportion to increased levels of productivity, as they have in the past, but the answer is obvious.  The median wage is the highest wage of the lowest 50 percent of workers.  Productivity growth has occurred predominantly at the top of the wage scale.  It’s no wonder pay is growing increasingly unequal.  Over one-third of the U.S. output is produced by 5 percent of the workforce.

Pg. 71:  A worldwide surplus of unskilled labor will continue to drive manufactured goods offshore of the U.S. and manufacturing will become a smaller and smaller percent of our employment.  Luckily, it’s already small.  Innovation is the only way to keep our economy at full utilization. 

Pg. 89:  The willingness to take on risk is largely a function of wealth.  Wealth and equity are the same thing.  Short-term debt holders demand capital preservation and the right to withdraw and consume their savings at any time.  Short-term debt bears too little risk to grow the economy.  The amount of equity and its tolerance for risk, grows the economy. The Federal Reserve and the Department of Labor’s surveys show that the bottom 50 percent of income earners consumed more than 100 percent of their incomes leading up to the Financial Crisis.  Whereas low-income households invest half their savings in their homes, richer households invest half their savings in the equity of businesses—in assets that increase productivity and employment.  (The author seems to ignore 401k’s and the-like).

Pg. 136:  The notion that banks bought fraudulent ratings on specific securities in order to dupe investors is far-fetched.  Rating agencies use proprietary models to assess risk.  The rating agencies Standard & Poor’s and Fitch use a “probability of default” methodology while Moody uses an “expected loss” methodology. Sophisticated investors who set prices in the market place understood fully the two approaches and the nuances of difference between rating agency models. 

Pg. 158:  The author proposes that over-regulation, rather than under-regulation, caused the crisis. Specifically, he pinpoints blame on a 2001 recourse banking regulation rule, which many critics blame for loading the banks with toxic mortgage-backed securities.  Under the Recourse Rule, an AA- or AAA-rated asset-backed security, such as a mortgage-backed bond, received a 20-percent risk weight, compared to a zero risk weight for cash and a 50-percent risk weight for an individual (unsecuritized) mortgage. This meant that commercial banks could issue mortgages–regardless of how sound the borrowers were–sell them to investment banks to be securitized, and buy them back as part of a mortgage-backed security, in the process freeing up 60 percent of the capital they would have had to hold against individual mortgages. Capital held by a bank is capital not lent out at interest; by reducing their capital holdings, banks could increase their profitability.  The real problem in this area was allowing less than 20% equity positions by the buyers of homes.

Pg. 163:  Remarkably, the Financial Crisis shows that the value of government guarantees is enormous and that the cost of those guarantees is cheap because the government doesn’t have to set aside massive equity reserves to make its guarantees credible.  In fact, the Treasury expects the government to earn a profit on its bailout.  It only expects the bailout of the auto companies, Fannie Mae, Freddie Mac, and distressed home owners—losses related to defaults, not withdrawals—to produce significant losses.

Pg. 189:  Defaults didn’t render banks insolvent, withdrawals did.  When withdrawals forced banks to sell assets, assets sank to fire-sale prices, which made it impossible for banks to sell enough assets to fund withdrawals. 

Pg. 190:  Policymakers should never have allowed banks to fund the AAA-rated tranches of default-prone subprime loans with short-term debt.  In reality, however, lawmakers aggressively encouraged, even demanded, that banks fund these loans and cheered their success when subprime home ownership grew.  GSEs guaranteed funds to by $1.6 trillion of subprime mortgages.

Pg. 198:  The Dodd Franks 2010 Act is dangerously misguided in its aim to limit the role of the government in backing up the banks when a “run” occurs.  Reducing the size and interconnectedness of banks will do little to reduce the threat of panicked withdrawals. The government is the only institution large enough and credible enough to accomplish deposit guarantees.  Most likely, just as occurred in the latest crisis, the government can even turn a profit.

Pg. 202:  Dodd-Frank’s real threat to the banks comes not from its threat of allowing them to go bankrupt, but from the increased latitude of unreliable politicians to hinder the Fed’s ability to act swiftly and boldly by politicizing its response. 

Pg. 210:  Banks need enhanced ability to foreclose on home owners who fail to pay their mortgages, rather than providing these squatters with legal avenues to delay foreclosures while they continue to live in homes without paying their mortgages.  Also allowing mortgages with personal recourse beyond only the collateral of the house would similarly deflect default risk away from banks and their depositors. Again, political expediency has produced the opposite result.

Pg. 216:  Fortunately, the Financial Crisis shows that the cost of government guarantees large enough to mitigate the risk of withdrawals is near zero if regulation properly manages the risk of moral hazard.

Pg. 244: Lawmakers need to demonstrate their clear understanding of the contemporary economy, the Financial Crisis, and the limitations of the government to increase employment permanently.  They must take responsibility for passing this understanding on to their constituents.  Falsely blaming predatory lending and fraudulent securitization when the problem is a buildup of hair-triggered short-term savings, unreliable government guarantees, and default-prone mortgages causes risk takers to lose confidence in the effectiveness of lawmakers to solve the problem.

Pg. 246:  Harvard economist Robert Barro estimates that the Obama administration’s extension of unemployment benefits from twenty-six weeks to ninety-nine weeks has increased unemployment from 6.8 percent to 9.5 percent.  The longer benefits slow rather than accelerate the necessary reallocation of labor and capital as well as increase the likelihood of future tax increases.

Pg. 249:  American corporations face one of the highest tax rates in the world—39 percent when including state taxes.  Germany’s corporate tax rate is 30 percent; Korea’s is 24 percent.

Pg. 253:  The Obama administration’s disregard for the expectations of risk takers added further to the recession.  It diverted blame for the Crisis to bankers and used the resulting public sentiment to pass unnecessarily far-reaching regulatory changes filled with unintended consequences that slowed lending.  It fought to prevent foreclosures, which added to withdrawals and still-idle savings.  It rammed through health care legislation over the objection of voters that redistributed income without truly containing health care usage.  It wasted opportunities to use the stimulus to reduce long-term expenditures.  It fought hard to prevent Republicans from using Congress’s authority to increase the debt ceiling to cut cost.  And it refused to address long-term entitlement reform despite Republican willingness to support reductions.

Pg. 259:  It’s no surprise that the poor capture so little of the value from investment.  Of the 44 million people in poverty in 2009, according to the Census, very few work.  They largely garner value through income redistribution, not through the economics of investment, which creates value through wages and the consumption it buys.  Sixteen million of the 44 million are children.  They’re in poverty because their caregivers are poor.  Of the 28 million adults in poverty, only 2.6 million work full time.  Almost no one with a full-time job lives in poverty.  Of the remaining 25 million adults, 75 percent don’t work at all, and 3.7 million are disabled.  Approximately 4 million represent an increase in unemployment from 2006, when unemployment was essentially zero and anyone who truly wanted a job could have one.  Single mothers number 4.4 million adults in poverty.  Those single mothers are caregiver’s to two-thirds of the 16 million children living in poverty.

Pg. 283:  Reducing the size of banks that are too big to fail will do little, if anything, to solve the problem.  Financial crises stem from shocks, like a 30 percent drop in real estate, that affect the entire economy, not a select number of financial institutions.  Limiting the size of banks will only reduce U.S. competitiveness in an increasingly integrated global economy.