Airs - Ian Lance Taylor

Almost six months later, I’ll look back at my earlier post about financial complexity. Considering the continuing troubles of the financial markets, it seems clear that I underestimated the degree of the problem. But I think I was generally correct in pointing out that the complexity of modern markets helped hide the nature of the bets that institutions were making. Many institutions thought that they had only a controlled amount of exposure to the mortgage market, only to find out that they were wrong. They had lent money to other institutions, which had made derivative bets, which were founded on the mortgage market, and problems rebounded back to institutions which thought they were acting soundly.

I believe the complexity has exceeded the ability of people to fully understand it at this point. That may be a general trend for financial markets–they naturally push the limits of complexity, limits which do increase over time as people learn more and develop better tools.

It remains to be seen how much this will affect the real economy. While it seems quite likely that the U.S. is now in a recession, it could still be a mild one. I suspect that some of the problems are facing now are really due to stagnant middle class income and increased health care costs–the ongoing issue of increasing inequality. At this stage of the business cycle, more people are vulnerable than usual, because fewer people did well when the economy was relatively strong.

But that need not be a bad thing. If few people do well when the economy is strong, it is possible that few people will do poorly when the economy is weak. Not very likely, perhaps, but possible. We’ll have to see.

A friend of mine who has been working for many years in an area that is now known as social entrepreneurship commented that there is no good economic model for it (he thinks of things like this because he went to business school).

This led me to think about economic models for charitable giving. Economists usually try to model people as rational utility maximizers: we all make decisions that we believe will make us happier. Of course this is laughably false on the face of it, though in many areas of interest to economists it works well enough. Many economic theories make a simple assumption which makes the model even worse as an approximation of reality, which is to treat money as a proxy for happiness.

Models like this don’t have a good way to handle charitable giving. They have an even harder time with major philanthropic organizations. What is Bill Gates buying with the Bill & Melinda Gates Foundation? Yet surely if homo economicus exists, Bill Gates is the type specimen.

Now, obviously I’m setting up a straw man here. Nobody really thinks that money is everything. But it’s awfully easy to make a mental slip into thinking that the simplifying assumption is the reality. A signal for this is the number of articles I see about “why do people give to charity”—as though it were some sort of weird decisions that needed to be explained (there was just such an article in last Sunday’s New York Times Magazine). Medieval Europeans would have needed no explanation. The fact that we need an explanation today is a crack in our conventional view of people–a place where the mirror we use to see the world in ourselves has broken.

According to the U.S. census, median household income in the U.S. has not changed much since 1998. The economy does continue to expand. What is happening is that the richer households are absorbing all the gains, leading to increased inequality. I’ve commented before on whether or not this matters.

I’ve now seen a couple of attempts to argue against this, on the basis that household sizes are shrinking. The argument is that when the household gets smaller, then even if the household has the same amount of money, there is more money per person.

Unfortunately, this argument is too simple. A household has fixed expenses which remain the same regardless of the number of people. One obvious fixed expense is the cost of the house itself. If the cost of housing as a proportion of household income has increased faster than the size of the household has decreased, then the argument does not hold.

It is also quite possible that the earnings-per-person of a single parent living alone has increased, while the earnings-per-person of a single parent living with children has decreased. That would maintain the same statistics, but would suggest that more children are living with fewer resources, which would seem to be undesirable.

More importantly, I think this type of argument is somewhat off-the-point. I think what matters to most people is stability of shelter, food, and health care. Stability of income is acceptable provided those prices are stable. Instability of income is rarely desirable. So the whole issue of tracking average household income seems much less interesting to me than tracking income stability for families in different economic strata.

The U.S. government is trying to free up credit, by reducing interest rates and other steps. This is probably good for the economy. It also has the effect of reducing the risks faced by banks which made some very bad investment decisions in purchasing unsecured debt. This is a moral hazard: when things go well, the banks keep the money; when things go badly, the government cushions the blow. The effect is to encourage risky behaviour by banks.

We can avoid a lot of this moral hazard by realizing that banks are run by individual people. We can bail out the bank and punish the people, thus getting the best of both worlds and not encouraging future risky behaviour. Certainly it’s true that some bank CEOs have lost their jobs recently, but they walked away with millions of dollars, which is hardly punishment. I don’t think any of them committed a prison offense, but I certainly think some stiff fines coupled with losing their job would be appropriate–whatever it takes so that they are not rich.

Unfortunately this will never happen because the people who make the regulations are also individual people, and they are friends of the people who run the banks.

Oil is currently purchased in dollars. That means that the price is set in dollars, and oil producers accept payments in dollars. There are occasional suggestions that the price should be denominated in some other currency, typically euros. This is generally intended to weaken U.S. hegemony. But does it make any sense?

In today’s financial world, the major currencies can be transformed to another at the press of a button. While the currencies float against one another, there is no immediate penalty to moving from one currency to another. The amount of money which currency speculators move around the world every day is actually far higher than the amount of money which moves in and out of stocks every day. So even if oil is sold in euros, somebody holding dollars can simply conver to euros and buy the oil.

It’s true that since oil is sold in dollars, holding dollars means that even when the dollar falls, you don’t therefore pay more for the oil. If oil were sold in euros, and you were holding dollars, and the dollar fell against the euro (as it has been doing recently), then you would have to pay more dollars for the oil.

However, the price of oil is already fairly volatile, and the volatility in the price seems considerably greater than the volatility in exchange rates. So if you have some other reason to hold dollars, I don’t think stability in the price of oil would be a convincing reason to switch away from dollars.

In short, it seems to me that selling oil in euros would have little or no real effect. It would certainly send a signal that the euro rather than the dollar was the world’s reserve currency. But it wouldn’t by itself make people switch away from dollars. At least, that’s how it seems to me.