Freakonomics

Steve Levitt appeared on The Daily Show with Jon Stewart on Comedy Central last evening to discuss his new book, Freakonomics (buy website), written with Stephen Dubner (who profiled Levitt a couple of years ago in The New York Times).

Steve is the next generation of the "Chicago School" of economics, in which the basic price theory of economics is inserted into every social environment imaginable. The original generation--Friedman, Becker, and Stigler--focused on what are by now traditional areas like education, the family, and the law. But I'd wager that even the founders of the School would have to admit that Steve's ability to see the economics in unusual situations is without equal, past or present. The next generation also comes armed with modern computing power and thus a much greater ability to analyze data in support of their claims. I will soon get my copy of Freakonomics and enjoy my chance to read it.

What does it mean to "see the economics" in a given situation? Economics consists of exactly two ideas: optimization and equilibrium. Optimization is the process by which all economic agents--households, workers, firms, governments--achieve their objectives subject to constraints on their resources. It leads to the familiar condition that an activity is undertaken until its marginal reward equals its marginal cost. Equilibrium is the process by which the competing efforts to optimize by these agents form a stable arrangement. An equilibrium is defined by relative prices, and those prices typically form the basis of either the marginal reward or the marginal cost in the individual agents' optimization processes. So "seeing the economics" means figuring out what is driving the optimization and equilibrium in a given context. As I often tell my students, if you cannot see the optimization and the equilibrium in what I am saying, then I am not talking about economics.

Here are the book's chapters, from the Freakonomics website, showing where the authors are looking for optimization and equilibrium:

• Chapter 1: What Do Schoolteachers and Sumo Wrestlers Have in Common?
  In which we explore the beauty of incentives, as well as their dark side-cheating.
• Chapter 2: How Is the Ku Klux Klan Like a Group of Real-Estate Agents?
  In which it is argued that nothing is more powerful than information, especially when its power is abused.
• Chapter 3: Why Do Drug Dealers Still Live with Their Moms?
  In which the conventional wisdom is often found to be a web of fabrication, self-interest, and convenience.
• Chapter 4: Where Have All the Criminals Gone?
  In which the facts of crime are sorted out from the fictions.
• Chapter 5: What Makes a Perfect Parent?
  In which we ask, from a variety of angles, a pressing question: do parents really matter?
• Chapter 6: Would a Roshanda by Any Other Name Smell as Sweet?
  In which we weigh the importance of a parent's first official act-naming the baby.

On The Daily Show, Jon Stewart thought Chapter 4, in which the book supports a hypothesis that the reduction in crime in the late 1990s was attributable to fewer "unwanted" children in the wake of Roe v. Wade entering their prime criminal years, was the most interesting. He then asked Steve how he "controlled" for other factors that might affect the crime rate, like the number of police. Steve then tried to give an answer based on multiple regression (which he did in an excerpt from the book, shown here). That's got to be a first for late night television.

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Pensions Lost in Translation

It has finally happened. The Pension Benefit Guaranty Corporation (PBGC) has assumed responsibility for the four defined benefit (DB) pension plans at United Airlines. The impact, as reported in The New York Times is as follows:

The federal government said yesterday that it had reached an agreement to take over all four of United Airlines' employee pension plans, with a shortfall of $9.8 billion, making it the biggest pension failure since the government began insuring pension benefits in 1974.

Because the PBGC caps the benefit amounts it insures, only $6.6 billion of this amount is guaranteed, but even that hit to its balance sheet will increase the PBGC's net deficit (reported as $23.3 billion last September) substantially. Plus, we can now expect all of the other legacy airlines to seek the same sort of treatment from the PBGC.

However, there has been a tendency in news reports to suggest that the American taxpayer is somehow on the hook for this money. That isn't true, unless the federal government passes new legislation to make it true. At present, it is the rest of the DB pension sponsors in the PBGC-insured universe who are on the hook. As the PBGC's press release explains:

By law, the PBGC is required to keep premiums as low as possible and has no call on the U.S. Treasury beyond a $100 million line of credit. ...

The PBGC is a federal corporation created under the Employee Retirement Income Security Act of 1974. It currently guarantees payment of basic pension benefits for about 44 million American workers and retirees participating in over 31,000 private-sector defined benefit pension plans.

Pension insurance--not the idea but its implementation, and certainly not the dedicated people who work at the PBGC--is a complete joke. There are three problem's with the PBGC's setup:

1) The premium amounts are too low. On average, companies do not pay enough to cover the risk to which they expose the PBGC.
2) The premium formula is inadequately linked to underfunding. Pension sponsors whose plans are underfunded do pay slightly more in premiums than pension sponsors whose plans are fully funded, but the amount of additional premiums does not adequately compensate the PBGC for the added risk of a claim.
3) The premium formula is unrelated to the PBGC's risk exposure--the portfolio allocation between stocks and bonds and the bankruptcy risk of the company.

There are some extremely smart people working on pension insurance, both at the PBGC and outside. The issue is not that we couldn't figure out how to charge the appropriate premiums. The issue is entirely that Congress will never allow the PBGC to charge actuarially fair premiums. That would put too large of a burden on key political constituencies. United would have been paying enormous premiums over the past few years. Airline, steel, autos--these are the industries that have been least responsible in funding their pension plans. So this is what we get--subsidized risk-taking at the expense of responsible plan sponsors.

Defined benefit (DB) pension plans pay out benefits to retirees (and often survivors and occasionally the disabled) based on formulas that may increase with age, years of service, and earnings. The obligations look like the payment stream from a bond. In fact, a pension sponsor with a steady aggregate earnings profile and employee hiring and turnover could fully fund the liabilities and insure against risk with a portfolio heavily weighted toward bonds.

With PBGC insurance, the company has an incentive to invest in a portfolio heavily weighted toward stocks. If the stocks do well, the company can cut back on future contributions. If the stocks do poorly, then in some cases, the company can terminate the plan and leave the liability with the PBGC. Classic moral hazard. When the economy goes through a period of weak stock market returns (so the pension fund's assets fall in value) and low interest rates (so the present value of the future liabilities rise in value), we get tremendous underfunding. And the laws governing minimum pension contributions don't require pension sponsors to make up the difference quickly enough.

What to do? Impose a levy on each DB pension plan sponsor that is proportional to the current value of all past PBGC premiums paid for current participants. Impose the levy based on 2004 data, so there is no rush to the exit. The levy should be enough to put the PBGC at a zero balance position. Then retire the PBGC and allow companies to obtain pension insurance privately if they so desire. For current sponsors, pass a law that moves pension participants' claims in bankruptcy ahead of all unsecured creditors. If this means that fewer firms offer DB pensions, then so be it. Unhealthy companies--like United--ought not to be making promises to pay beneficiaries decades into the future.

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Hockey, I understand ... but lacrosse?

I took some time this weekend to enjoy the Dartmouth-Cornell men's lacrosse game, in which the Big Red edged the Big Green, 8-7. This was the first game I have seen in over a decade, and I confess that I couldn't figure it out. It seemed like Cornell was playing a different sport than Dartmouth was.

Hockey, I understand quite well, after 20 years of watching it closely. It basically comes down to three principles:

1. Failure to clear the puck out of your defensive zone is the source of all bad hockey. (This means that the entire team, including the forwards, must work as hard as possible to get the puck across the blue line.)
2. If there is a 2-on-1, and you are the 1, prevent the pass not the shot. (The goalie has to play the opponent with the puck no matter what, so the defender's primary objective should be to make sure he doesn't also have to worry about a pass to the opponent without the puck.)
3. Favorable rebounds far outnumber perfect passes. (The best opportunities arise when the puck is near the net, so when in doubt, shoot.)

Can anyone enlighten me on comparable principles for lacrosse? And what are the rules governing physical contact and contact with the stick?

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FactCheck and Senator Reid's Calculator

Yesterday's update from FactCheck.Org pertains to the assumptions in the Social Security calculator found on Senator Reid's (and other Democratic Senator's websites). I posted about this in February when the calculator first appeared. I listed five things that I thought were missing from the website if its intent was to be a constructive part of the debate on Social Security reform. The post also had some useful back and forth in the comment section. It's worth another look.

Elsewhere in the blogosphere, we Outside the Tent takes FactCheck to task, and Armchair Genius is sympathetic to FactCheck's points.

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Blogging at the Speed of Mud

I'll confess that I haven't blogged in a while because I liked the title of my last post, and I wanted to leave it at the top of the blog for a while. There were several thoughtful comments, and I like the sympathetic arguments from a fellow professor, Mark Thoma, of the new smash hit Economist's View and a fellow by the name of Mister Naxal in Texas, who offers a cautionary note on reform, with which I largely agree.

Elsewhere, I rediscover the maxim that if you think you have something interesting to blog about economics or academia, Arnold Kling has probably gotten there first. He picked up the thread in his post on Academic Self-Selection and refers us to two excellent pieces of his at Tech Central Station, one on the workings of the university and the other on Larry Summers as Martin Luther in reforming these institutions (a fantastic analogy).

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A Kibbutz Hooked up to an ATM

I should have my head examined for getting into this discussion, but I suppose New York Times columnists are supposed to be provocative. In his column yesterday, Paul Krugman discusses why "registered Republicans and self-proclaimed conservatives make up only a small minority of professors at elite universities."

I am a self-proclaimed conservative and I think Dartmouth qualifes under a description of "elite university," so I figure I should chime in here. I'll start by stating as clearly as I can why I chose this profession. First, I enjoy doing research. I have quite a lot of autonomy in what I work on. My work is evaluated by a profession of competent and thoughtful people. And I get to discover new things. Second, I love to teach. From the time I was tutoring my classmates in secondary school, I felt that I had a calling to be a teacher. (See this early post for more.) I presume that these two reasons, or similar ones, explain why most of my colleagues chose this profession, be they liberal or conservative. For the record, I made this decision when I was 18 years old.

I am friends with many liberal professors. At least in the economics department at Dartmouth, I have never in 11 years heard of a single instance where any professor made his or her political viewpoints central to the classroom experience. I've talked to many of my students, liberal and conservative, about the good and bad aspects of my time in Washington during office hours. That's not politics--that's just being a mentor. Before some classes, when there is a topical news story on campus or in the world, my students and I may exchange ideas about it. None of that matters for the class per se--once the group is assembled and ready to go, it's all about the economics. I would consider it a breach of my professional duties to put my own political views into the courses I am teaching. I presume the same is true of my colleagues in the economics department, be they liberal or conservative.

I have been involved in a decade's worth of hiring and promotion decisions. Never at any time has a person's politics come into play in any deliberations. My own experience suggests no evidence of a "left-wing bias" in the way my department is constituted.

I agree with the general terms that Krugman uses to frame his explanation:

The sort of person who prefers an academic career to the private sector is likely to be somewhat more liberal than average, even in engineering.

But I do not buy into the remainder of his argument, which can be loosely paraphrased as not enough conservatives believe in the virtue of scholarship to get enough of them to be interested in the academy. Rather, I think the explanation for why liberals outnumber conservatives is that they actively like the way the academy is organized.

An elite university is like a kibbutz hooked up to an ATM. It is the closest thing we may ever find to a socialist enterprise that endures. The key element of the kibbutz--that the workers collectively decide on the activities of the entity--is hardwired into the university via faculty governance. (The departure from the ideal--that some workers are "more equal" than others--is also evident, in that it is faculty, not employee, governance.) The notion that this is a sensible way to organize one's professional life is bound to resonate more with people who have a soft spot for socialist, utopian ideals. In my opinion, that you find more liberals than conservatives in the modern elite university is largely (though not exclusively) a reflection of liberals rather than conservatives feeling at home in such an environment.

Under normal circumstances, we would expect such an enterprise to implode, because some members of the collective are more productive than others, and they eventually get tired of subsidizing the lifestyles of the less productive members of the collective. So what keeps the elite university alive?

It's the ATM--alumni generosity. With outside money, even those who cross-subsidize the rest can feel like they are being adequately rewarded. A place like Dartmouth survives because in good times and in bad, alumni and other benefactors provide it with external resources to make the numbers add up. The federal government provides an assist by making those contributions tax-deductible. At public universities, it is the generosity of the state taxpayers via the state legislature. Take away that ATM, and I wager that a lot of the perks that make the quasi-socialist utopian enterprise so interesting to those who are left-of-center would disappear. Universities would have to conduct their daily operations more overtly like a business, and we would find a more balanced mix of people trying to get jobs there.

I think that there has been too much emphasis in this debate on pernicious explanations. Krugman makes thinly veiled accusations from the left that conservatives have no respect for scholarship, and the David Horowitz crowd makes equally absurd accusations from the right of a left-wing conspiracy. Have I proven that both are wrong? No. I have just offered a much more benign explanation. I don't claim that it is the only explanation. I do believe it is an order of magnitude more relevant than these two extreme arguments.

So perhaps the last question to ask is: would universities be better off by operating more like a conventional business and less like the kibbutz hooked up to an ATM? I think the answer is "no" (or not really), precisely because the money flowing from the ATM is voluntary and not coerced. The benefactors of universities seem to believe in the mission, the personnel, and the institutions to continue to support them, despite their flaws. And there is a tremendous amount of goodwill on both sides of that relationship.

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Representative Stephanie Herseth (D-SD)

At the Rockefeller Center, we have started a New Voices in Washington series. One of my biggest disappointments with the Presidential conventions last summer was how little they seemed to showcase and cultivate younger members of the two parties, whom we might look to for leadership in the years to come. So we are actively seeking out new voices to bring to campus.

We inaugurated the series last evening with a visit from Representative Stephanie Herseth (D-SD). You can find her Congressional website here and her campaign website here. She's a centrist--she has to be to represent South Dakota--and she had full command of a range of issues, which mainly focused on domestic policy in her lecture. There are several issues on which she and I disagree (as many to the left as to the right), but it is also safe to say that if the Democratic leadership in Washington held her views, I would vote Democratic.

Here's a new test of the skills of those at the helm of the Democratic Party: can they find a way to make her a vice presidential candidate in '08, '12, or '16?

Read other coverage in The Dartmouth and at Joe's Dartblog.

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Dog Fights

Based on this cryptic note at Maxspeak:

P.S. The dog that didn't bark. Nothing on this from Vox, Baby.

And this generous comment at AngryBear:

Greg might have given a citation to Andrew Samwick for this:

If the dividend yield is approximately irrelevant, as Modigliani and Miller tell us, then it is easy to imagine that it could undergo a major change in the years to come. Looking ahead, it seems plausible to me that dividend payouts broadly construed could rise significantly. If we are about to experience a period of slower economic growth because of demographic change, then firms might well have fewer profitable investment opportunities and, as a result, may decide to pay out a larger percentage of their earnings.

It seems like PGL should take Max for a walk to the dog pound.

I'm sure that for those inside the beltway, the Baker-DeLong-Krugman presentation at Brookings, along with the Mankiw comments, was big news. The crux of the matter is simply that the projections of future stock returns can be reconciled with the low economic growth rate in some models only if U.S. corporations do something other than reinvest a large chunk of their earnings domestically. I posted about this issue about two months ago, and subject to minor adjustments, that original post still represents my basic viewpoint. In the absence of additional knowledge and insights, I offer no additional posts.

Elsewhere in the blogosphere, Scrivener raises some interesting points about what happens to bond returns as stock returns fall relative to their historical values. Dean offers some followup comments over at MaxSpeak, and Brad offers some brief comments on his blog. To quote the MinuteMan, "[T]he intellectual ball seems to be advancing."

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Ben Bernanke To Be CEA Chairman

From today's White House personnel announcement:

The President intends to nominate Ben S. Bernanke, of New Jersey, to be a Member of the Council of Economic Advisers. Upon confirmation, the President will also designate him Chairman. Dr. Bernanke currently serves on the Federal Reserve System's Board of Governors. In addition, he also serves as Professor of Economics and Public Affairs at Princeton University, a position he has held for twenty years. Dr. Bernanke previously taught at Stanford University, New York University, and Massachusetts Institute of Technology. He earned his bachelor's degree from Harvard University and his Ph.D. from Massachusetts Institute of Technology.

Bernanke is an excellent choice and I wish him the best.

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