Developing a Theory

I'm slowly developing my own views about global climate change.

Don't anybody rush me.

One aspect of my emerging view is that markets are rational, and unbiased by any of the various factors that may bias scientists with or even without political interference. So where market rationality seems likely to be strongest, believe it over even the best credentialed experts.

Look at the earthquake in Japan, unpredicted by any scientists, but predicted by Dennis Gartman, author of a widely followed investment letter.

But in the matter of climate change, the news would come from, say, increasing flood insurance premiums.

Unfortunately, in the U.S. and in much of the rest of the world, flood insurance is a heavily socialized and political matter.

Anyway, I have discovered even since beginning work on this post that Matthew Kahn, a guest blogger at The Volokh Conspiracy, has been way ahead of me.

Back in November, Kahn wrote that for-profit insurance companies must be allowed to engage in price gouging, because price gouging is exactly what the price signalling will look like if the market for flood insurance does begin to reflect oncoming climate change and rising sea levels.

So: are there places where such price gouging is allowed by law, and where govt doesn't discourage it by in effect offering a competing subsidized product. And, if so: has that gouging become more successful, more profitable, of late? are there new entrants into those markets? This is where we should be looking, if we hope to understand the direction of climate change.

What is to be done?

There are reports this morning of a done deal on Capitol Hill. The degree of concord may again be over-stated.

Nonetheless, the wisest discussion I've yet found of how policy makers might overcome the Wall Street crisis, how they might in the process "save capitalism from the capitalists," is that set out here on the faculty page of a professor at the graduate school of business, University of Chicago.

Dr. Zingales sees the issue as one of an expedited bankruptcy proceeding. In bankruptcy, what happens is that equity is wiped out, and debt is traded for equity. This means that those who had control of the enterprise formerly take the first wave of loss, and those who had lent them money move into the position of greatest risk, and of greatest control moving forward, vis-a-vis that enterprise.

We can not wait for bankruptcy proceedings to move forward in the case of the investment banks of Wall Street. There simply isn't enough time. But that doesn't mean that the principle should be scrapped.

There is no need to put taxpayers on the hook at all. The stockholders of the investment houses at issue must logically take the loss, and the bondholders must step up to the plate, in a way that maintains continuity for the counter-parties of those institutions.

Janet Tavakoli, an influential consultant, the principal of Tavakoli Structured Finance, is echoing Dr. Zingales' message, as she does here for example.

I'm happy to be counted in their number.

[Note: By use of the term "echo" I didn't mean to make a judgement about chronological priority. Ms Tavakoli reminds me that she advocated related views more than a year ago, as here. All who advocate a debt-for-equity swap as a crucial part of the proper government response to this situation are taking the truly capitalistic side, whatever the chronology of it. Call it 'echoing' one another without chronological presumption.]

There Will Be Blood

I saw the movie There Will Be Blood last weekend.

The plot is straightforward, and kin to that of The Aviator or Citizen Kane. The protagonist in each of these three cases is an entrepreneur, and we see him overcoming various obstacles in order to build a thriving business and get himself a large mansion.

But in movies of this sort we're also supposed to get a sense of vast human costs intertwined with that success. We end up with Hearst/Kane dying alone in that mansion with the name of a childhood toy on his lips. Or, in The Aviator, with Howard Hughes so imprisoned by his various obsessions that he can't enjoy his victories in the marketplace. There is an analogous ending here, which I won't give away.

The point I have to give away, though, is that we feel the loneliness of the big mansion Daniel Plainview comes to own, a mansion that may have been inspired by one he saw as a kid back in Wisconsin, but one surely on a far grander scale, with enough room for its own bowling alley. We were allowed along the way to enjoy the sheer force of will, the human energy, that force that laid the pipeline to the sea, the pipeline that the Standard Oil honchos thought the protagonist would never be able to build. He built it, by gum. But we feel the hollowness at its end.

This movie makes abundant reference to the biblical resonance of brotherly struggle. Esau the ruddy hunter, and Jacob, his (barely) younger brother, the studious fellow who "dwelled in tents."

There are two distinct brotherly rivalries at the heart of this movie. On the one hand, there are two brothers (played by the same actor) in the Sunday family, which owns land that the Oilman needs for his derrick.

On the other hand, there are (or might be) two Plainview brothers in the movie, and their relationship is foreground just when that of the two Sundays is background.

In short, I loved this movie.

Capital Gains

What is a "capital gain"? and why is it taxed at a rate lower than than of ordinary income?

The textbook answer to the first of those questions: a capital gain is the amount by which proceeds from the sale of an asset exceed the original cost.

Further, there is at least one obvious and intuitive reason for treating capital gains differently. The income from the sale of an asset that a taxpayer has held for several years realizes the accretion of value over each of those years, whereas his/her salary, wages, tips etc.(paradigms of "ordinary income") represent the return on labor expended in the taxable year involved. This means that if the income from the sale of a house were taxed as ordinary income the year of the sale, the homeowner would experience an enormous hit that year. This is called the "bunching effect," i.e. taxable events from several years bunched into the year of realization. That, in turn, would freeze up assets -- everyone would become afraid to sell anything valuable for fear of the tax hit -- with disastrous economic effect.

So far, so good. But there are also short-term intra-year capital gains. Why aren't they taxed as ordinary income? Suppose I bought a house in February 2006 for purpose of flipping it. Did so in April 2006. Why shouldn't my profit be treated as ordinary income? The best argument against doing so is that there would still be a "lock-in effect" even without any bunching. We (policy makers or others putting ourselves in their shoes) want people to be able to flip house, because they contribute to the liquidity of the marketplace -- to the ease with which non-speculators too can find something to buy or sell when the time is right.

But the intuitive appeal of that argument is weaker, it would seem, than the appeal of the bunching argument for longer-term investments.

And since we're thinking about it ... there might be better ways of dealing with the "bunching effect" in the case of long term investments too. Conceivably, the accretion of value to my house could be taxed each year as it happens, so that the final sale would have no or only a very slight significance for tax purposes. (Yes, there would be obvious practical difficulties there.)

Aside from the bunching and lock-in effects, the only significant remaining argument for differential treatment of capital gains is this: taxing such gains discourages investment or (what is the same) discourages savings, encouraging immediate consumption and indebtedness.

Does it, though? The late Milton Friedman always used to maintain that fiscal policy is much less efficacious at shaping behavior than policy-makers flatter themselves it is. I wonder about this one.

Also, there seem to be a number of areas defined by law as "capital gains" arbitrarily, or simply as a response to lobbying power and cronyism, where the definition isn't warranted by any of these arguments. But more of that another time perhaps.

Corporate (Voluntary) Bankruptcies

On June 23 I wrote in this blog about corporate bankruptcies, chiefly to make the point that the chapter 11 "process is and should be a very public, very transparent one."

But today I'm wondering why that piece was so timid. Maybe I should've called for the abolution of any such process, insofar as it can as now be voluntarily chosen by the debtor.

There should be a procedure for the orderly liquidation of chronically insolvent corporations. I concede that. But wouldn't it make more sense to expect that the creditors themselves would initiate the process in the normative situation? If the creditors decide there is no other way they'll get much of their money back, they'll be the ones to petition for an orderly wrap-up.

The company management represents the owners of equity. In principle they should always care more about seeing to it that the stock retains some value than they care about anything else -- even the payment of their bonds. They aren't working in the first instance for the bondholders. Bondholders don't have proxies.

If a corporation's management is the party that initiates a bankruptcy proceeding, there is already a prima facie case that they think it possible they'll survive, to be the managers of the re-organized company. As, often. they are. They can do this either while assuring that the original stockholders still get some share of the new company, or despite their failure to ensure that. Logically there is no third choice.

So, logically, it seems that whenever a corporate voluntarily files for bankruptcy either the decision-making management is hoping to help the stockholders cheat the bondholders, creditors, etc., or it is planning to cheat those stockholders. Neither is a good thing, or even a policy-defensible thing.

So ... down with voluntary bankruptcies and re-organizations! That is my new view of the matter until something or someone persuades me otherwise.

"Gotcha!" says NYTBR

Brian Doherty, a senior editor at Reason magazine, has written what he calls a "freewheeling history" of the modern libertarian movement, centered on five figures of enormous importance: von Mises, Hayek, Rand, Rothbard, and Milton Friedman.

The New York Times has run a rather mean-spirited review of the book, in which critic Leonhardt plays trivia games of "gotcha."

Here's a sample from the review, "In a single chapter, Milton Friedman is described both as an active writer at Stanford University and, accurately, as deceased."

Well, yes. That kind of thing can happen when one of the crucial figures upon whom a book is based happens to die while the book is in page proofs. Leonhardt doesn't seem very lion-hearted here, more like a jackal.

Another example of this critic's oh-so-substantive contribution to the conversation about serious ideas, about liberty and sovereignty and such, is this gem: "And almost everything about 'Radicals for Capitalism' is too long: the terms ('Popperian falsificationist'), the sentences that sometimes run more than 100 words, and the book itself, at more than 700 pages."

That seems a remarkable expression of anti-intellectual bias. "Why shucks, I can't handle dem big words, Brian. That's why I write book reviews for this down-home cornpone type publicashun." If you aren't interested in the intellectual history of recent political and economic ideas, you won't read the Doherty book at all. If you are interested enough to read the book, you'll probably already know that there's been a lot of debate over whether such ideas can be considered "scientific," what is the demarcation of science, and so forth. You'll be ready for the term "falsificationism," modified by the name of its best known advocate.

The whole Leonhardt review reads like a sad failed effort at a fisking.