Introduction

1. Introduction • Today’s lecture covers a few areas of government policy that we have not addressed so far. • It also covers some miscellaneous topics that are of particular interest or import. • Then we turn to National Defense, Foreign Policy, and Security; • Then Crime, Property Rights, Contracts and related issues. • The remaining lectures will then address “big picture issues” like overall themes.

2. Outline • Financial Markets • Transportation • Disaster Relief • State Lotteries • Housing • Nuclear Power • Tort Reform • Miscellaneous

3. Financial Markets • Financial markets are subject to substantial regulation and intervention in the U.S. and most countries. • The stock market receives the most attention: • Prohibition on insider trading; • Disclosure requirements imposed by the SEC. • There is also substantial intervention in other areas: • Quasi-government agencies that buy and sell mortgages or other financial assets (Fannie Mae, Freddie Mac, Sallie Mae). • Government agencies that insure various financial assets or institutions (PBGC, FDIC)

4. Financial Markets, continued • The standard claim is that regulation is necessary to protect investors and help financial markets work efficiently • Likewise, agencies like Fannie Mae or FDIC allegedly protect participants and improve market efficiency. • In fact, there is little reason to think these inter-ventions are beneficial, and they impose their own costs on the economy. • The discussion here focuses on the ban on insider trading but also examines other aspects of government intervention in financial markets.

5. The Ban on Insider Trading • Under current law, “insiders” cannot trade stocks based on “inside” information. • This ban dates from 1934. It was adopted in response to the Great Depression and the stock market crash of 1929. • The definition of who is an insider and what constitutes inside information can get complicated, but the general idea is, for example, that a CEO who has just learned that the company’s key product is defective can not (legally) go out and dump his stock (or short the stock). • This might sound like a reasonable policy, but it is in fact hard to justify based on efficiency or equity.

6. The Effects of Banning Insider Trading, I • The most obvious effect of banning insider trading is to delay the release of relevant information and delay the adjustment of stock prices to this information. • This is inefficient, not efficient. • It is not obvious this is a major inefficiency: • As a rule, delay of a few days or weeks is not a big deal. • And, in many cases the information leaks out quickly, no matter what the rules, so the damage caused by the ban is probably modest overall. • But efficiency considerations nevertheless argue against a ban on insider trading, not in favor of such a ban.

7. The Effects of Banning Insider Trading, II • Under a ban, some insiders break the law and trade on inside information anyway: • There are multiple mechanisms for accomplishing this, such as telling family and friends, trading related stocks, using hidden assets, and more. • Thus, a ban inevitably rewards dishonest insiders and penalizes honest insiders.

8. The Effects of Banning Insider Trading, III • By banning insider trading, policy implicitly supports the view that individuals should consider buying and selling individual stocks. • In fact, that is crazy: • Virtually everyone, including PhD economists, should buy the market and hold it. Period. No exceptions. • It is insane for people to be trading stocks on AmeriTrade or through their brokers: it eats up commissions, probably adds variance, and at best fails to improve the average return. • Thus, if policy were inclined to be paternalistic, it should make most people think they are at an enormous information disadvantage relative to insiders: • This might help convince them to buy and hold the market.

9. The Effects of Banning Insider Trading, III • Of course, libertarians rarely want to be paternalistic. • But in this case, the efficient thing to do also happens to be the correct paternalistic thing to do. • So, libertarians would not ban individuals from trading stocks, even if that is dumb. • But good policy should certainly not encourage people to engage in stupid behavior, and the ban on insider trading does just that by creating the appearance that everyone has access to the same information.

10. The Effects of Banning Insider Trading, IV • The ban on insider trading also makes it harder for the market to learn about incompetence and/or malfeasance by management. • If there are any honest insiders (or even dishonest insiders who want to make a profit), they should start selling/shorting the company stock as soon as they learn about bad acts. • Under the ban, however, they cannot legally do this, so information stays hidden longer.

11. The Ban on Insider Trading, continued • The only possible reason for a ban, therefore is distributional: • Protecting poor relative to rich investors. • But the main effects are between some high-income participants and other high-income people; • And by giving a false impression to unsophisticated investors, the ban might even worsen the distribution of income. • Thus, there is no good case based on either efficiency or equity.

12. Fannie Mae and Freddie Mac • These two entities are the: • Federal National Mortgage Association • Federal Home Loan Mortgage Association • They are, for our purposes, similar enough in what they do to ignore the distinctions. • They are both private companies but chartered by the federal government. • They issue “mortgage-backed securities,” which increases liquidity in this market.

13. Fannie Mae and Freddie Mac, continued • The argument usually given for chartering these entities is that home ownership is good for the country and that private markets will not provide an adequate supply of mortgages. • Both assumptions are problematic. • Without question, mortgage lending and home ownership have grown enormously during the existence of these companies: • But this is probably a coincidence. • Note also that government policy encourages home ownership in other ways, such as by allowing the deductibility of mortgage interest. • The likelihood is that policy is substantially oversubsidizing home ownership in the U.S.

14. Fannie Mae and Freddie Mac, continued • The problem created by these entities is that everyone views them as, de facto, backed by the federal government. • Each is chartered by the federal government • Each has a line of credit w/ Treasury • President appoints some board members • Exempt from state and local income taxes • Thus, if they ever fail, taxpayers are probably on the hook for their liabilities (which are huge). • Moreover, political pressure on these entities has, in recent years, caused them to expand lending substantially to riskier borrowers: • For example, people who cannot put much money into a down payment when they buy a house.

15. Fannie Mae and Freddie Mac, continued • Thus, the next time there’s a serious downturn in the economy, a large number of these borrowers are likely to default. • That imposes loses on Fannie and Freddie, and the taxpayers are likely to bear the brunt of the damage. • The magnitudes involved are enormous.

16. The Federal Deposit Insurance Corporation (FDIC) • One persistent feature of the U.S. economy during the pre-1934 period was bank runs. • Under fractional reserve banking, banks hold in their vaults only a small amount of the money that has been deposited; • The lend out the rest to earn a return. • This means that if depositors get nervous and try to withdraw their money, the bank fails. • This happened to some degree pre-1929, and then to an enormous degree during the 1929-1933 period. • As a result, Congress created FDIC in 1934.

17. FDIC, continued • Under FDIC (and FSLIC, for S&Ls), deposits at banks are insured: • If the bank fails, the depositors get their money back in full. • This system creates an enormous moral hazard problem for the banks: • There is a temptation to use deposited funds to buy risky assets because if the assets pay off the bank wins big; • If the assets fail to pay off, the bank owners do not have to pay the consequences. • To limit this problem, there is substantial regulation of the assets that banks can hold: • They were historically restricted to relatively safe assets.

18. The Savings and Loan Bailout • In the 1980s under Reagan, however, Congress relaxed the restrictions on asset holdings, allowing S&Ls to gamble a lot more: • They did. • They lost (partially due to bad judgment and/or corruption, partially due to bad luck). • Taxpayers bore much of the cost.

19. The Pension Benefit Guarantee Corporation • Created in 1974, this government agency guarantees the pension plans of private companies. • PBGC maintains a fund based on premiums paid by companies. • These are available to pay pensions if private plans fail. • Again, this system creates an obvious moral hazard: • Companies promise overly generous pensions and take additional risk with their pension investments. • A number of companies, or company plans, fail. • Taxpayers foot the bill, since the assets of the PBGC are not nearly sufficient to pay off all the pensioners whose pensions have gone bust.

20. Financial Markets: Summary • Financial markets entail risk: • This is an unavoidable fact of life. • Government attempts to reduce risk, or promote other goals, inevitably create moral hazard problems or generate other unfortunate side effects. • Many existing interventions in this area are time bombs waiting to go off.

21. Transportation Policy • Governments intervene substantially in the transportation market: • Building and maintaining Roads • Building and maintaining Subways • Subsidizing Railroads, such as Amtrak • Promoting Safe Air Travel via the FAA • Operating City Bus Systems • There is probably an appropriate role for government in the transportation sector, but it is undoubtedly much smaller than what currently exists.

22. Transportation: Roads • It is hard to imagine a situation in which there is no government involvement in deciding which roads go where and the like. • But there is substantial scope for reduced involvement: • Leave all roads to states and cities. • There is also substantial scope for better operation of existing roads: • Tolls and peak-load pricing; FastLane systems; faster repairs in those cases where repairs are warranted. • Plus, a substantial amount of road work is pork for unions, construction companies; • Right amount to spend is much less than currently.

23. Transportation: Subways • There is nothing wrong in principle with subways; • But in most places, population density is not high enough to justify them on standard cost-benefit grounds. • In addition, virtually all the benefits go to locals, so it makes no sense for federal tax dollars to pay for a subway in SF (or the big dig in Boston). • If the federal government stayed out, states and cities would do something closer to the right calculation, and there would be many fewer subways (or other dumb transportation projects).

24. Transportation: Railroads and Amtrak • The federal government has been subsidizing Amtrak for decades. • There is no plausible justification for this, and as long as the subsidy continues, Amtrak has reduced incentive to improve. • Likewise, there are subsidies for other rail travel. • It’s all based on emotion and nostalgia, not economics or common sense. • The federal government should just eliminate all subsidies, and let the market decide whether rail travel is economically viable.

25. Transportation:The FAA • Airplane safety is something everyone values. • The usual assumption is that airlines will undersupply it if not regulated: • They will cut corners to save money. • This view ignores basic economic realities: • Airplanes are expensive. • Pilots and flight attendants will not fly unless they think the planes they fly in are safe. • Insurance companies also hold airlines accountable. • Reputation and market forces also push airlines to maintain adequate safety.

26. Transportation: The FAA • Thus, it is not obvious the FAA does a better job than private incentives. • Indeed, when they are under FAA regulation, airline companies might believe they have done “enough” so long as they comply with FAA rules; • By so going, they can defend themselves against liability claims by saying “we did what the government told us to do.” • But this is not necessarily the right approach. • So, the private sector may well do it better.

27. Transportation: City Bus Systems • Local bus service seems to be something the market values. • But the private sector can provide this. • The standard argument for public provision is that private companies provide inadequate service to poor neighborhoods. • But the evidence does not support this: • In places with private bus service, poor communities do get served because there is sufficient demand to make it profitable. • And the private services are more efficient.

28. Disaster Relief • Governments often provide aid to victims of disasters both domestically and abroad: • Katrina • Tsunami • Pakistan earthquake • There is no question that the victims deserve compassion; • The question is what, if anything, governments should do in these situations.

29. Disaster Relief, continued • The single most important government response should be to avoid creating these situations in the first place: • Katrina is a good example; • Had government not built the levees and offered subsidized flood insurance, the magnitude of the disaster would have been far smaller. • Similar issues arise more broadly; governments routinely encourage this kind of stupid risk-taking; • And governments routinely bail out victims in ways that encourage continued, inappropriate exposure to risk.

30. Disaster Relief, continued • In some instances, however, there is no issue of the government having subsidized risky behavior or of the private sector having taking undue risks; • There is just bad stuff that happens. • Nevertheless, there are reasons to be cautious about the merits of government disaster relief.

31. Disaster Relief, continued • To begin, it is clear that private relief efforts do exist and play a significant role. • For example, the Red Cross, Doctors without Borders. • Thus, it is a mistake to think there will be no help provided unless government provides it; • Apparently private altruism is substantial, despite the public goods issue. • Second, government relief efforts probably reduce the incentive for private giving. • People give less to private efforts because they know their tax dollars are supporting government efforts. • Thus, the net reduction in relief efforts that would occur if the government stopped providing relief would be substantially smaller than the amount of government relief. • And the private efforts are probably more competent.

32. Disaster Relief, continued • Third, intervention in situations where there is no issue of rewarding dumb past behavior or of encouraging new inappropriate risk taking still potentially sets a precedent that makes it harder to avoid relief efforts in future cases where the situation is less clear. • Thus, the right policy is plausibly no intervention at all, despite the fact that this approach appears heartless and is not politically easy.

33. State Lotteries • Virtually all states now operate gambling operations like lotteries, whether or not they allow private provision of gambling services. • The main argument usually offered is that the lotteries generate revenue. • Whether lotteries are good or bad depends on the alternative.

34. State Lotteries, continued • Compared to no legal provision of gambling at all, state lotteries accommodate some of the demand for gambling and thereby shrink any black market. • The first best, however, is to allow free entry into the provision of gambling and have the state exit the business. • If there is a reason to reduce gambling relative to its free market level, a simpler approach is to tax the provision of gambling services.

35. Housing Projects • One component of income redistribution to the poor in the US and other places is housing subsidies. • These frequently take the form of housing projects: • Apartment buildings that offer low, below-market rents to low-income families. • An alternative approach is to provide housing vouchers that allow low-income families to afford housing in various neighborhoods.

36. Housing Projects, continued • Libertarians prefer unrestricted transfers of cash (holding the total value of the transfer constant) rather than transfers that try to restrain the kinds of spending by recipients. • But the housing project approach to providing housing subsidies has substantial negatives, even given the desire to constrain purchases to housing. • The housing project approach gives recipients one or a small number of choices of where to live. • This approach forces low-income households to live in neighborhoods that have high crime, lousy schools • Maintenance of these projects is usually poor; they are depressing places. • Allocating these projects generates an excellent opportunity for corruption and arbitrary redistributions to the “wrong” people.

37. Housing Projects, continued • An interesting research project, Moving to Opportunity, uses an experimental design to assess whether the voucher approach yields better outcomes in terms of increased educational attainment, lower crime, higher income, and the like. • The result is disappointing in one dimension: • The impact on quantifiable things like education are pretty small and occasionally even perverse. • But, the recipients do seem happier; • This is entirely consistent with my assessment of educational vouchers.

38. Housing Projects, continued • Thus, if there are income transfers to the poor and if policy insists on constraining the way that income gets spent, vouchers are a much better approach than government provision of housing. • The same general principle applies broadly: • Education vouchers • Health care vouchers • This is in fact exactly what already occurs now in one area: • Food Stamps.

39. Nuclear Power • Environmentalists are strongly opposed to nuclear power. • There is some risk of a major catastrophe; • In addition, are the costs of disposing of the nuclear waste; • And there are other environmental costs, such as dealing with large amounts of superheated water. • Some groups see these concerns as highly exaggerated and advocate nuclear power for various reasons: • Claims about costs being relatively low • Global warming concerns • It might seem hard to sort out the competing claims, especially since one key component is a “rare” event.

40. Nuclear Power, continued • In fact, the issue is easy to address and provides an example in which the solution is, “Get rid of the bad government that created the problem in the first place.” • The Price-Anderson Act, adopted in 1957, limits the liability of the nuclear power industry in the case of accidents. • This limitation is important, since the potential for a horrific event, while small, is not zero.

41. Nuclear Power, continued • If the industry did not have this implicit subsidy, it would have to buy insurance from the private sector, and this would be enormously, if not prohibitively, expensive. • Thus, the true costs of nuclear power are much higher than they appear; • This means the private sector would not want to invest in nuclear power, so there would be no controversy in the first place.

42. Tort Reform • Under the tort liability system in the U.S., persons who believe they have been injured by someone else’s conduct can sue for damages. • There has been substantial unhappiness over this system for decades. • Businesses believe that juries hold them liable inappropriately, or find them liable for ridiculous amounts of money. • The “poster-child” incident for this view is the $2 million award to a women who burned herself opening a cup of McDonald’s coffee while driving in traffic.

43. Tort Reform, continued • There is no question that juries have awarded damages in cases where the fault of the defendant was far from clear. • And there is no question juries have on occasion awarded ridiculous amounts. • But the claims that such awards are destroying American business, or that these awards have skyrocketed, however, do not seem supported by the data.

44. Tort Reform, continued • Likewise, the claim that juries are biased against businesses does not seem right overall. • The best evidence is tobacco litigation: • There have been hundreds of suits by individuals based on claims that they were mislead • Would seem to be a perfect venue for juries to hand out huge awards. • Until recently, however, the tobacco companies had not lost a single case. • And a recent Vioxx case also shows juries are not inevitably biased.

45. Tort Reform • So, it is not clear there is any crisis that needs fixing. It is nevertheless reasonable to ask whether the existing system is well-designed. • In recent years, many business interests have pushed for “tort reform.” • laws that specify the maximum amount a jury can award in a given case. • rules that awards for punitive damages cannot be more than “X” times the awards for compensatory damages.

46. Tort Reform, continued • Some of these changes are defensible: • In particular, punitive damages allow for “company bashing” and the like. • But the new rules will not make much difference: • There are many ways clever lawyers can litigate around the limits in “reformed” rules. • For example, if there are limits on punitives, inflate the compensatories. • Thus, tort reform will probably have little effect other than generating more work for lawyers.

47. Tort Reform: State or Federal • In addition, there is no reason for the federal government to impose tort reform on state courts: • If there are better approaches, each state can capture these for itself; • And having the feds impose one approach on all states suppresses innovation, variety, etc. • So, any reform should come from individual states. • This is a case where conservatives manage to forget that they support “state’s rights.”

48. Miscellaneous • Unions • Child Labor • Pork • Public Libraries • City Tennis Courts • Post Office • Seat Belt Laws • Weather Service