Category: Economics

Insider Trading and Crime

I recently rediscovered a short piece I had written about insider trading. It’s not particularly relevant to anything happening today, but insider trading continues to be a crime prosecuted by authorities and here I offer a couple of reasons it should not be.

The standard libertarian counterpoint to insider trading being a crime is to ask who the victim of insider trading is when, for example, an insider sells their stock before it is announced that a publicly traded company has gone bankrupt. The intuitive answer should be the people who bought the stocks from the person with insider information.

But this doesn’t hold up very well. Those people could have bought the stock the day before from someone else. They could have even been indifferent to when they bought the stock. If that’s true, then how could one person selling it be moral and another person selling it be immoral? The people who bought the stock the day before are just as screwed. The people who bought it the day before would be screwed even if there was no insider trading, since the company is bankrupt anyway in this example.

Someone dumping the stock adds information to the market. If insider trading was legal, you’d have investigatory firms that spend lots of money infiltrating into companies, and you’d probably find out about a company having trouble way before they file for bankruptcy. In the long run fewer people might be screwed over.

Yet don’t we prosecute other similar “insider” situations, like a scam where someone sells a lemon car to an unwitting customer?

This seems different. There is a clear victim if someone lies about their car before selling it. The victim of insider trading is hard to find. It’s not the person who bought the stock, since they put in an order without knowing about who was selling or not that day. They could have bought it from anyone, since stocks are commodified. The victim is all stockholders, collectively. Yet the vast majority of the cost borne by stockholders is due to the actual company being bankrupt. In fact, had the insider trading not occurred, everyone who bought stocks that day would have had to pay a bit extra for their stock, losing even more money. Thus, there’s an argument that insider trading is actually beneficial to the theoretical “victims”, a very odd criminal justice situation.

However, a better argument is if the insider trader bought a ton of “put” options at high price from a market maker. The people holding the other end of the options would be screwed and clearly identifiable. I think it would make more sense to punish people who do those trades than public stock trading.

Also, it’s worth noting that there is a similar situation for “lemons”, referring to cars with manufacturing defects. This is an information asymmetry problem regardless of whether selling them is immoral. Even if you’re a nice person and tell everyone who inquires all the problems with your car, they may think you are still hiding something, since everyone has to assume any car may be a lemon. Thus, we need other ways around this market failure. Government is one method, but it’s got its own issues, as it’s not very agile, subject to political graft, etc. A better one is cheap inspections offered by local mechanics, which help fix the problem. Another is companies like CarMax, which have a national corporate reputation that would be damaged if they sold lemons.

The point being that long-run, as I mentioned before, allowing insider trading might actually be beneficial, as information leaks more freely when there are clear incentives to leak it. Going back to the put option example, the holder of the option knows they are exposed, so they are incentivized to sell some underlying stock as soon as they make the deal with the (unknown to them) insider. It’s one level removed from the insider directly trading on the stock price, but there’s still an incentive to reflect the insider knowledge in the stock price. Moreover, options can be traded as well as stocks, so a put option seller could be selling to both insider and non-insiders at any time; that again creates the situation that the “victim” would have likely had very similar things happening to them regardless of the insider trading (assuming a pretty liquid market). Again, the seller of the options is actually better off in the hypothetical world where there is an insider trader if you assume they would be selling these options regardless. The insider drives the price of the options up the more he buys them.

Information is valuable, and I don’t think it’s practical to expect everyone to have perfect information all the time (this is a consequentialist argument). If someone sells you their old crappy car, it doesn’t feel like he’s an outstanding person, but on the other hand, when someone lists something for too cheap on craigslist, it doesn’t seem like buyers should be required to tell them the item has been undervalued. Maybe they know that, but are moving this week, maybe they have two of something and the second one just isn’t worth the effort to talk to lots of buyers. And shouldn’t anyone selling know not to take the first offer?

In some sense, every agent in a trade has access to information the other person doesn’t have; this is the source of consumer surplus. You can buy cold medicine for cheap at a local pharmacy because the pharmacy has no way to price discriminate between rich people who are feeling terrible with a cold and would pay $200 for Sudafed, and someone who is cheap and only buying it just in case for $10. This results in huge consumer surpluses on almost every good, yet no one would seriously argue pharmacies or grocery stores are getting ripped off because they can’t tell how much you’d be willing to pay for every item. Some renters may be ready to do all sorts of bad things to an apartment, while some will leave it in perfect condition. Is this unfair that the landlord doesn’t know what kind of renter their tenant will be? I don’t think so. So then what makes insider trading economically special?

The real question is whether the decriminalization of insider trading creates perverse incentives to waste resources on finding out information. We already spend way too many societal resources on stock trading in my opinion. Reducing the clearing of stock market trades to once a second or once a minute would have minimal impact on long-term knowledge gathering about company performance, yet it would stop incentivizing millions of dollars spent on fractional-second computerized trading. Insider trading means firms could get a new edge by hiring infiltrators and detectives to get information on a company, or even just their financial data. Even though I believe strongly that the information usage of insider trading to make money on the market does not create victims and thus isn’t worth prosecuting, there is a risk that actual actions that insider trading incentivizes are negative.

Companies are free to run their organizations as desired, but as Matt Yglesias points out, right now they outsource enforcement of insider leaking to federal authorities. It might prove cheaper to have the Feds enforce information security than to have each company do so. CEOs might also be incentivized to trade on their knowledge, paying off others, securing information and funneling money through intermediaries, which is all wasteful. Of course, companies would want to avoid this, and so they might come up with good systems to thwart any approaches. However, interests external to the firm, like investment bankers or private equity, would have incentives to buy insider information from detective agencies, leading to an industry that wastes time tracking down these now legal information leakages.

Matt Yglesias notes this would lead to elements of a low-trust environment. I think there is some truth to that, but I think it’s also clear that jail time for insider trading is not a good use of societal resources. I think high fines and attaching names to guilty verdicts should be effective enough. Sending people to jail doesn’t protect anyone since there are no victims. Disincentivizing behavior monetarily and through public shaming should be enough, and I think it’s worth trying. Of course, this isn’t a a vital immediate criminal justice reform needed, but rather should be done as part of a larger rethinking of the criminal justice system as a whole.

Things Mars Can Export

Imagine an economy on Mars or the Moon. Some people move there, excited about the chance to live on the new frontier of human development. They set up shop and start providing services and goods to each other. They’ll need jobs like metallurgist, construction worker, physicist, farmer, material scientist, physician, etc. The technician with the 3D printer will trade with the computer repairwoman who will trade with the doctor who will trade with the solar panel producer. Certainly very early colonies won’t do much trading and work more as a cohesive unit, with specific team members and job duties, running as a ship’s crew or military base more than a small town. But eventually once the outpost becomes big enough, trade will occur.

What will they use for money? Well, it’s not the point of this post, but I’d like to take a moment for speculation anyway. It’s possible that the centralized group that creates the space colony will see this problem ahead of time and establish their own currency. But it wouldn’t take much for someone to introduce a simple Bitcoin fork to create their own blockchain. Such a currency would only require an application running on a computer, something the colony would likely have lots of. I’ve written before that Bitcoin isn’t that great of a currency at present, but it does have benefits if your local currency is already pretty bad, see Venezuela. On Earth it functions as a floor beneath which local currencies can no longer do worse than. However, on Mars, the local currency would have a lot of uncertainty surrounding it. Maybe a bank has been set up, but why would people trust the bank? It doesn’t have a long history of trustworthy monetary policy like some Earth central banks do.

Suppose SpaceX sets up a Martian colony and creates a bank to hold everyone’s dollars. It’s too long to wait to ping back to Earth (average message/reply round trip is 6-40 minutes) to transfer Earth currency, so you’re left with trusting SpaceX’s bank that they won’t mismanage the currency, even though SpaceX doesn’t have any experience managing currency. Well, what if some enterprising people come over with a “MarsCoin” clone of Bitcoin, running a blockchain on Mars? You can send the code to Earth for audit, then run the code yourself on a local network of servers. If the block time is lower than it takes for a return ping to Earth (almost always true even if you’re using the 10 minute blocks of Bitcoin, which could be shortened), then you have a decentralized, trusted currency that’s much simpler than relying on distant Earth institutions or unproven Martian ones. Of course, then you need a special interplanetary blockchain to move currency between Earth and Mars with a very slow block speed, but we’re getting off on a tangent.

We have established that there will be a way to trade on Mars and between Mars and Earth. Mars will obviously have things it needs to buy from Earth, like difficult to manufacture parts, engineering and consulting services, and likely entertainment. But what will they be able to export to Earth? A country that can only import goods probably can’t sustain itself, unless there was positive immigration. We can thus treat reasons to immigrate to Mars as part of the answer to what Mars can export. I have compiled a list of possible ways the Martian economy can maintain a stable exchange rate with Earth.

Science

Science is the clear primary export of Mars today. As Robert Zubrin states in this excellent video, we believe Mars had liquid water on its surface for a long time, perhaps a billion years. On Earth, life showed up much sooner than a billion years after liquid water appeared. If we go to Mars and find evidence of life, that would help prove that the development of life is pretty common in the universe. On the other hand, if we don’t find much evidence of life, that could help point out that life isn’t very common on in the universe. Evidence of current or past life, could also help us determine whether all life is similar to that of life on Earth, using DNA to create amino acids and so on. These questions are “…real science. This is fundamental questions that thinking men and women have wondered about for thousands of years.”

From an economic standpoint, it’s clear that scientists on Earth are willing to pay billions of dollars for this data. They might send their own scientists to Mars, which would count as positive immigration, or they might hire Martians to conduct the science for them, but it’s clear that scientific interest in Mars is worth billions. It’s also worth mentioning that other celestial bodies would also have this benefit, the Moon likely less so than Mars, and Jupiter’s moons perhaps similarly valuable.

Tourism

Space tourism also seems like an important industry for a space colony, although perhaps not Mars. Andy Weir’s Artemis takes place on the Moon and space tourism is an important export industry. Tourists visit the Apollo 11 landing site and jump around at 1/6 Earth gravity. It seems likely that similar tourism might function on Mars, although there are serious limits. For example, the trip to Mars takes months, would occur in essentially zero-g, and usually is only done one way every two years. Large rooms with windows would seem both vital for any tourism industry and highly impractical without radiation shielding. Vacationing for a week on Mars wouldn’t be practical, unlike taking a week or two week vacation to the Moon. Perhaps a two year long sabbatical would appeal to some people, but probably not most. A more efficient transportation system, such as an ion drive ship between the planets might reduce the travel time or allow for interplanetary travel even when the planets are not close in their orbits. But until then, tourism is likely to be very limited.

Martian Souvenirs

If tourism is limited, perhaps actual Martian rocks will be more highly valued. Those might be much simpler to ship to a mass audience on Earth. Given the monopoly Martians would have on this industry, they could theoretically charge a hefty markup. This is, of course, in addition to the scientific relevance the rocks would have. On the less positive side, there may be regulatory issues for bringing alien rocks to Earth. Fears of alien bacteria that could kill everyone on Earth might cause prohibitions. Such a threat seems unlikely, but import bans are often irrational.

Reduced Launch Costs

Of all the rocky places in the solar system to launch a rocket, the surface of Venus with its Earth-like gravity, sulfuric acid rain, and insane heat, is probably the worst one. But Earth is a close second. Rocket launches must accelerate out of the “gravity well” of wherever their launch site is and then expend the energy needed to get to their target transfer orbit. Escaping the gravity well is very difficult on Earth’s surface. The Apollo program required very little fuel to get off the Moon’s surface because the gravity was so reduced (and the Moon has no atmosphere). Thus, the energy needed to get off of other rocky surfaces in the solar system is much less than Earth. Mars also orbits further out from the sun, which means you also need less energy to get to a transfer orbit to the asteroid belt or outer solar system. Thus, one economic benefit would be to offer Mars as a cheaper launching point for outer solar system exploration.

However, if you need to first bring an entire rocket and fuel to Mars before departing for your eventual target, you’re better off just leaving from Earth directly without dipping into the shallower, but still significant Martian gravity well. For this to be valuable, you’d need to be able to build the rocket on Mars, which seems much further off than the other ideas discussed here, or you’d have to create the fuel on Mars. This may be possible; SpaceX’ plan is to use the carbon dioxide in the Martian atmosphere and water ice on or near the surface to produce methane and oxygen as rocket fuel. One might also be able to find an asteroid or comet with water ice, carbon dioxide, or even methane, and bring it into orbit around Mars or the Moon, avoiding having to accelerate it into and out of Earth’s gravity well. Rocket manufacturing could then use a combination of terrestrial, martian, or lunar parts and fuel, supplemented by materials already in orbit, or even manufacturing plants in orbit. This could be sustainable in the long term. Asteroid mining would be extremely lucrative, with perhaps tens of billions of dollars in potential profit. If an asteroid mining company believed Mars, or the Moon could save them launch costs, they would likely purchase property, bring equipment and employees, and thus improve the Martian trade balance.

Natural Resources

Mars also has an abundance of natural resources in various compounds where they may be more common than on Earth. These include halogens, organic compounds, and deuterium. The extent and speed at which these will become useful to export from Mars are unclear, but they may eventually be useful as a source closer to the outer solar system than Earth, due to the reduced launch costs. Editing note: I decided to add this as separate category later after discussing this post.

On-Site Entertainment Production

This is another odd case, but it may be more immediately plausible than launching exploratory rockets from Mars. The low gravity of Mars or the Moon would allow for a different type of videography, with actors that actually weigh less able to jump large distances. This could be literal as for science fiction films that need to take place in low gravity, or perhaps more creative and unusual projects that endeavor to take advantage of this location in ways we have not yet conceived of. Again, however, the Moon may be a more accessible location than Mars, given the length and difficulty of travel.

Medicine

From what we know about the human body in lower gravity environments, the health effects are largely negative. There may be the possibility that osteoarthritis would be improved by living in a low-g environment, but anyone who has that problem would likely be old and might suffer from other problems. However, the severity of injuries from falls would likely be much less in low-g environments, and perhaps high blood pressure would be less of an issue. Nonetheless osteoporosis is known to get worse in zero-g, and so astronauts are forced to do weightlifting regimens in space to try and maintain their bone density. It’s possible that if the osteoporosis could be combated, people who suffer from osteoarthritis might live more comfortable retirements on Mars or the Moon. They could likely never return to Earth though, as their heart and muscles would have become significantly weaker and would likely give out upon return to Earth. We need more research on the human body under low-gravity conditions to see what the long term medical effects are.

Law and Society

This is much more likely to be a reason for positive immigration than for exports. People who currently live under legal systems on Earth may be interested in moving to a different legal system not currently available on Earth. They may even want to start their own society. That is not currently possible on Earth, as states claim almost all land on Earth. Moving to Mars due to its nonexistent or only slightly existent legal system would bring with it a variety or related goals and ideas, such as chance to shape the cultural future of Mars. One can see the related desires of immigrants who moved to the Americas from Europe in the 18th and 19th centuries (and earlier, I suppose). This would also include people who wanted to live on the edge of human exploration or contribute to the project of humanity reaching other celestial bodies, and perhaps eventually other stars.

There are of course limits here as well. Any existing Martian colony would have its own law and rules that might be just as restrictive as Earth, especially given the harsh conditions and lack of natural resources on Mars. To create a legal system and society on Mars, any group would require a massive amount of resources, equipment, and specialized knowledge, essentially creating a whole new colony. Could such a move possibly be cheaper than simply establishing a place on Earth? It’s hard to say. The problem on Earth is not just money and resources, but confronting states who have access to military power.

Capital Flows

It should be pointed out for completeness’ sake that of course Mars could potentially export nothing, but still expand their economy as Martians did productive work for each other. Then could borrow money from Earth, invest it, and Earthers would see a positive return. This would counter the negative pressure on the Martian exchange rate from exports. If Martian investments were failing though, then Martian currency would likely become pretty worthless to Earthers, and they’d likely stop selling goods to Mars. We should thus note a financial crisis could be quite problematic!

Conclusion

Mars has a variety of goods it can export, although the only immediately available ones are likely Science, Society, and perhaps space rock souvenirs. Others may eventually become economically useful, but will likely take some time.

Picture: Public Domain Image, Global mosaic of 102 Viking 1 Orbiter images of Mars taken on orbit 1,334, 22 February 1980. NASA 

Netflix, Entrepreneurship, and the Case for Economic Freedom

How would you go about convincing a free market skeptic of the benefits of economic freedom, as opposed to a tightly regulated or even a command economy? A common approach is to discuss productivity gains from free market systems, which reward higher efficiency production as consumers purchase the best and least expensive products. Competition between firms pushes companies to find efficiencies and new production methods.

One might also point out that it’s possible to divide the question of taxation and distribution from that of free market pricing and competition; in other words, if the market skeptic is concerned about the effects of a free market on the unskilled or the handicapped, it’s possible to have a robust safety net and tax system that is built on the most efficient taxes and welfare payments (land value tax, consumption tax, and direct cash grants).

However, today I want to focus on a more amorphous part of the free market, entrepreneurship. The Library of Economics and Liberty has an excellent encyclopedia style article on entrepreneurship written by Russel S. Sobel. He defines an entrepreneur as

…someone who organizes, manages, and assumes the risks of a business or enterprise. An entrepreneur is an agent of change. Entrepreneurship is the process of discovering new ways of combining resources. When the market value generated by this new combination of resources is greater than the market value these resources can generate elsewhere individually or in some other combination, the entrepreneur makes a profit.

Sobel also discusses the approaches of economists Joseph Schumpeter and Israel Kirzner in describing entrepreneurs. Schumpeter is famous for his theory of “creative destruction”, where entrepreneurs are the primary agents of disruption, upending the status quo and altering the market, leaving competitors behind. Kirzner focuses on the aspects of discovery that entrepreneurs perform, as they seek new markets, new processes, and new business models.

We should note that entrepreneurs don’t assume all risks. If their projects fail and the business operates at a loss, they lose their investments. However, if worker jobs are lost not due to performance but poor management, workers might be laid off, which is a risk workers assume, not the entrepreneur. Nonetheless, entrepreneurs likely take on more cumulatively, risking their job and also capital investment. Entrepreneurs are usually thought of in terms of small business owners or startups, but I’d argue many of the roles of an entrepreneur can be undertaken by larger companies. Maybe a publicly traded company cannot, by definition, have an entrepreneur, but if there are still market discovery and disruption operations that the company undertakes due to the search for untapped profit, that’s good enough for our purposes today.

So far, we’ve discussed that entrepreneurs search for market opportunities, new ways of doing business, and undertake risks, but what does this have to do with economic freedom? The benefits of entrepreneurship can be difficult to notice. Sobel uses the examples of Bill Gates and Microsoft which at the very least took over virtually (ha!) the entire personal computer market, and I’d argue created a large new market that hadn’t existed before. However, we don’t know what tomorrow’s entrepreneurs will come up with, and that’s the most vital point. Someone has to envision the new product or service, develop it into something that can be sold, create an organization capable of producing it, and then execute on those plans before the market reacts. If it was well known what needed to be done, it wouldn’t be innovative, and it would already be happening. Entrepreneurs need the freedom to operate, to create new ventures, and to attempt new processes and approaches.

Contrasting with state-run economies or state-owned enterprises, the benefits entrepreneurs bring to a free market economy are pretty straightforward; government enterprises aren’t going to be as profit focused because they don’t reap the benefits of any increase in efficiency. Command economies or highly regulated industries may have price controls imposed on them, and so innovation does not occur because there is no opportunity to do so. Political incentives might also overrule efficiency improvements, and since the state has a hard time going bankrupt, poor rules can hamstring organizations for years. My local DMV still refuses to accept credit cards.

Other forms of economic freedom are more subtle; regulation is a broad form of curtailing economic behavior, although certainly not always for bad purposes. Nonetheless, many well intentioned rules reduce the benefits of innovation or were in fact written with the help of powerful actors looking to keep out competition. Licensing can be especially destructive to innovation; Uber controversially solved this by ignoring licensing laws in many cities until they were too popular to be outlawed (results pending). Taxi licensing had allowed the taxi industry to remain relatively complacent, with poor service, product quality, and ease of use. Uber saw an opportunity to exploit the market with new technology and transformed the industry.

Finally, it’s worth mentioning that a strong defense of property rights is vital for the entrepreneurial process to occur; people will not take risks on new ventures if their asset can be seized at will by the government, or if the currency that transactions are conducted in could lose it’s value overnight (looking at you cryptocurrencies).

Now I’d like to walk through an example of the benefits of entrepreneurship. Netflix was established in 1997 to take advantage of the brand new DVD format for movies. The DVD format was introduced on March 21, 1997, and Netflix was formed by August. That’s an impressively quick turn around. At the time, the most common ways to see entertainment at home was to watch TV shows as they aired, watch movies that had been cut up for TV with commercials when a cable station played them, rent movies from Blockbuster if they had it in stock, or buy the VHS tape of a film.

DVDs had a lot of benefits over VHS when they came out, such as skipping directly to certain scenes, no rewinding, and often better durability than VHS tapes. But Netflix saw that DVDs offered something else: no prior storage format was small enough to be cheaply mailed and large enough to hold an entire film.  They foresaw a new method of home rental, and indeed, once DVD players became cheaper in 2001, Netflix took off. They dominated the mail subscription movie rental space, essentially creating a market where none had existed. Unlike movie rental stores, Netflix had a larger catalog and no late fees. Blockbuster was probably in the best position to take advantage of the new DVD technology; they had a pre-existing distribution network for their stores, and they had a customer base interested in movies. Yet Blockbuster peaked in the mid-2000s and filed for bankruptcy in 2010, a victim of Netflix’ creative destruction.

It’s worth mentioning a couple things about Blockbuster. In 2004, they attempted a hostile takeover of competitor Hollywood Video. They abandoned the deal in 2005 citing the FTC would probably block it. Yet both companies were either gone or bankrupt by 2010! The myopia of seeing a merger of Blockbuster and Hollywood Video as threatening to consumers when both companies would be essentially gone in five years underscores the points made here about the value of innovation and entrepreneurship. The state couldn’t look ahead and see that the industry consolidation they were concerned about would have shorter lifespans than many currently airing TV shows. Blockbuster’s competitors were actually Netflix, Redbox, and streaming video–even YouTube, which was founded in 2005 as well. Blockbuster itself made poor management decisions, opting for short term profitability over long term investment for a new industry. They eventually did create an online DVD rental subscription business similar to Netflix, but it was so poorly run, it either lost money or was too expensive to attract customers.

Yet customers did not suffer from this poor management! The entrepreneurship of Netflix filled the void before it even appeared. Netflix leveraged its online presence to profile its users with data, creating personalized recommendations in the mid-2000s, years before Facebook even started running ads. Netflix also saw that the future was streaming video, and noting the success of YouTube, they began including a streaming service with their DVD subscription in 2007. At the time, virtually no one had the bandwidth to watch movies in high quality on their computers, and essentially no technology existed to stream it to TVs. Yet, by 2011, Ars Technica was reporting that Netflix was responsible for about 30% of all North America peak internet traffic.

Netflix had accumulated many streaming titles, but was aware that as the importance of streaming grew, many publishers would be unwilling to renew their contracts, or raise prices. They might even face new streaming competition from content owners (like Hulu).  Consequently, Netflix started to invest in original content in 2011, something essentially unheard of for rental/streaming company, by buying the rights to make House of Cards, a political drama, for $100 million. In 2013, it premiered and went on to obtain 5 Primetime Emmy nominations for Outstanding Drama Series from 2013-2017. Other shows, such as Orange is the New Black, the various MCU Defenders series, Bojack Horseman, and Narcos have all been fairly successful. By this year, Netflix’ original programming pieces are in the hundreds if we count all seasons, original films, documentaries, comedy specials, and more. The Economist reports that Netflix will make more TV content than any television network this year, and release 80 movies, more than any Hollywood studio. Warner Brothers, the largest studio, will release just 26, admittedly most with much larger budgets. The critique that Hollywood doesn’t have original ideas is only true if you forget that Netflix is the largest player in Hollywood.

The foresight here for Netflix to to see and invest in the benefits of DVDs in providing by-mail home entertainment, to see streaming as the next iteration of entertainment consumption, and to see that any streaming service will require original content, when none of those markets had yet existed, is the foundation of entrepreneurial benefits. The ability to see where the market will be and adapt your organization to meet those needs in pursuit of profit is the dynamism of the market economy. Other companies’ failures are immediate market feedback on their inability to adapt. It’s not to say that a free market automatically takes advantage of all opportunities that present themselves; sometimes technology has made a new concept viable but no one is able to take advantage of it for some time because of lack of creativity. I also don’t intend to state that large corporations love competition and innovation; on the contrary, they are often trying to remove any competition through any means necessary. Out-competing another company results in better products for consumers; constructing barriers to entry so that consumers don’t have a choice does not.

Finally, given the benefits of entrepreneurship, we should note that it has been declining in the US. Why? It could be due to better economies of scale due to technology, it could be increased regulation has made it harder to form new businesses, it could be reduced labor force participation, or several other theories. Tyler Cowen has discussed this phenomenon in his 2017 book, The Complacent Class. He views it as a possible response to risk avoidance that accompanies increased wealth. Regardless, the questions of why entrepreneurship is declining, and what tradeoffs are involved in the level of dynamism of the economy are the important questions to ask. Dynamic markets are valuable tools to create ideas and innovation that cannot be predicted. Yet lack of clear future benefits should not be counted against the value of economic freedom.

 

Prediction Markets: What are they and why are they useful?

Given the importance of the topic to this blog, I thought it best to create a discussion of prediction markets here that I can refer back to. In the process of researching this topic, I found some other resources of varying quality which I will be referring out to as necessary. The best analysis is Paul Sztorc’s Prediction Market Sequence, which is unfortunately kind of buried under a subsection of the Bitcoin Hivemind website, and is also a combined ~75 pages (!). I would definitely recommend it to anyone who wants more details, but if you only want to read 3000 words, this blog post will cover a lot of the main ideas.

What is a prediction market?

Prediction markets are exchanges where you can buy and sell “derivatives”  (also referred to as shares, contracts, options, depending on context) on whether a given event will occur. They can be simple yes or no questions, or they can be more complicated, which we will cover later. The market price reflects what people believe to be the probability of the event occurring. A simple example would be a prediction market on whether Donald Trump will win the 2020 election. Suppose each contract resolves to $1. If you buy a “yes” option at 40% or 40¢ and then Trump wins, you’d be able to redeem it after the event at 100% or $1. If he loses, the share value would be 0% or $0. Other prediction markets can use any pricing scheme reflecting 0-100%.

PredictIt.org, a well known prediction market site, uses shares that resolve to $1 or $0 with trading occurring in between those prices until the event occurs. A 70¢ price would indicate a market belief of 70% in the event occurring. This is similar to betting markets on external events (like betting on the outcome of sports events) and also futures markets, where additional contracts can be created as long as there is interest in trading them, unlike stocks or bonds which are issued by an organization in limited quantities.

For more info, check out the first three sections of Paul Sztorc’s first PM paper.

What’s the point of a prediction market, is it just a way to gamble?

They can be used for gambling, but that is not their most interesting use case. Prediction markets aggregate information, and so they are sometimes called information markets. They offer a profit incentive for someone to share information publicly or for you to investigate something to try and uncover information. For example, in 2016, there wasn’t a great deal of presidential election polling in Wisconsin and other Midwest states. You might have been able to leverage information you found out about Trump’s support among Obama voters in those areas to place bets on Trump doing better in the electoral college. While talking heads on TV get paid for giving opinions, they don’t get paid for correct ones; prediction markets change that, allowing for a direct reward mechanism for correct predictions. Prediction markets thus improve the quality of predictions while simultaneously cutting through the self aggrandizing opinionators who have nothing on the line.

Aggregation of information is a concept so broadly applicable, it’s hard to convey the potential impact of its widespread use. At the very least, we would have a significant improvement in forecasting due to the profit incentive of those with useful information as well as those who can find out information and profit off its discovery. In the best case, we can aggregate all human knowledge into singular probabilistic forecasts about the future, providing real world application and feedback of empirical methods for everyone’s benefit.

If prediction markets are so great, why aren’t they being used already?

They are being used in limited ways, although they face many challenges. One is legal; the US has made it illegal to gamble on the internet. That means no large scale prediction markets can function in the US. PredictIt.org, a well known politics prediction market, has limitations on the amounts individuals can stake in a market as well as the number of individuals allowed in a single market. This limits the liquidity and financial interest in prediction markets. There is also the fact that knowledge about them isn’t widely dispersed; it’s a niche topic for obscure blog posts and academic papers.

Even if banned publicly, private organizations have an incentive to use prediction markets to improve their forecasting. Why haven’t more done so?

Prediction markets don’t necessarily mesh well with human organizations; managers may not be optimizing for the best information, but rather the decision making policies that make them look good. Dan Ariely writes how resistant companies are to conduct experiments that would actually give them better information; experimenting on customers is seen as immoral even if that results in a company never improving the products it provides for fear of trying new things.  In addition, as Bryan Caplan points out, markets themselves aren’t very popular generally, and the Senate shut down a Defense Department experiment on prediction markets because Ron Wyden found it “grotesque”, despite the obvious national security incentives to learn as much information about security threats as possible.  Paul Sztorc discusses similar challenges prediction markets face in his first paper, linked earlier. Prediction markets challenge the status quo and conventional wisdom and thus may never be adopted in organizations with established hierarchies.

I believe that in addition to the points Sztorc makes, prediction markets are simply expensive to set up. You need a market infrastructure (likely a digital platform, secure database architectures, etc) but also a mechanism for resolution, a decision structure for what markets will be created, and of course money to seed the market (If you’d like to learn more about market seeding, this blog post dives into Hanson’s logarithmic market scoring rule). You also need people to know to go to your market to make predictions; if no one is going to make predictions or buy shares on your market, other people won’t be incentivized to either. This is a network effect that may be hard to overcome.

So why are we talking about them if they can’t exist in real life?

One reason is to increase the awareness of the potential of prediction market to the readers of this blog. But the big reason I’m talking about prediction markets right now (as well as Paul Sztorc) is because of the rise of cryptocurrencies. Many of the social challenges to prediction markets can be overcome by instituting prediction markets on decentralized platforms and trading the contracts in cryptocurrencies. If you need more background on cryptocurrencies, I have some previous blog posts.

Prediction market projects on distributed blockchains, like Bitcoin Hivemind and the recently launched Augur, cannot be blocked by traditional legal prohibitions.  They also don’t need permission from the established experts in a field in order to make predictions. They are, however, more expensive than prediction markets like PredictIt or Betfair; they may require additional money to transact and specific cryptocurrency expertise to enter, and they risk uncertainty in how dispute resolution will occur in this new space. Nonetheless, many of these risks and costs may decrease over time as this technology becomes more familiar. Their location on a blockchain of course also means they are not just censorship-resistant, but effectively immortal.

Furthermore, prediction markets can do much more than the simple binary option market we discussed before.

What else can prediction markets do?

Ok, it starts to get complicated here. I’m mostly pulling from Paul Sztorc’s second paper on prediction markets (Unlocking the Power of Prediction Markets). Prediction markets can also create scaled markets instead of simple Yes/No binary markets. This is like trading a stock. You can buy Apple at 100 and sell at 200. The only difference is that the prediction market ceases after the event occurs, so instead of buying Trump at 40¢, you could buy Trump at 250 electoral votes in August 2016 and your share would mature at 304, since that is the total number he received when the electoral votes were counted in December. On such a trade, you’d receive a profit for guessing that Trump would receive more than 250, and the total profit would relate to how much more the ultimate “price” or quantity beat the price you paid.

The more interesting addition is the use of multiple dimensions. For example, you could create a market with 4 outcomes trading across two dimensions: Unemployment up year over year and whether Trump adds tariffs to Chinese imports. The resulting percentages should yield a relationship in how the world views these events; it’d be likely additional tariffs would increase the expected unemployment, but the prediction market would tell us if the expected effect were certain or uncertain. If we used a scaled dimension, we could even see the magnitude.

This is pretty powerful. I highly recommend Sztorc’s paper on this, as even more complex markets could tell us more detailed info (and he has nice illustrations). However, we should note that more complex markets require more complex contracts embedded into the blockchain. Blockchains don’t scale well (so far), so complex contracts may result in expensive transaction fees, and the multiple bets you can place may mean overall liquidity is low. If liquidity is low, people may not feel like betting is worth their time, since large bets might not be possible, reducing the incentive to research hidden information.

What are some examples of prediction markets?

The simplest prediction markets are already in existence at places like Betfair and PredictIt. For those betting markets to be useful to us, those websites have to share our interest in betting on things. And while this is generally true for broad markets (like prediction markets for president or senate seats), there are very few places you can easily place a bet on something other than company or commodity stock prices, political races, or sports. Moreover, current prediction markets have various problems, like legality and limitations on bets.

So there are simple prediction markets, like binary options on whether an event will occur, that could be useful to those who are curious about the world. Examples might include current events, like North Korean nuclear tests before the end of next year. North Korea might even buy shares anonymously (especially if this is a cryptocurrency market) which could actually directly convey information from inside North Korea in a way we never have before, albeit by directly financing a dictatorship. We will talk more about the criminal uses of prediction markets later.

Paul Sztorc points out in “Extra-Predictive Applications of Prediction Markets” that prediction markets could offer an easier way to bet on company stocks. You wouldn’t need a brokerage account with a bank, just access to a cryptocurrency. Perhaps this is more difficult for less tech savvy users to get than a bank account, but perhaps not. Many foreigners or people without good access to banking might not be able to trade in stocks. This would allow them to have a portfolio. It’s Finance 101 that you should diversify your assets to save for the future and hedge against risk, yet many people without access to banking and financial markets have no way to diversify their assets. With a prediction market tied to the S&P 500 price, you could simply buy a contract and you’d immediately have an asset that tracks the general stock market. In fact, you could use something similar to track any publicly known stock or ETF.

This would also allow for insider trading similar to the North Korean nuclear weapons market. Interestingly, this is a strength of the market, causing any insider knowledge to be quickly dispersed to the outside world. That’s actually another fascinating application Sztorc discusses: whistleblowers.

Whistleblowers risk lawsuits, job loss, prison time, and their lives, and yet they are guaranteed nothing in return, even if successful. Can we do better?

Sztorc goes on to point out that whistleblowers could collect money for their knowledge, providing more of a safe haven for coming forward sooner.

There are other fascinating applications for public construction, which would allow public betting on whether a project would complete on time.  This could be used to keep public officials who awarded the contracts accountable and called out directly when making corrupt deals. You could also make markets estimating what the expected level of depreciation are for various new models of cars to assist people in buying cars that will retain their value. Nominal GDP futures markets are an idea that has been discussed on this blog as a useful tool in monetary policy, providing feedback for setting interest rates.

Prediction markets don’t even have to be used just for information gathering, as Sztorc points out. They can be used as insurance as well. There could be a market for natural disasters which allows people to place bets on events that they don’t have any additional knowledge on, but simply want to be insured against poor outcomes. They can then collect the winnings of the bet as their insurance claim.

The possibilities for simple single event prediction markets are countless. But there are even more interesting examples when we get more complicated markets.

How can we get more complicated than North Korea using insider trading to make money off of their own weapons program through online cryptocurrency betting markets?

It’s time to explore multidimensional prediction markets and in particular conditional prediction markets. Robin Hanson has suggested conditional prediction markets for publicly traded companies. One dimension would be the company’s stock price and the other would be whether they fire their CEO. It would provide immediate input from the market on whether people believe the CEO is actually useful and adding value to a company. If the projected company value was similar to or higher if the CEO was fired, that would provide good justification for getting a new CEO.

I also like the idea of a conditional prediction market for candidate policies, conditional on them getting elected. This would provide feedback on whether anyone actually believed the candidates’ promises to deliver on various policies. One can imagine cultural norms arising where candidates had to provide proof that they had purchased significant amounts of shares that they would carry out the policy if elected. Political campaigns might then be more substantial, focusing on policies candidates had demonstrated they were actually committed to.

Robin Hanson has also suggested the idea of Futarchy, where prediction markets are created to predict the outcome of various policies, conditional on their implementation. He proposes the concept of “voting values, but betting beliefs”, where legislative bodies would vote on what we would want as an outcome of some policy, and then commit to implementing whatever policy is favored by prediction markets. It’s an interesting idea although it mostly moves the debate in legislatures from “what policy should be undertaken?” to “what policy indicator are we trying to maximize?”. That may be a better debate, but if poorly chosen, the indicator could maximize something to the detriment of the polity. It’s probably still worth investigating on a narrower scale, and certainly the existence of the markets themselves could only improve the information available to policymakers.

Paul Sztorc also discusses some complex applications of multidimensional prediction markets in the Bitcoin space. Unless you are really interested in Bitcoin, they probably won’t catch your eye, so I’ll just mention them briefly, as they are technically impressive. The first is a way to allow Bitcoin investors to gain more information about possible hard forks (changes in the network and blockchain) and insure against them occurring or not occurring. Hard forks are turbulent times in a blockchain, but current discussion is just theoretical arguments of what might happen. Network effects could mean people like the idea but don’t switch to a new fork, but a prediction market could give immediate feedback and allow people to purchase shares of post-fork-Bitcoin while insured against the possibility the fork does not go through.

Also discussed is the idea of “stable” coins which would be futures markets on the exchange rate between Bitcoin and the US dollar, as well as issuing stock through a prediction market. The most interesting to me was the idea of efficiently funding public goods. The basic concept is that you create a prediction market asking whether a public good will be provided (like a lighthouse) and then people who want the public good buy shares of “no”. They won’t lose any money unless someone builds the lighthouse. People intending to build the lighthouse can buy lots of shares of yes, and, when it’s built, the lighthouse builders would reap the benefits of the shares, and those who wanted the public good would pay for it, only if it existed. You can also create lots of different possible “yes” shares, based on publicly available information, like “what letter will be painted on the side of the lighthouse?”, which would allow different teams to compete. For the full write up, check out the paper.

Sztorc concludes with generalizing this idea to “smart contracts” based on prediction markets. This is built on top of the idea that prediction markets are a robust way to determine not only the future, but how the future eventually resolves (i.e. there is a mechanism that ultimately is used to determine what happened in the 2016 election to determine whose shares are paid).

What about insider trading you were talking about earlier? Can you use prediction markets to do other illegal things too?

Mostly likely yes. Just like Bitcoin and other cryptocurrencies, prediction markets can be used for illegal transactions since they aren’t tracked well by the state, and they can be used to bet on unsavory things or incentivize criminal behavior. Insider trading is one of those activities. However, I tend to buy the libertarian argument against the illegal prohibition of insider trading. Crimes require a victim, and insider trading provides information, while its prohibition does little to stem the flow of information to those who have little concern for the law anyway.

However, stranger markets exist as well. Sztorc devotes most of his final paper to discussing prediction markets in deaths, which could be manipulated by assassins. Sztorc is skeptical this could work, as any markets that believe someone is highly unlikely to die are automatically creating an incentive for an assassin and so the market would self regulate back to equilibrium where the predicted death is both more likely and less profitable. I’m still somewhat concerned. The bottom line is that death markets provide an avenue for assassins to reward themselves that does not exist today. Perhaps such incentives would be small compared to the difficulty and bodily harm risked by assassins, but it’s unquestionable that not everything about prediction markets is purely good. That’s expected though; information is powerful and does not always lead to to purely good outcomes.

Conclusion

The benefits and potential of prediction markets to improve the world is vast. As Sztorc states: “Their greatest benefit lies in their unlimited ability to scale”. Conversations are one to one, classes are at best a few lecturers and a few hundred in the audience, while prediction markets can take input from everyone in the entire globe and condense that into comparable and understandable probabilities. Being able to retrieve the world’s knowledge by doing something as simple as checking prices online is nothing short of a revolution in information. With the advent of decentralized blockchains, prediction markets are here to stay; we should embrace their power and potential.

 

Podcast Recommendations June 2018

A while ago I had an idea to try and catalog everything I could about the libertarian ideas on the internet, what organizations exist, which writers are interesting, whose podcasts discuss what, and compile it into a giant document. It was ambitious, but I figured over time I could add to it until it had tons of useful information.

When the 2016 election happened, a bunch of people and organizations I had considered pretty libertarian and conservative free marketers suddenly embraced a populist with no understanding of free trade or individual liberty. Not every conservative I had listed became someone I didn’t want to recommend, and I didn’t particularly want to politicize the list based on Trump, yet I couldn’t leave many recommendations out there. There was way too much to update, and so I abandoned the project. I’ve kept the blogs list in the sidebar, but I figured it was time to revisit some podcast recommendations.

Podcasts have become an excellent demonstration of the wonders of an unfettered free market. There are podcasts on virtually any topic you might be interested in, because they are just audio files, they can be distributed in a variety of methods and platforms in a decentralized way, and many are profitable on advertising alone. This decentralization also means that there aren’t specific places you might go to find out about new podcasts, and I have personally learned about most podcasts through other people. Consequently, I wanted to pass on some of the ones I listen to. If you have some good recommendations, leave a comment here or on reddit, or tweet @postlibertarian. I’m always looking for new podcasts.

EconTalk – A great podcast covering all sorts of economic issues, this is probably my favorite libertarian/economics podcast. Hosted by Russ Roberts, Hoover Institute Fellow, and free market leaning economist, Russ does an excellent job interviewing people he agrees and disagrees with, offering skepticism, even of his own biases, and investigating claims along the way.  It’s part of the Library of Economics and Liberty which also hosts EconLog, linked in the sidebar. It used to be about an hour, although nowadays he’s letting it go a bit longer.

Reason Podcast – This is podcast put out by Reason Magazine, which includes a Monday roundtable of all the senior editors at the magazine, including Katherine Mangu-Ward, Nick Gillespie, Matt Welch, and Peter Suderman, with occasional substitutions. I really enjoy it, and I recommend following them on Twitter as well. During the week, there are additional interviews, usually by Nick Gillespie, which I sometimes listen to. Also on the podcast is the audio for the monthly Soho Forum Debates, which are really interesting always debating topics of interest to libertarians.

The Fifth Column – An excellent libertarian news and analysis podcast with Matt Welch, Editor of Reason magazine, Kmele Foster, an entrepreneur and libertarian talking head, and Michael Moynahan, a libertarian-leaning columnist.  It’s more news focused than EconTalk, and more crude, but I find it is entertaining and provocative.

Security Now – If you are interested in cryptography and information security, this is the weekly podcast that covers security news. It’s on the TWiT (This Week in Tech) Network, hosted by Steve Gibson and Leo Laporte. You can get a lot of the information by just reading through the show notes or the transcripts which are there on the website linked, and I’d recommend that as the podcast is pretty long. I just find there’s so much security news I don’t ever want to miss this podcast.

Rationally Speaking – Hosted by Julia Galef, this interview podcast covers a broad range of topics, but often centers around epistemology, science, and knowledge. Galef is a good interviewer and is able to engage with an eclectic and wide-ranging series of guests. I’m not sure how best to place this podcast besides in the “rationalist/LessWrong community”, but it’s absolutely not necessary to have any other interaction with that community to enjoy the podcast.

The 80000 Hours Podcast – 80000 Hours is an Effective Altruist organization focusing on how people can spend their career best benefiting humanity. The podcast, hosted by Rob Wiblin, explores various effective altruist interest areas, such as artificial intelligence, pandemic risk, animal welfare, or international development. It is worth listening to even if you aren’t interested in a career change, as they tend to go pretty in depth with each guest on exactly how an organization or person can have a large impact on the world.

The Economist Editor’s Picks – Sometimes I’m looking for a more international view of world affairs and The Economist is a lot better than many mainstream news sources. Of course, they publish way too much to read every week, so the editor’s picks podcast selects four top articles to check out. They’re usually pretty short so they’re easy to consume.

This post may end up becoming its own page, as I’ll certainly be able to update a page just for podcast recommendations.

Policies We Should Be Talking About – in 500 Words or Less

What policies should be undertaken to improve society? I would hope that would also be the fundamental question of politics, but it often seems to take a backseat to “how do we obtain and hold political power?”

Nonetheless, I like to push back against that worldview, and I hope this blog has somewhat succeeded at doing so. Efficient Advocacy is a way to answer the question of what policies should be undertaken to improve society, while Artificial General Intelligence and Existential Risk analyzes why we might be concerned about extremely high impact, although unlikely, events. There’s also a good discussion of the various aspects to consider when choosing where to expend resources and effort: is the policy widely known or discussed, is it popular, do candidates take a position on this issue, should political processes themselves be reformed before the policy can be implemented?

This post is going to be the first in a recurring group of posts discussing various good policies. For the most part, these posts will discuss policies that are outside of the main political discourse, but ought to be discussed more. I’ll try and note why they may or may not be politically tolerable, but I’ll also try and keep each policy discussion very brief, to 500 words or fewer, with three policies in each post. I’m not ruling out that policies will repeat, but that will depend on the frequency of posts and how good the policies are. Many of these policies may be new or incomplete, but all discussions start somewhere.

Nominal GDP Futures Targeting

The Federal Reserve is the most important institution for macroeconomic stabilization policy. It is not particularly political, it can react quicker than Congress, and it controls the money supply for the most widely used currency in the world. The 1977 Federal Reserve Reform Act gave the Fed the goals of price stability and maximum employment in what is known as the “dual mandate”.  However, these particular goals are often at odds, which means the “correct” policy the Fed should be taking isn’t obvious.

The 90s saw the rise of the Taylor Rule, although Milton Friedman had argued for a rules-based policy regime long before this. The Taylor Rule isn’t an exact rule, but it is an attempt to codify monetary policy to stabilize prices, increasing the real interest rate in response to inflation, and thus targeting a specific inflation level.  Nominal GDP targeting, on the other hand, doesn’t target specific interest rates, but levels of spending in the economy. Scott Sumner, and others at the Mercatus Center have argued that the Taylor Rule is inferior to Nominal GDP targeting because the Taylor Rule relies on retrieving more information, specifically both inflation and the “gap” between real and potential economic output. It’s argued that Nominal GDP is much simpler to get data on in real time, allowing the Fed to apply monetary policy with better understanding of the economy’s current state.

Additionally, NGDP targeting can be enhanced with futures markets, allowing the Fed to have direct feedback from the market on the expected levels of NGDP growth. This helps to solve the Hayekian knowledge problem, by pulling as much data as possible into a single market price. NGDP is also beneficial in that it doesn’t target specific interest rates, just spending levels, so in a low-interest rate environment, like the 2008 recession, the Fed would have had a rule to help guide the level of quantitative easing, instead of just shooting in the dark and hoping it would work.

So what is the political status of this policy? Well it’s pretty technical and so I doubt any voters have or could be persuaded to have much of a view on this. That also means it doesn’t have much political opposition, although conservatives interested in monetary policy don’t love it. The actual legislation that would need to happen would probably revolve around the legalization of NGDP Futures markets, which would essentially be speculative gambling on government data collections. Luckily, from the Fed’s perspective, policy change requires no legal hurdles; the Taylor Rule is a self-imposed policy goal that could be exchanged for NGDP targeting as soon as Fed officials are convinced of its benefits.

To convince them, here is some further reading:

Social Security Identity Theft Reform

Social Security wasn’t meant to be a national ID program, but because it is the only national program everyone is guaranteed to be enrolled in, it has become the de facto national ID number. SSNs can’t be revoked easily like credit cards, they weren’t assigned randomly until 2011, and they are used for authentication despite being universally stored, subjecting them to serious security issues. Identity theft is thus a major problem.

The solution is to make SSNs a public/private key pair. For a 5 minute intro on Public Key Cryptography, check out my post on encrypted communication apps. The basics of SSNs wouldn’t need to change. This cryptography system would utilize a particular type of Public Key Cryptography called Elliptic Curve Cryptography; the only reason this detail is important is that in ECC, any number can be a private key (as opposed to only prime numbers) and keys can be relatively short and human memorizable. I would recommend new SSNs with at least 12 digits to make them harder to guess. SSNs don’t have a checksum digit, so I’d recommend adding that as well.

The technical details of how people would use this number to authenticate themselves would be with the application of the Elliptic Curve Digital Signature Algorithm. For an average person, all that needs to be known is that this algorithm is standardized, like sending a message to an e-mail address; any computer can send a message without it mattering what the message says, since “sending an email to an address” is something all computers know how to do. When a person has to prove who they are to a company or the government, instead of the organization checking their SSN against a database, the person will type in their private SSN, the computer will compute a digital signature, and that will be sent to the organization. The organization would compare the signature to the public key of the person to validate they are who they say they are.

How will they know the public keys? Unlike private keys, public keys can be published freely, so the Social Security Administration can maintain a public database of public keys without issue. Digital signatures can only be computed with private keys, which should be kept secret. The benefits arise because organizations can hold signatures in their databases instead of private keys. Stealing a signature in a data breach would do nothing; today losing SSNs is equivalent to losing your private keys. Problems that could arise involve lack of knowledge on the part of organizations, which could mistakenly store private keys instead of signatures. However, this is already the problem today, so things can only get better.

Potential political pitfalls involve people believing this would be a national ID number, even though SSNs already are, and that it’s difficult to update systems for better security.

Increase the Housing Stock in US Cities

This idea was taken from the Niskanen Center’s Wil Wilkinson, in his response for the single best policy to reduce inequality in the United States. Wealth inequality doesn’t concern me too much, but this policy would solve inequality by improving the options of those least well off, allowing them to move to high productivity cities where high paying jobs are. Wilkinson’s piece is already pretty short, so I’ll be quoting it a bit here.

Wages have barely budged in decades, yet housing costs have soared in the bigger cities in which most Americans live, because restrictive municipal zoning and land-use policy have prevented housing supply from keeping up with demand. When rent takes an ever-larger chunk of workers’ paychecks, savings and wealth accumulation rates go down.

Additionally, the restrictions on housing have caused massive losses in productivity. Chang-Tai Hsieh and Enrico Moretti suggest in this paper that the inability of labor to relocate to high productivity cities has significant effects on GDP growth rates, leading to pretty massive losses in potential productivity. Andrii Parkhomenko suggests that federal policy that incentivizes localities to deregulate housing supply would have a pretty sizeable impact on growth rates. Going back to Wilkinson, he details what this policy might be:
If I were king for a day, I would dangle a huge pot of federal infrastructure money in front of states, and then condition those delicious, fat federal grants on big cities in those states hitting growth targets for housing supply. If big cities fail to add new housing stock fast enough, they and the states they are in will lose many, many, many billions in federal funds for new and upgraded infrastructure.
So why isn’t this happening now? Wilkinson continues:
The political power of NIMBY-ism (“not in my back yard”) has made it nearly impossible to tackle rising housing costs, and the wealth inequality it produces, at the municipal level. But a federal lever can offset the self-seeking forces of NIMBY-ism by giving city and state governments a strong incentive to cut the red tape that keeps housing supply lagging so far behind demand.
I’m skeptical that it will be straightforward to get a federal bill like this passed, although it will probably be easier than in local municipalities. The potential benefits here are far too great to be ignored, but it’s disappointing housing policy isn’t a major issue for most voters today.

 

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Book Review: The Case Against Education

Most people believe education increases students’ skills, and thus, education is a way to improve your life and career through learning how to be an engineer or a… (checks most common majors) …business…person… psychologist. Bryan Caplan’s latest book disputes this claim, arguing instead that education, especially college and graduate degrees, but even high school, is largely signaling, and not skill building. What does this mean?

Caplan believes employers look at your college degree and GPA and see that you are smart, hard-working, and conform to social norms, and it is that information, not skills you have, which gets you hired (mostly). Prior to reading this book, I held views that higher education had some issues, and I was particularly suspicious of the increasing cost of a college education that has significantly outpaced inflation. With new technological breakthroughs that make teaching much easier, is it really that much more expensive to teach undergrads than it was 30 years ago?  With all the new amenities American colleges are adding (study abroad programs galore, student life funding, food, study rooms, etc), it seems like most of the money is not going to teaching, but shouldn’t a free market among colleges force them to compete on price?

The Case Against Education presents a solution to this puzzle, and much more that I had not considered. Signalling is about relative appearance. If the US and USSR both have ICBMs, no one will fire them out of fear of retaliation. But if one superpower develops submarine launched missiles, then there is a relative difference, and now the other must develop submarine launched missiles as well, or they risk being destroyed in a submarine first strike. Afterwards, the new equilibrium re-establishes a balanced peace, but both countries have wasted time and resources building submarines only to get back to the exact same situation. College is an academic arms race; if everyone could agree not to go to college, we’d be in the exact same place but without having to pay all that expensive tuition.

How can this be though? We know college raises people’s earnings, ergo shouldn’t the market fix this by finding better ways to figure out if prospective employees are worth hiring? Not really. College degrees give employers a “free” way to see which prospective applicants would be best to hire, paid for entirely by the applicants (or the government). Most jobs require pretty specialized skills that can only be learned on the job, so what employers are really looking for is intelligence and commitment. Having a good GPA (and getting into a good college) indicates not only intelligence but also the ability to work hard to achieve long term goals. This system is wonderful for employers, and they have no incentive to change their hiring practices to target non college grads who would probably be more productive with direct on the job training. Those hires are riskier on average as some hires will have been unable to enter college, rather than more interested in work. Employers essentially outsource job screening onto colleges at no cost to them. Colleges also have no incentive to fix the system of course, and the government funding that helps make the problem worse doesn’t respond to financial incentives, especially as education is pretty popular. Students can’t escape either as they are stuck in the arms race, and thus the problem persists.

We Don’t Learn Much From School

Nonetheless, the signalling case may not be intuitive. Most people know they learned things in school, after all, we all had tests on the material! I earned a pretty good GPA at my school, and I had to learn a bunch of stuff for it! The Case Against Education‘s second chapter addresses this quite aggressively, and the following few paragraphs are discussions arising from that chapter. First, it points out that a large fraction of what we learn in school isn’t very applicable to our jobs. I really enjoyed my social studies classes, and I certainly use some of the things I learned when writing this blog, but I do this as a hobby. In my actual employment, I have never needed the years of history, government, or economics classes I took. My counter is that Caplan just asserts some classes are worthless. He has some numbers to back up the particular claim that despite most American high schoolers being forced to learn a foreign language, very few actually speak anything other than English as an adult. There also don’t seem to be many useful careers in the social sciences outside academia. Maybe you need to study civics to get a job in government, although not for most basic bureaucracy desk jobs. I think some more concrete numbers would help his case, although I concede he’s probably right on most accounts.

(Caplan also points out that some “useful” classes, like Math, aren’t necessarily that useful if you break them down; almost everyone takes Geometry, yet very few people need to reason about triangles in their everyday life.)

There’s also an excellent counterargument to the idea that knowledge might become useful later (e.g. “Latin might be helpful if I need to know meaning of an unknown word”). Hoarders make the same argument, “I might need this 17th water bottle someday!”. Education costs resources, and we shouldn’t be purposefully spending them on concepts that may never be useful to students.

Caplan also extensively evaluates whether students actually retain what they learn in school years later. The results are incredibly dismal. Even basic literacy and numeracy, which Caplan argues are the most practical skills we learn in school, are pretty awful when tested. Civics, Science, and foreign language skills were similarly terrible. It’s even suggested that 38% of American citizens would fail the citizenship exam.

The claim that school teaches you how to reason or how to think and analyze is also refuted. Moreover, as I would add, if that’s the main benefit of school, why not teach that directly instead of lots of classes based off of memorization? There may be some argument against the exact examples and studies Caplan uses; perhaps the ability to apply statistical knowledge in non-academic areas is slightly better than the book suggests, or perhaps a year of education raises your IQ slightly more than a few IQ points higher, but overall these themes are hard to overcome; students don’t retain much information from decades of education, they don’t become brilliant by being in school, and they don’t learn skills they eventually use on their jobs.

More Signalling Evidence

Other interesting observations by Caplan that impressed me were that top educational institutions give their classes away for free. You can watch many of the best lecturers online without paying anything, but you can literally walk into Duke or Harvard and watch lectures from professors. If schools were charging for the education, there would be barriers to getting into classrooms, but there aren’t, because that’s not why you pay to go to college; you pay for the degree. Also of note, in Chapter 3, Caplan analyzes whether some college degrees are useful in building skills while others are not, which might indicate that the “human capital story” could be true, just not true for every major. He points out that even if you are mismatched in your career from the major you studied in college, you often earn significantly more money than a high school graduate.

This is clear evidence for the signaling model, but time for a little bit of pushback. Caplan estimates signaling’s share at 80% of the value of education. However, this obviously changes with subject level. In the wheat-chaff section of Chapter 3 I was referring to in the last paragraph, the book states that engineers see a 20% decrease in earnings if an engineering degree holder works in a non-engineering field. But the entire premium of engineering is about 60% above HS graduates, adjusting for ability. This means a 20% drop in earnings brings us back down to 28% above HS grads. That means about 53% of engineers’ higher earnings are due to skills, since they lose half of their bonus above HS grads if they are working in a field without those skills. Not to mention there could be some skills engineers pick up that helps them in other areas, despite Caplan’s points otherwise. Of course, humanities majors are much worse for this case, since many of them see zero loss of earnings if they do not work in their field. Anthropology, liberal arts, sociology thus might be demonstrations of pure signalling. Interestingly, their college premiums are pretty close to engineers’ premiums if the engineers are working outside their field.

The point I make here isn’t that Caplan is necessarily wrong about 80%, but rather that I thought this particular discussion clarified where these numbers might be coming from and what the interaction is between my prior concept of “school teaches me useful skills” and this new concept of “school is mostly signalling”. In other words, these compensation numbers indicate that while there are some skills taught in school, large swaths of students are taking classes that do not teach many skills. Signalling may be argued as a reflection of “people study useless subjects”, rather than “school is inherently bad at transferring skills”, which may provoke outright dismissal by some readers.

Another counterpoint to Caplan is that Sheepskin Effects, the effects of graduation on earnings, may be a reflection of ability bias, rather than all signaling. This blog post discusses a possible method, where people who make it to 3 years of college and then drop out may be disproportionately people who could not complete the hardest classes, saved them for the final semesters, and then failed them, causing them not to graduate. Had they spread them out, perhaps they would have failed out earlier, dragging down first and second year benefits, while allowing third year benefits to rise.

The problem is that signalling would still make up a massive fraction of education, even if Sheepskin Effects are partially reflection of ability; Caplan doesn’t discuss professional schools, as they tend to be pretty good about teaching skills, but he also doesn’t mention that even for medical school, the vast majority of required undergraduate classes in the United States are not skill-building. Calculus, physics, and organic chemistry are not necessary for practicing medicine, yet they are still required.

The Case Against Education also discusses how you might calculate selfishly whether college or advanced degrees are worth pursuing. Caplan even includes helpful spreadsheets that you can manipulate yourself to calculate the returns to your own education.

On the other hand, the following chapter on social returns asks if perhaps there are positive externalities to education that might be helpful besides teaching people useful career skills. I found the section that it was hard to find nation-level benefits to economic growth surprising at first, but more realistic given slow US GDP growth despite higher and higher educational attainment.

There’s also a brief, but thought-provoking section in Chapter 6 regarding the impact of education on democracies and policies. Education correlates with higher political engagement, although whether that’s due to ability bias or actual impact of education is not dealt with. Instead, Caplan asserts that whether education’s impact on policy is good or bad “…the social value of participation hinges on the quality of participation”. This is a statement I strongly agree with, but I’m not sure most people would necessarily endorse. He rightly points out that the quality of participation is inseparable from the question of the quality of policy itself, which is way too big a topic for an education book. Nonetheless there is an implication that the general promotion of civic participation is not necessarily good for society, and I suspect such a notion is controversial.

Solutions

Finally, towards the end of the book, Caplan gets into his proposed solutions for the problem of signalling. The Case Against Education makes a strong argument that education doesn’t have great payoffs and wastes resources on relative signalling, and so Caplan suggests we reduce government subsidies for education. Notably, from a libertarian perspective at least, Caplan’s argument rests on the idea that the education free market itself wouldn’t be optimal, as signalling would actually cause an overconsumption of education over what is socially optimal. He actually has a section in Chapter 7 discussing if it would actually make sense to tax education. He makes the cursory libertarian argument that the government should leave people alone unless we know policy interventions will be highly successful. This is probably fair, but if we were to miraculously find ourselves in the position of having no government education subsidies, I suspect that some taxation of signalling heavy education might be socially ideal, if economically and politically untenable.

The book is also aware of how unpopular any calls to reduce education subsidies would be. Nonetheless, Caplan makes a good point that the proper response to poor education effects implies we should stop bad policy until we figure out better ones, not continue them while we debate alternatives. At the very least, college subsidies should be ended. Tuition will rise, but pushing more of the burden on students is what we want; education should only be undertaken from a social cost-benefit analysis if its benefits outweigh its costs. An excellent way to do this is to force individuals to undertake the costs, since they will be incentivized to go to college only if they can study something that will pay for it. This will negatively impact humanities enrollment, but right now much of humanities coursework is subsidized by the taxpayer and seems to be largely signalling. We should save the money.

The Case Against Education also makes the point that the poor are by far the hardest hit by credential inflation. Reducing government subsidies means the poor will have a much harder time getting to college, but it also means you should see a systemic decline in the necessity of college degrees for jobs that don’t need them.

Caplan also devotes a chapter to the benefits of vocational education, and getting young students (especially those who aren’t doing well in school) on the job experience as early as possible. I don’t have much to add, but it seems disturbingly obvious; if school doesn’t teach us much that we remember, and if there exist jobs that aren’t taught in school, but can be taught with work experience, we need to change the cultural aversion to vocational education ASAP. Additionally, I’ve been following many of my friends in medical school and, it’s incredible to me how vastly it differs from the requirements to enter medical school. Important parts of medical “school” is literally on the job apprenticing with actively working doctors, nurses, residents, etc. Meanwhile, med school undergrads spend 8 semesters learning things that are virtually useless in their planned vocation. It’s absolutely bizarre, although well explained by the signalling model.

Finally, I want to briefly discuss Caplan’s explanation for why no one else is talking about education with similar critiques. He places most of the blame on social desirability bias; basically, it’s unpopular and costs us socially if we critique popular views as incorrect. This story make some sense to me: calling for education cuts is often seen as heartless and evil, yet so are lots of calls to cut government spending, and there are plenty of libertarians and fiscal hawks that are ok with taking those views. I think a significant part of the puzzle arises from the fact that the signalling model is not widely known or understood. It’s also counterintuitive, since we have quite plausible explanations for many things signalling suggests, e.g., people with higher education get paid more because education imparts skills, no signalling model required.

Overall, this book was really interesting and has convinced me that signalling is a substantial fraction of the benefits of education. I feel like there was no definitive place where Caplan calculated exactly why he thought signalling should account for 80%, but doing some of my own calculations around education premiums for workers working inside and outside of fields where their degrees were focused, I can see how there is a chance signalling could indeed be as high as 80%. Nonetheless, even if the proportion is much lower, say only 40% or 30% that would be incredibly wasteful for a trillion dollar industry. After reading The Case Against Education, I feel that a significant cut to at least college education subisidies is probably warranted, and further research into the usefulness of education and the signalling model is vital.

 

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Weird Stateless Healthcare Solutions

Most developed countries have significant involvement in the healthcare market. I have written previously that it’s pretty clear down-sloping demand curves exist in healthcare, and thus we could realize efficiency gains in healthcare if a healthcare pricing system existed where patients could compare procedures and stand to benefit from getting them done for less money. This would not necessarily preclude government intervention. For example, Medicare could offer to pay its rate for various procedures directly to the patient who could then look at several hospitals, go to the one with the best deal and pocket the difference.

However, I’m going to explore a much more difficult thesis, that a completely free market in healthcare could exist outside of state intervention entirely. Nothing should be taken from the following to imply I think such a system is “good”. I have free market inclinations, and so I think some liberalization of healthcare markets would be good, but changes discussed in this post are highly radical. Any such scenario is unlikely in the future unless an unexpected event occurs, such as a global geopolitical destabilization never before seen, or a mass adoption of a cryptocurrency as the reserve currency, rendering taxes on transactions (and thus strong central states) obsolete. In other words, it seems unlikely a healthcare market with no state intervention would be something purposefully implemented. Nonetheless, I think this is an interesting thought experiment to consider, and it may help point us to where the market is least able to provide solutions and thus where government might be most helpful.

Supply Side

Most of this will be a discussion from the patient’s side, but first let’s discuss some of the implications of the supply side. With less government, there are going to be a lot fewer restrictions. That means licensing will still be important (and in fact medical licensing is largely done by non state groups), it just won’t be state enforced. Just for fun, this would be a great application of digital signatures in an area we don’t use them today. Your doctor’s office could have a simple sign indicating all the doctors in the office have been licensed by the governing medical agency, with an accompanying QR code encoding a digital signature from the licensing agency, signing the names of the doctors or something similar. You could then scan the QR code with your phone, using a generic app, or perhaps one you can download from the medical agency, and it would check the signature against the agency’s public key to ensure it was them who issued it. This is similar to how website security works today, just used in real life.

Other things worth mentioning on the supply side is that certificates of need, which today prevent hospitals from being built unless the government allows it (yes this is really a thing), would optimally not be an issue. Additionally, with price pressure from individuals actually interested in price, medical providers would have to compete on price, meaning they would need to offer good services at competitive cost to gain an edge in the market, something they don’t do now. This is an extension of my previous post that downward sloping demand curves exist in medicine. Since they do, and if prices existed, costs would be driven down because patients prefer to spend less money if they can.

Individual Annual Insurance

We’ll now start with an average adult buying healthcare. This is going to be closest in distance to arguments about healthcare today, so the ideas I’m going to suggest aren’t too radical, and you may have even heard them before. In a free market, an average person can probably buy a lot of their procedures, consultations, and check-ups on the market. Perhaps they will buy catastrophic insurance coverage in case something large happens.

Individual insurance could take several forms. It could include catastrophic care, more comprehensive coverage, or perhaps something closer to the HMO model, where you pay a network of healthcare providers a fixed amount for a fully managed healthcare service. There are interesting questions regarding how the market would deal with insurance pools. One is how it would deal with healthy patients who do not buy insurance, an issue Obamacare is seeing today, and a related problem of where insurers could just reject patients with pre-existing conditions. I’m going to get to that in the next section.

What is worth thinking about, and about which I remain uncertain, would be to what extent civil society insurance groups would spring up. Right now, people often get their insurance through their employer, but I suspect many people would gladly take more cash from their employer in our hypothetical free market system, and then buy insurance themselves. They could buy it individually, but perhaps they would join a pool, not necessarily through their employer, but perhaps through other civil society groups, such as church groups, unions, political groups, etc.  I imagine tablet wielding Libertarian Party recruiters offering membership benefits of joining the party insurance pool, as long as you promise to keep up with the libertarian reading list. These pools might be able to buy healthcare in bulk from specific providers, which might be cheaper, but that again separates patients from the price system, which is what is causing so much difficulty in the first place. The one clear benefit is that you could switch insurance purchasers much easier than you could through a job.

This is one possible equilibrium for annual healthcare markets, but it doesn’t take into account long term factors outside of a single year. Let’s explore that.

Individual Multi-Year Approaches

Suppose you buy catastrophic insurance on the market for a single year. There is a significant issue you could run into, namely a catastrophic injury or a diagnosis of a chronic illness. Now, when you return to buy insurance for the next year, the free market I’ve been bragging about creates an incentive for the insurance company to charge you much more or refuse to cover you. Not to worry, there’s a market solution here: you were just under-insured.

What is needed is a long term insurance policy that offers as a reward the option to buy insurance for years at a given rate, rather than actual coverage. This is a re-insurance market. This could be purchased early on and last for years, more similar to life insurance than health insurance.

Re-insurance is also a useful policy for allowing healthy people who don’t want to bother with insurance the ability to buy into the market. Today, many younger people aren’t joining Obamacare exchanges because they feel the coverage is too high for what they want to pay. Re-insurance could offer them the ability to buy insurance later if needed, but skip the higher premiums for now as long as they’re ok with no coverage. On the other hand, perhaps this wouldn’t be needed as they could purchase lower coverage insurance plans more appropriate to their risk level.

The question insurance is solving generally is how best to spread risk. The way we are looking to spread risk today is through involvement of more people. The long-term re-insurance solution mentioned here applies the principle of spreading risk over longer periods of time. Government’s approach is theoretically to spread risk across time and people, just unfortunately under the management of a sprawling organization that doesn’t have an incentive to manage it well. The interaction between risk spreading between time and people will be difficult to predict in a free market. Individuals won’t just be allowed to join an insurance pool opportunistically, as that would punish the people who paid in over the long term. Perhaps non-monetary trades would exist to allow opportunistic joiners (e.g. Mormons allow you to join their insurance pool if you convert, and yes this is creepy), although they can be hard to enforce. Other options might include packaging (your dues cover several services including insurance, but perhaps also advertising for the group or funding a rec center), or paying in over several years before being allowed access to the insurance pool.

One could also imagine a different strategy for charities, such as health NGOs that instead of offering only free primary care to the needy, they also buy transferable re-insurance options. When someone comes in with an infection, they can provide free care, but when someone comes in with a chronic illness, the charity can transfer one of their re-insurance options which would allow the patient to buy affordable coverage for the long term.

It’s also worth noting that while annual insurance policies in this regime don’t really have an incentive to get you to go for preventative healthcare (since if your doctor finds something, they have to pay for it, while you might switch to a different provider next year), long term re-insurance plans would actually pay you to obtain preventative care to catch something early since they are on the hook for long term costs if you wait.

So far, a patient actually has a lot of choices in this hypothetical system; they should be able to compare and measure different procedures and providers for various healthcare services; these providers could have different licensing regimes, and be less supply restricted resulting in lower costs. Competition on price should also drive down costs and drive up patient benefits. Unexpected expenses that are still too expensive could be covered by insurance policies purchased by patients. Various levels of coverage could be offered, including long-term re-insurance options to buy coverage at a set price. These could be combined with insurance pools to spread risk further both among different people and longer periods of time.

Insurance Information and Genetics

While patients want to spread risk, insurers don’t face the same incentives. They will get as much information as they can about a patient in this hypothetical world to charge them for risky behaviors. We could, of course, go back another layer and talk about “hobby insurance” or something like that; motorcyclists have higher health insurance premiums or something, so when people are young and don’t know what activities they will engage in later, they buy some insurance that covers them if they get into a dangerous hobby. However, this doesn’t work that well, as these risks are much more agent-driven than others; people can know they want to get into mountain-climbing or motorcycles, so they may buy the “hobby insurance” knowing they are going to do dangerous hobbies, which immediately provides a payoff. There are some ways around this; maybe you can only get coverage for several years in the future if you are still doing that hobby, and you take the full risk now.

Overall this isn’t very satisfactory, and that’s because we are thinking about this backwards. Setting aside things we can’t control, like genetics, engaging in dangerous hobbies voluntarily seems like something we would want to respond to incentives. After all, we are restricting this by definition to things the patient can control. The analogy is that the state wants us to be healthier especially if the state is covering our medical bills. But when the state haphazardly tries to promote healthy things or safe driving, it feels quite coercive and frustrating. The insurance solution is to just charge people more for risky behaviors. Sidestepping the libertarian-Marxist debate about coercion, this outcome doesn’t seem that bad from a consequentialist perspective. Motorcyclists get injured, which costs resources in our health system, even this free market health system we are describing. If fewer people did dangerous activities, there would be fewer resources needed to fix their medical problems, which means those could be used elsewhere.

This type of thinking seems much more unfair if we expand it to include other things such as being overweight, or being sexually active. In today’s world, it seems likely insurance companies would consider being sexually active to increase risk or health costs, not to mention likely cost discrimination against gay men. I’m not sure there is a good solution to this. There will also be debates between insurers and customers on what counts as “controllable”. We can hope that the market will efficiently figure out what can be insured against (things that are not controllable), and offer insurance accordingly. This will most certainly be unsatisfactory to people caught in the system without as much coverage as they would like.

On the topic of things you definitely can’t control, genetic factors affect health, and it seems in this unregulated environment, customers will be forced to take genetic tests in order to be offered coverage. Of course, what is needed here is a form of “genetic insurance”. But when exactly would you buy that? Your genes are part of you already! There is no time you can buy insurance to avoid risk of a state that you’re already in. Well, it turns out there is still a good time to buy it, and that’s before you’re conceived. Parents can purchase “genetic insurance” for future children. In all likelihood, it would probably be combined with long-term chronic health insurance as well, as chronic problems could arise because of genetics. There may be different approaches to this, as you’d want the insurer holding the other end of the policy to be able to pay out potentially many decades into the future.

Finally, the pre-conception insurance piece would probably include pregnancy related complications as well. Or perhaps that will remain the domain of the health coverage of the mother. Exactly where it falls though is important for understanding the incentives which can be quite disturbing; since parents are looking to gain coverage for various genetic problems, insurance companies may calculate that it’s cheaper to pay for abortions of fetuses that are diagnosed with very expensive genetic problems. Pregnancies themselves can cause lots of complications though, so perhaps companies won’t want to have women go through lots of pregnancies. However, this depends on whether the same company is covering the mother and the child. If they don’t have the correctly aligned incentive, they could offer discounts to mothers who put their lives at risk. In an efficient market, the mother’s insurance company would compensate them for not doing that, so it would work out. Of course, markets are never as efficient as we would like.

Conclusion

I’ve constructed a complex series of possible insurance schemes, however I suspect an individual could roll most of them into a single long term life/health/genetic insurance policy initiated as early as possible, preferably by their parents before they’re even conceived. There’s a chance this approach will be too risk inclusive, and it will end up being a re-insurance scheme, but that’s really up to the market to decide. The main point is that insurance schemes can be constructed to properly shift risk around and avoid catastrophic and unplanned health issues. There are some lingering risks about how best to utilize risk pools or how to deal with insurance companies that go bankrupt, but generally speaking, there seems to be a framework for a free market solution to exist.

Nonetheless, the ability of insurance companies to use every possible way to gather information about you means that there will be a real “tax” on freedom to live our lives the way we want. I suspect from a consequentialist perspective, there is a lot to gain here, like people having financial incentives to exercise more, drink less, do fewer drugs (since drug laws probably won’t be enforce). On the other hand, from a libertarian ideal, having to pay for more expensive insurance because you drink a lot or have lots of sex seems patently unfree. Yet, this seems better in many ways than how government might deal with risky behaviors: bans, massive public relations campaigns that might not work, or simply doing nothing and letting the problem build. Social solutions, like public shaming for risky or different hobbies also seems fairly aggressive and unfree. Perhaps this is an acceptable middle ground where risk averse people are compensated by risk takers through the method of insurance.

There are serious issues though. The most obvious is that many people would have trouble buying insurance, especially if anything needs to be paid ahead of time, or all at once. In response, many would probably forego insurance altogether. This would result in poorer health outcomes and more expensive costs in the long run. The solution here, if the state were available, would be something like government transfer payments, or health credits.

Another issue is that people are poor planners. If cultural norms were changed such that everyone purchased some insurance plan when having children, that would probably help the situation. With today’s technology, they probably wouldn’t even need to do it prior to conception because genetic data on fetuses in the womb is scarce apart from diagnosing trisomies (like Down Syndrome). Of course, this stateless healthcare system would only come about through serious upheaval as mentioned in the intro.  The “correct” social norms surrounding this new insurance model may not properly take hold, as tons of social norms will be overthrown.  Even though it would probably help fix other issues we see today like mothers who can’t afford pre-natal care (since long term insurance companies would be heavily invested in making sure the pregnancy goes well), hoping social norms are correct seems optimistic.

Finally, the takeaways are that insurance is a pretty powerful tool, and where government could perhaps be most useful is in fixing income problems so that those with few means can participate in the market. The system described here is radical, and probably not something anyone but the most radical libertarians would choose to move society towards. At the same time, it also shows that there is room for significant improvements in insurance incentives even while keeping the high amount of government involvement in the healthcare market today.

 

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Rawls and Consequentialism

I.

Are things getting better?

The Cato Institute’s HumanProgress.org promotes the wonders of the modern world as a general cheerleader of liberal capitalist democracy. It highlights that the Human Development Index is up around the world over the last 30 years, and worker earnings can purchase higher quality and cheaper goods than they could 40 years ago. However, not everything is peachy. Inequality is up, US labor force participation is down, and healthcare and education spending have increased faster than inflation for some time now. Technological breakthroughs seem to be about how best to spy on you to sell you targeted advertising instead of flying cars. I favor the idea that things have indeed gotten better, but perhaps it’s not as straightforward as I would like.

Let’s revisit an idea I wrote about two years ago.

John Rawls proposed the Veil of Ignorance as a thought experiment to help imagine a just society derived from first principles. Designing a world, people should imagine themselves having no knowledge of their natural abilities or social standing. In order for society to be just, it must be one that everyone would agree to behind this veil of ignorance (this is a big simplification, you can read more here).

Robert Nozick famously responded to Rawls’ A Theory of Justice, with Anarchy, State, and Utopia, and part of his critique of Rawls was that even a society that fit Rawls’ criteria of “just” would quickly become less equal since people do have unequal natural talents. Voluntary transactions between citizens would quickly reward those with natural abilities for in-demand skills, and thus society would quickly fail to meet Rawls’ “just” criteria despite starting from a state of justice and undergoing nothing but voluntary transactions.

Of course, I’m more interested in policy than political philosophy today. I should be clear that Rawls wrote this as a philosophy thought experiment, not a political goal, but that hasn’t stopped it from being used to encourage certain policy outcomes; economist Dan Ariely polled people, asking them to create a wealth distribution for a society they would willingly enter in a random place, and they overwhelmingly chose extremely equal societies.

There are a few fronts I’d like to push back on this. The first is that those polled severely underestimated the current level of inequality. This means they imagine society should be more equal than what they think it is, meaning they believe society is flawed today and perhaps could be fixed. Yet the problem is much “worse” than they imagine, and they didn’t seem aware today. Perhaps people overestimate the impact of wealth inequality on their lives. In fact there is some debate among economists on the extent to which inequality impacts economic growth (although most agree severely lopsided wealth disparities in developing nations indicate poor economic institutions and thus poor growth). Secondly, average people don’t have a great understanding of economic principles; a recent survey found only 57% of Americans thought free trade was good for the country, and this was one of the highest percentages ever recorded. This is despite the fact that economists overwhelmingly believe free trade benefits all societies. Thus, even if people did know the extent to which this was a problem, it’s unlikely they could provide a great argument balancing trade offs inherent in economic policy calculations.

The final, and most important point is that it would take significant policy interventions, economic and otherwise, to change the layout of society to match that which Rawls’ derives from first principles, and certainly which people surveyed want. These interventions could not be undertaken without massively changing the incentives for people in society. If high earnings are taxed at a massive rate, people may be significantly less interested in being productive, or they may choose to start businesses in other countries where productivity is not as punished by the tax system. Additionally, public choice theory tells us that government having control over a larger budget will become the target of rent-seeking and special interests who will prevent the more philosophical policy goals of redistribution from being carried out. American policy today is somewhat re-distributive. Transfer payments make up a vast amount of the federal budget, yet with annual budget deficits hovering around $1 trillion, there doesn’t seem much political will to increase taxes.

Given the political and economic realities we face, it’s worth investigating what options really appear in front of us. As I wrote two years ago, we can hijack an aspect of the veil of ignorance to actually promote an unequal society. Placing yourself behind the veil of ignorance, would you rather be in the more equal society of 1968 America or the more unequal society of 2018 America? In 2018 you have more expensive healthcare, it’s true, but you also have significantly more treatments available to you. You have more food choices generally, and certainly more healthy food choices for cheap. You have incredible communications and entertainment improvements for extraordinarily cheap. A gallon of gasoline costs almost the same in inflation adjusted dollars from 1975, yet it gets you several times as many miles in cars that are safer, more comfortable, and more reliable.

II.

So it does seem intuitively that things are better despite today’s society being arguable less fulfilling of Rawlsian justice. If society is improving in ways that  Rawls’ political philosophy can’t capture, we should be careful about referring back to it as justification for policy. Nonetheless, Rawls did ultimately endorse specific economic institutions, and did so 30 years after his original publication in his revised book, Justice as Fairness: A Restatement.

Rawls rejected utilitarian approaches to political philosophy, believing that his system would be rationally selected over utilitarian ideas, yet even if rational actors would choose a Rawlsian setup of society, we have no way to get from here to there in the real world. Government is subject to political pressures and it cannot carry out idealized philosophical implementations. Thus, it’s true that we could propose policies that might create a better society, perhaps even one that better approximates a “liberal political conception of justice” as Rawls states it. Yet those policies have to be grounded in the political reality of our world, and there may be tradeoffs.

Modern political philosophy, and Rawls in particular, seems to be ungrounded from real world political policies. Chris Freiman, author of Unequivocal Justice, agrees. Rawls’ chosen economic systems have never worked. Does democratic socialism exist? If it does, is Venezuela the height of liberalism? If it doesn’t, then maybe we should stick with working on welfare state capitalism, while political philosophy goes back to the drawing board with the knowledge that governments are subject to biases and interest group politics. Rawls’ other endorsement, “property owning democracies”, is an economic system that I had never heard of before, but again doesn’t seem to exist, and I’m not sure it has even been tried. Freiman goes further, pointing out that if a perfect state could exist, we wouldn’t need the state at all, as people would just voluntarily give their extra wealth to create the perfect society. The assumption that is the basis for needing a state to redistribute is the same assumption that shows why states cannot redistribute wealth perfectly.

I enjoy speculating about fundamental changes in society. But there’s something deeply fatalistic about creating an entire political philosophy, defining liberalism and the ultimate way to craft the good society, and then declaring that the only method of realizing it is through political and economic systems that have been abject failures, or, in the best arguable case, have never existed. This is not an argument for libertarian economic policy or a libertarian society.  That would tend to run into the exact same problem. Instead, this is a fundamental argument for a consequentialist philosophy. At the very least, idealized utopian fantasizing cannot be used to justify real world policy goals unless it’s built upon real world assumptions. Consequentialism is an excellent way to ground philosophy in the real world. This is also an argument for humility. There are very few economists who suggest state control of the economy would work without issues. It feels obvious that Rawls would have known this, so perhaps this is simply the best you can do with a current political philosophy knowledge, and perhaps technology will make these types of societies easier to achieve in the future.

Again though, this concedes that Rawls’ philosophy is only useful if it is completely separated from the real world. At the nicest, that seems risky to spend all your efforts on a philosophy that rests on fundamental assumptions of idealized government that is widely known to be false. Consequentialism focuses our work and discussion on the real world and demands empirical data to support policies.

Finally, don’t take this essay as a end-all critique of Rawlsian Contractarian Liberalism; instead, take it as a first step approach to why consequentialist utilitarianism is a helpful philosophy in policy discussion.

Free Market Arguments from National Security

Libertarians are not fans of wars or government spending, often for overlapping reasons. Consequently, libertarians often remain uninterested in foreign policy, writing off the entire area of study as something not worth engaging in. Given the current administration has found a way to be both not interested in global affairs (“America First“), while also highly anti-market and pro-government spending (especially defense spending), I believe there might be an alternative that both retains a small government approach to the economy, as well as an important role for American leadership in the world.

The overarching theme here is that China is a rising power, whose outlook is distinct from that of the U.S. and the liberal world order generally. We might have expected China to continue its trajectory towards a freer economy and perhaps even a freer political ideology even 10 years ago, but no longer. Economic reforms touted by Xi Jinping have not materialized, and in fact the Chinese Communist Party and the state have strengthened their hold on the economy and the role of state owned enterprises within it. The Chinese state has maintained a highly nationalistic ideology; American foreign policy has created plenty of messes, but has also done some good in promoting free trade and at least stated goals democracy and respect for human rights. China is looking to offer an alternative to the current American-dominated world, and it is likely one that is worse for the world. American policymakers need to do better. Here are ways they could do so.

Institute Fiscal Discipline

The first point is that any potential policy that looks to achieve American goals vs Chinese goals will cost money. The U.S. government had a deficit of $665 billion last year. This year it will probably exceed $1 trillion. Entitlement spending will cost money, military R&D will cost money, cybersecurity will cost money, projecting power near China will cost money. Yet, we have passed a massive tax cut with no way to pay for it. From a libertarian perspective, unfunded tax cuts could be argued either way; they reduce the tax burden on citizens, but they crowd out investment, don’t actually change the amount of government interference in the economy, and they could lead to higher taxes later on. But from a national security perspective, this fiscal policy is terrifyingly irresponsible.

I find it uninteresting who owns the national debt. Much has been made of the fact that the Chinese government owns large portions of our debt. So what? They will receive future interest payments, but the federal government received cash from outside the U.S. economy it could spend immediately.  That kept interest rates low in the U.S. while Chinese savings and taxes were taken by the U.S. government and used to pay for Medicare, Social Security, and the War in Iraq. This is just a trade and doesn’t even seem like a great investment from China’s perspective. China could dump its American debt holdings onto the market, pushing up interest rates in the U.S., but by flooding the market, they’d also be selling the debt at a discount, writing off the losses. Moreover, China only owns a bit over a trillion dollars of debt, compared to the national debt’s total size of almost $21 trillion.

China could have put that capital directly into infrastructure investment or education or buying off communist party officials to implement more complete market reforms or even malaria nets in sub-Saharan Africa! But instead they bought low yield American government bonds. Seems like a waste of capital in my opinion. Had China not purchased that debt, the federal government still would have issued it, but interest rates would have been higher. On the other hand, the fact that the treasury owes some of this debt to other entities in the government isn’t super comforting. Those government agencies need the cash too; if they aren’t paid, they won’t be functioning, and their employees won’t be working.

No matter who owns our debt, increases in interest payments, whether through interest rate rises or increases in the underlying total debt will make accomplishing any policy goals, including foreign policy, that much more difficult.

Stop Military Counter-Terrorist Interventions

Predictable point of any libertarian foreign policy critique? Yes, but it’s unfortunately unavoidable. The cost of the Iraq and Afghanistan Wars are hard to calculate exactly. Direct appropriations costs were over $1 trillion, but the Afghanistan War remains ongoing (are you sick of winning?). Long term costs including veterans benefits will probably be more than double the direct costs.

The U.S. has a long history of Middle East interventions, and they just don’t have much to show. There are still almost no democracies, Libya, Syria, and Yemen are still divided states living under various governments, Iraq has been suffering under a war with the Islamic State which has cost a hundred thousand lives and displaced millions. The Iranian nuclear deal prevented a theocratic autocracy from obtaining a nuclear weapon, which was said to be only a couple years away.  This would be one of the only bright spots in U.S. policy in the Middle East, yet the President has threatened to tear up the deal.

If China is to be the focus of an American foreign policy, we can no longer afford to sink resources into fighting small terrorist groups that kill 10 times fewer Americans per year than police officers. And despite Trump’s so-called “America First” approach, we are most certainly still wasting resources in the Middle East. The President has carried out operations in Syria, Iraq, Yemen, Afghanistan, Pakistan, Somalia, and Libya. There are also U.S. forces apparently in Niger, Chad, and Cameroon. Perhaps it’s too late, and China’s expanding influence means the U.S. has to maintain a military presence in developing countries around the world to offer an alternative, but it would have been nice to save those expenditures in the intervening 30 years between the end of the Soviet Cold War and the ratcheting up of whatever this new one is. As it is now, these interventions have left American foreign policy broke.

Reform the Military Budget

As (grudgingly) stated earlier, we will need to fund the Department of Defense if our goal is to geopolitically confront China. Nonetheless, the DoD budget needs serious reform, and perhaps should be torn down and rebuilt from the ground up. The Government Accountability Office (the best government office) has never been able to audit the DoD in over 20 years (see page 3). In 2010, Congress told the DoD it had seven years to get its act together and finances in order. It missed the deadline. This year, the Department will allegedly finally undergo an audit, the report to be released November 15. This is, of course, a step in the right direction, but we need so much more.

The procurement system in the DoD is a complete mess.  The F-35 fighter is way behind schedule and already $400 billion in. Last year, Lockheed Martin produced 66 planes. This exposé from 2014 is deeply disturbing. When the military isn’t pouring money into contractors who are making out like bandits, or paying for tanks it no longer wants nor needs, or blowing up perfectly usable munitions because it can’t keep track of what is needed and where it should go, it dumps its extra assets, including leaving thousands of humvees in Iraq that were eventually captured by the Islamic State.

This military budget needs a reckoning and I’m unsure Trump is up to the task.

Promote Free Trade

China is jumping off the free market ride, and the U.S. needs to pick up the slack. The best way to expand the benefits of markets is to expand markets themselves through trade. More to the point of this post, countries that have a stake in global trade and free movement of goods are much more likely to have economic goals and values that align with the U.S. and its allies. During the Cold War, there was a strong alternative to capitalism and trade, and while most countries didn’t have a “choice”, many countries did exist outside of the free trade liberal market order pushed by the West. After the fall of the Soviet Union, that alternative largely dried up. Today, if you want to have a successful, rich country, freer trade and openness to foreign investment are vital steps to take.

China is much more open to trade and markets than the Soviet Union ever was. Nevertheless, any policies or goals where their motivations are less market oriented and more nationalistic would be exactly where they would differ with that of western values/free trade/liberal markets. This is evident in their extensive protection of Chinese industries and even in non-tariff barriers such as the Great Firewall. To the extent that China seeks to offer an alternative to the United States’ world order, they support protectionism and oppose free trade.

This means increasing trade and integration into the global economy of an allied (or possibly allied) country is the national security interest of the United States. A hypothetical Cuba that was highly integrated into the U.S. economy would be much less likely to be flirting (metaphorically I think) with Chinese dignitaries. The Trans-Pacific Partnership played exactly this geopolitical role, integrating Pacific countries’ economies with the U.S. and its allies, while leaving China on the outside. Yet Trump declared that we should leave the TPP as soon as he entered office, effectively siding against American national security and promoting China’s geopolitical goals.

Tying U.S. policy to free trade and global markets is powerful. It’s very difficult for a country to become rich and successful without at least selling their products on the global market. Access to the global market is thus in every country’s national interest. If U.S. policy is to have open trade, then the American economy will be highly integrated into the global market, meaning it is in the national interest of other countries to gain access to the American market. U.S. trade policy has been to offer access to the American market as part of bilateral and multi-lateral free trade agreements, thus offering foreign countries’ national interest goals if they conform with American goals of free trade and free markets. Integration with the U.S. economically necessitates geopolitical alignment with the U.S. That’s why it’s not just obviously economically stupid to oppose free trade (like crazy stupid), it’s against American national interests.

Allow More Immigration

All of these points have been critiques of the current administration. Some of these might also be critiques of conservative positions generally, but that will depend on to what extent current Republican positions are defined by historical conservative positions or by Donald Trump. This final point may still be the most difficult for conservatives to hear.

As a matter of national security, the U.S. needs more immigrants.

Immigrants are more entrepreneurial. Immigrants are less likely to commit crimes. Economists widely agree that high skilled immigration would benefit the average American, and tend to believe that even low skilled immigration would benefit the average American (although they are more split on the second). If we are concerned about the political effect of immigrants, we should take Rush Limbaugh’s (fairly progressive) approach and allow immigrants to work and live in the U.S., but not vote for a long period of time. Perhaps that’s more politically difficult than I imagine, but it seems like a good compromise from a national security perspective (and voting is sort of worthless anyway). That’s also not the only solution; if today’s political climate means only highly skilled labor can be let in, then at least that should be done. This administration has instead made the H-1B visa process more arduous. Trump’s immigration allies in the Senate have also introduced a bill to reduce legal immigration, including high skilled immigrants.

Immigration is an important engine for economic growth, an engine that nationalistic Chinese policies will have a hard time replicating. America is better able to absorb and benefit from immigration than any nation on Earth; it should apply this strength.

The final point relates back to deficits; entitlement spending is projected to continue to grow and consume the federal budget. The ratio of workers to retirees is dropping. Immigration can help change that tide, keeping our working age population growing, when fewer Americans are entering the workforce, often because families are just having fewer children. It won’t be enough, entitlement reform is important as well, but immigration is tool that must be utilized.

Conclusion

I don’t know how much of a danger China really poses to the U.S. Xi Jinping’s recent power grab is a bad omen though, and a large highly nationalistic protectionist country led by a dictator is certainly worth keeping an eye on. But if Sino-American relations get worse in the next decade, U.S. policy is in a poor position to adapt. Trump has claimed to want to confront China, yet his policies are actively harming our national security.

 

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