It’s what you might call a “perfect storm.”  In the midst of the worst recession in seven decades, America is also experiencing the most acute shovel shortage in its history.  At least that’s what some might have concluded in the seven weeks after President Obama signed the American Recovery and Reinvestment Act (ARRA)—a bill funding $787 billion of welfare provisions and “shovel-ready” infrastructure projects—and before any such construction projects began.

During those seven weeks, three things happened.  Unemployment jumped ten percent, GDP growth fell to lowest rate since the Great Depression, and, most troubling, Americans rediscovered the power of rhetoric; that “shovel-ready” was a euphemism, and a dangerously shortsighted one at that.  That getting the “shovels” was the hard part.

The truth is that any federal initiative involving states, including the ARRA which gives states money to finance construction projects, takes months to get money in the hands of Americans.  And that’s the root of economists’ debate over how to best legislate fiscal stimulus.

Since people tend to spend a larger fraction of money when its in the form of a reliable monthly paycheck rather than a onetime bonus, hiring new workers to complete projects should, at least in pure economic theory, provide a larger stimulus than distributing the same amount of money as tax rebates.  However the length of time it takes governments to plan projects, hire workers, and begin work may negate the stimulus advantage of employment programs.  After all, $200 billion in stimulus when the economy is risking recession will probably better excite growth than will $400 billion in stimulus two months later, when the economy has already entered recession.

In the past eighteen months both methods have been tried—tax rebates by President Bush and government employment by Mr Obama—and ultimately both have failed.

Although Mr Bush’s stimulus was an admirable, albeit cautious, attempt to spur growth it was far too small to avert the coming recession, and it was made worse by its small multiplier; since people’s marginal propensity to consume (MPC) falls during times of economic uncertainty, even less of the stimulus circulated into the economy than would with rebate checks in a typical economic environment.

Mr Obama’s stimulus was a more informed one.  Having already seen the low MPC of Mr Bush’s program, Mr Obama attempted to incite more spending by distributing the stimulus money to workers in the form of paychecks.  While this method will probably yield a higher MPC and therefore have a larger multiplier, it works too slowly to change the economy‘s course.  Five months into the stimulus program, less than one-quarter of the money has been spent.

And yet politicians around the country are calling for another stimulus.  Before following them, Americans ought to examine the lessons of the last two.

The first stimulus proved that wealth distributed without consumer confidence won’t be spent, and given that consumer confidence remains below 50%, another round of rebate checks would provide very little stimulus.  The second stimulus proved that Congress and state governments aren’t capable of implementing infrastructure projects quickly enough stimulate the economy; by the time states pay money to workers the economy has deviated from the situation the stimulus was designed to address.  If the economy worsens, this will make the stimulus too small to take care of the lack of domestic consumption; if the economy improves, this could make the stimulus larger than necessary, eventually leading to inflation.

If Congress passes a new stimulus package aimed, like the last one, at increasing government employment it could have dangerous consequences, in part because any such stimulus will continue through 2013 and possibly into 2014.  Assuming the current economic outlook—that the domestic economy will begin to grow and unemployment fall in coming  years—the velocity of money will accelerate along with rising consumer confidence.  Once the velocity of money accelerates, the effects of deficit spending will reveal themselves.

Consider the ways in which the Federal Reserve funded the current stimulus—selling Treasuries and quantitative easing, or ‘printing money.’  Both of these are methods of increasing the money supply.  Since consumers tend to save any money given to them during times of economic uncertainty, increasing the money supply rarely leads to inflation when consumer confidence is low.  When consumers regain their confidence, however, they begin to spend the money saved during periods of uncertainty, and when this happens on a macro-economic level too many dollars chase too few goods.  Inflation develops.

But selling Treasuries can also hurt the economy.  Although selling Treasury securities doesn’t carry as high an inflation risk as quantitative easing, it crowds out private lending and investment since money that people invest in Treasuries might otherwise be lent to a non-government debtors or invested in private industries.  A long-term fall in private investment will increase the portion of U.S. GDP that’s composed of government programs.  For Americans this means that too much stimulus for too long a period could ultimately shrink the private sector and foster a nation addicted to government spending.

So what’s to be done?  First, Americans ought to recognize that fiscal stimulus of any breed is a dangerous proposition—an action often more economically damaging than healing particularly when it’s unnecessary or financed through unsustainable means.  Furthermore, Americans should understand that GDP growth led by stimulus is only a temporary economic fix.  Not only does it compromise private industries’ growth potential, but it also breaks down at the end of stimulus spending.  That said, stimulus can be a necessary evil, and when pursued ought to be implemented correctly.

If Mr Obama and his Congress decide to pass another round of stimulus, they should recognize that the stimulating benefits of the ARRA are only beginning, and any similarly structured employment program will have lagging effects when it comes to decreasing unemployment.  Thus any additional stimulus should be in the form of a tax rebate, ensuring a quick, visible spending boost.  This program can be acted on once consumer confidence rises above sixty percent, indicating that the spending will have a larger multiplier.  After all, growth only takes place when rebate recipients actually spend the money they receive.

Yes, we must be cautious, but we can’t lie paralyzed, waiting for the next shovel shipment.

Nicole Adams, dissenting:

Given the number of calls in Washington for a “second stimulus” one might think Dr. John M. Keynes was our president.  That he’s not is one of two interesting observations; the other is that Americans are so eager to forget Mr Bush that they don’t seem to tally his Economic Stimulus Act in their stimulus count.

But perhaps that’s because it wasn’t a stimulus.

As a result of a remarkably high savings rate Americans only spend around forty percent of  their tax rebates.  And with most of the stimulus money being saved or used to repay preexisting debts, the stimulus bill seemed to have little effect on the economy—although the economy expanded by .9% and 1.9% in the two quarters following the package, growth shrank to .3% in the next quarter.  Rising consumer confidence, which the majority references as an indication that tax rebates might become effective, does not guarantee that people will spend  any more of a second round of rebate checks; new rebates could be equally ineffective.

On the other hand, Mr Obama’s stimulus has proved successful.  The beginning of ARRA spending has coincided with a fall in new unemployment claims and an increase in quarterly GDP numbers.  Indeed, employing new workers in stimulus projects takes longer than it ought to, but it does yield a higher MPC, and, in turn, a larger simulative effect.

To the extent that there will be another fiscal stimulus, it needs to employ people in long-term jobs with reliable paychecks.  Particularly since deficit spending has such inflationary potential (outlined in the majority’s opinion), any spending should carry the large multiplier that comes hand-in-hand with employment-based stimulus.

If that takes months to plan, so be it.

Opinion of the court, delivered by William Leich, signed by Nicole Adams:
Before recessing for the July 4th celebrations, the U.S. House narrowly passed an energy bill that seeks to tackle climate change through an emissions trading program.  The chief provision of the bill, dubbed the “cap-and-trade” program, is likely to put a cap on economic growth.

Under the plan the federal government releases emission permits—allocating 85% to companies at no cost and auctioning the rest—each of which allow recipients to emit a specified amount of greenhouse gases.  If companies need to emit more than their permits allow or do not need to emit as much as they are permitted to, they can exchange credits to pollute on the open market.

This emissions capping system is a quantity instrument because it guarantees certain emission reductions each year.  And although quantity instruments are often more damaging to economic growth than price instruments like taxes, they can solve environmental problems that are sensitive to changes in pollution concentrations, like waste water or acid rain.

In the context of global warming, however, emitting three billion tons of carbon dioxide one year and seven billion the next, has a similar impact to releasing five billion tons both years.  Thus a price instrument that can flex with the business cycle makes more sense than cap-and-trade; what we need is a carbon tax.

Instead, America could an emissions cap whose impact on the economy will be varied, unpredictable, and easily exploited.

At the top of the business cycle, demand for the consumer goods that drive carbon emissions will be at its highest, and therefore emission credits will be highly sought after and consequently very expensive.  This can drive up inflation, which is already—at least theoretically—at its highest during periods of high growth.

Meanwhile, a manufacturing company that recognizes emissions credits to be overvalued during growth could sell its credits and temporarily shut down its factories.  When companies are paid to produce nothing, items become scarce and price levels rise; this is exactly what Americans saw in the summer of 2008, when corn prices rose in the heyday of ethanol because production didn’t respond to price signals—a consequence of farm subsidies that pay farmers to leave fields unused.

Ultimately, both these phenomena will heighten inflation’s sensitivity to economic growth, which means when the economy expands too quickly inflation will result at a faster pace.  That alone, could trigger a slowdown.

When a recession does develop, the emissions trading program will hurt the economy and fail to deliver on its environmental promises.  Depressed demand for consumer goods during economic contraction will leave many companies with surplus emission credits; high supplies and low demand will make them, effectively, worthless.  Furthermore, companies may be able to cut costs  by reverting to less efficient means of production—thereby producing fewer goods but emitting the same amount of carbon since there will be no incentive not to.  Not only will a temporary movement away from environmental efficiency harm the environment, but it will also enable companies to produce goods at lower costs, heightening the risk of deflation during the part of the cycle when it’s already highest.

The past six months have proven that deflation and recession can feed on each other.

As low-cost emission credits kill the financial incentive for carbon-efficient production methods during recession, the motivation for environmental innovation will disappear.  Company research funding will come and go with economic growth, and any environmental innovation difficult.

But besides problems with inflation sensitivity and fickle environmental benefits, the cap-and-trade system also raises the issues on taxing imports.  The energy bill passed by the House contains provisions that could tax imports from countries whose carbon emission guidelines Congress deems less rigorous than the U.S. system.  Given the volatility in the cost of emission credits and the difficulty in measuring how much the cap-and-trade program actually costs American companies, tariffs on imported goods will probably be larger than the effective tax of the program and thus protectionist.  Traditionally, protectionism at home is fought with protectionism abroad.  The result is usually globally recession.

Congress could avoid the pitfalls of emissions trading by substituting a greenhouse gas emission tax.

Taxing emissions would give consumers and businesses a clearer idea of the cost of polluting.  That way taxes on imports from countries without strict carbon emissions laws can be more fairly priced, preventing protectionist retaliation from big manufacturers like China and India.  Moreover, a tax would guarantee that the drive for efficiency is a constant one, not one that recedes at the bottom of the business cycle; meaning that companies can’t revert to old technologies during recession and innovation can be more easily achieved.

But most importantly, since a tax wouldn’t rise during expansion and fall during contraction the way the cost of the cap-and-trade system would, it won’t increase inflation’s sensitivity to growth.  The tax won’t create recessions and won’t deflate prices during them when they inevitably come.

The only environmental drawback of an emission tax would be the variability of annual greenhouse gas emissions, which would mirror economic activity.  Still, steady tax hikes would reign in long-term emissions as well as any credit trading program could.

Particularly in a time of turmoil, Congress ought to recognize that the economy doesn’t grow at a constant pace; rather it grows in spurts.  Their energy bill ought to reflect that.  It should allow for the ebb and flow of the business cycle without exacerbating its volatility.  And it can’t be an excuse for protectionism; we tried that in 1930.

David Lamb, concurring:
Just how to balance economic growth with environmental protection is a struggle that has faced every president since Lyndon Johnson.  Climate change and greenhouse gas emissions, both because of their global nature and historically distant consequences, have always been particularly thorny issues; after all, why should U.S. workers sacrifice their living standards for the sake of the planet if Chinese workers will get rich off of their comparative advantage that results from an American emissions law?

They shouldn’t.

But American workers also can’t disproportionately discriminate against imported goods.  The majority opinion handles the prospect of protectionism well, saying  that a tax shows the cost of domestic emissions more clearly than a emission trading program and therefore allows for tariffs on goods “from countries without strict carbon emissions laws [to] be more fairly priced.”

As the Senate looks to pass its own energy bill, it ought to implement a carbon tax for that reason, and add a clause that guarantees tariffs are proportional, per good, to the carbon tax.  This means the bill needs to require foreign companies to report their emissions, needs to ensure reported numbers are accurate, and needs to provide a means for foreign companies to appeal the tariff if it costs more than producing goods domestically and paying the carbon tax would.

Fairness in global trade is especially important because the Treasury needs China’s money; without it, low demand for Treasuries would drive yields too high to sustain.  If China, Japan, and other exporters, find Congress’ energy bill to be protectionist, they could raise their own tariffs, cutting off global trade and preventing Americans from reaping the comparative advantages of countries abroad.

I side with the majority, supporting that an emissions tax ought to replace the cap-and-trade system for the reasons outlined in the court’s opinion, emphasizing only that the resulting “carbon tariffs” must ultimately be fair ones.

It’s also similar in that it exists in a world unburdened by basic economics; where the American system has a public program—Medicare—that will use federal money to treat cancer in a retired sixty-eight-year-old who no longer pays income taxes, it has no such program to help a fifteen-year-old buy antibiotics for pneumonia, even though local and state governments have invested tens of thousands of dollars in the fifteen-year-old’s education and even though the fifteen-year-old has decades of income taxes yet to pay.

It has been five months since Mr Bush fled from Washington, and yet the United States’ health insurance system, dreamed up by depression-era businessmen in rooms full of cigar and cigarette smoke, has continued to plague Americans like a self-induced lung cancer, that is, from the inside, out.

While President Obama’s proposed health care plan broadens eligibility standards for Medicaid—the public insurance program for low-income Americans—proposes another national plan to compete with private insurers, and mandates health insurance for children, it doesn’t socialize medicine, leaving the possibility that some citizens will remain uninsured. These people, who will be between eighteen and sixty-five, and in jobs which don’t provide health care benefits—often ones that pay below the national average—will be forced to pay more for health insurance if they want it.

As long as there exist public health insurance alternatives, private companies will be allowed to charge outsized premiums to risk-heavy customers—those likely to need significant medical attention in the near future. Meanwhile younger, healthier Americans, and those employed in high-income jobs, will opt for the private plans which they will rarely use. Federal plans will, therefore, either offer insurance at uncompetitive rates or hemorrhage money. In the second and far more likely case, healthy citizens, some of whom won’t have insurance, will subsidize the care of aging and unhealthy ones, much like they do now with current Medicare policy.

If instead federal plans offer insurance that reflects true costs, as they do in the first case, they will leave a price gap that private insurance companies will eagerly fill, which means that Americans now uninsured will be left sponsoring public insurance in addition to buying their own or buying insurance at above current prices. It begs the question: why does Mr Obama think people who aren’t currently buying health insurance will buy it after his policy is implemented and it’s, effectively, more expensive?

Among health insurance companies, it’s no secret that those who purchase health insurance are more likely to need it than those who don’t. This process of adverse selection, customers subscribing to insurance because they know something insurance companies don’t, makes insurance prices higher than if they were mandatory—a situation where there’s no selection process.

Whereas Mr Obama could decrease insurance premiums by proposing Congressional legislation requiring Americans to purchase insurance and subsidizing those who truly couldn’t afford it, he has opted to continue a policy of optional, more expensive insurance. If he believed in his argument that providing more Americans with health plans lowers health care costs by discovering health risks before they grow, then he would ensure that all citizens become covered and help close the budget deficit at the same time. That Mr Obama is looking to implement no such policy makes the argument look more like a fragile justification in the face of conservative opposition than a legitimate cost analysis.

As recent health care reforms in Massachusetts have proven, mandatory health insurance requires increased government funding in Medicaid as a result of a gap between those who now qualify for Medicaid and those who are able to fully pay for insurance. Ceteris Paribus, that would mean higher taxes. However skirting the so-called “death spiral”—healthier individuals dropping insurance because of rising costs leading to a higher proportion of insured individuals who utilize health insurance leading to rising costs—might cancel the costs of broader Medicaid coverage.

Without taking into account the risks of optional insurance, it will be difficult for Mr Obama’s health care reform to work. As Mr Obama may soon learn, leaving the health care industry partially private and partially public will result in a situation similar to that of the U.S. military and military contractors in Iraq: the private companies earning the profits and the public entities assuming the risk.

In any case, his plans do suggest an important trend—that health insurance costs rising by an average of nearly 7% percent per year have gotten the nation’s attention and motivated system-wide reform. Indeed, America is waking from a long and expensive coma.

William Leich, Concurring:
Indeed, socializing health care is the most sure way to avoid the type of adverse selection that fed the “death spiral” and driven health care further out of reach. However, socialized medicine will effectively eliminate price signals, spreading the cost of personal use across the nation’s tax base.

This creates a moral hazard where citizens who could resolve certain health issues, like obesity or type II diabetes, through behavior change and medications won’t carry the burden of more expensive solutions like gastric bypass surgery. Over the course of a decade, more patients using expensive but comparatively easy surgeries to take care of health problems, however trivial, will drive up the cost of health care.

In order to incentivize cheaper solutions, any socialized health plan ought to provide more limited benefits and require larger copayments than the typical private plan currently does.

Nicole Adams, Dissenting:
Meritocracy—where the most innovative, diligent, and skilled workers rise to the top of industry—seems to be at the core of America’s workplace identity. And responsibility seems to be a cornerstone of the American Dream; although America has bankruptcy laws, they are far less forgiving than their European counterparts. Yet when it comes to health, Americans like to regard it as if it were out of one’s control.

Quite often, it isn’t.

America has the ninth highest rate of obesity in the world, and some of the highest rates of heart disease and type II diabetes. America also has the forty-fifth highest life expectancy in the world.
But the reason our life expectancy isn’t on par with Japan’s and Singapore’s isn’t because of any lack of quality in our health care—rather our health care is among the best in the world—it’s because of the way our health care system is constructed.

That system, which features coverage for the wealthy, the indigent, and the old, offers the insured little motivation to lead healthy lives. Low copayments combined with the nation’s high quality care means that insured citizens can live an irresponsible lifestyle—whether that consists of smoking, binge eating, or deliberate self-harm—and get expensive treatment when it catches up with them. The negative externality is the bill, and it’s imposed on the rest of the country.

What America needs isn’t reform. It needs to continue on its current path to losing insurance. As the “death spiral” continues to make insurance an increasingly more expensive program for the unhealthy, the countries uninsured will grow. Since these people will be directly paying for any health care they use, they will be motivated to live responsibly and won’t visit doctors when they think it’s unnecessary.

Insurance comes with moral hazard and creates externalities. When it’s for something where the buyer knows more than the seller—a kind of information asymmetry—adverse selection will ultimately trigger an upward price spiral. For something as important and easily influenced as a person’s health, insurance doesn’t make sense.

The federal government should encourage its citizens to be as healthy as possible. The best way to do this is through an uninsured health care system where users pay for their use. If wealthy citizens want to overspend for escaping responsibility they can continue to do so.

The recent stock market rally of the past four months—only now beginning to falter—and results from the Federal Reserve’s bank “stress tests” in May have persuaded Treasury Secretary Geithner and Reserve Chairman Bernanke that America has avoided  the worst banana since the Great Depression.  Before passing such judgments, Mr Geithner ought to examine President Obama’s 2010 budget.

The budget resolutions currently in both houses of Congress are unlikely to reduce the $1.17 trillion deficit that Mr Obama’s plan forecasts.  If that federal deficit—the second largest nominal deficit ever—remains, it will be all but impossible to finance.

When the House and Senate settle differences in their budget resolutions and approve an identical plan, the budget will come into effect for the fiscal year that starts on the first of October and the Treasury will be responsible for bridging the gap between federal revenue and federal spending.  During normal times, faith in the U.S. government and an international need for secure investment allow the Treasury to finance the national debt through Treasury securities and government bonds with low interest rates.  This, however, will prove difficult if China isn’t a returning customer.

Over the past two decades, the Chinese government has reliably invested its annual surpluses in U.S. Treasury Bills.  By doing so China secures its wealth and, more importantly, helps the U.S. government to continue running the deficits that allow Americans to afford Chinese imports; if the federal government were unable to easily finance deficits, it would need to raise taxes enough to remove them, thereby decreasing every taxpayers’ disposable income—much of which is spent on products manufactured in China.

If nothing else, this recession has shown China how much it needs American demand: since the U.S. recession began, China’s exports have dropped more than 18%.  And combined with its own domestic recession, this drop has produced China’s largest fiscal deficit in sixty years.

So China’s government needs to buy Treasury Bills so that the federal government can stimulate demand for Chinese exports, but China’s government can’t buy Treasury Bills because it’s as bankrupt as the federal government.

What’s Mandarin for “pickle?”

America has been in this situation before—where Congress ran massive deficits without sufficient demand for government bonds.  The time was 1978 and the result a 12% inflation rate.

Instead of raising bond yields to rates at which they would be purchased, the Federal Reserve decided to purchase long-term Treasury Bills.  This method of funding, called monetizing the debt, is a form of quantitative easy, or what the layperson calls “printing money.”  Although quantitative easing works to finance deficits in the short-term it also creates inflation, which functions as tax on everyone holding the U.S. Dollar.  Since less affluent people tend to hold more of their wealth in the form of cash savings—instead of in a home, a car, or the stock market—the tax is regressive.

Mr Geithner should ensure that this doesn’t happen again.  He should testify before Congress, advising its members to minimize deficits in their budget resolutions and explaining to them why “free lunch,” at least in fiscal policy, is so elusive.  In a global outlook where the Treasury’s best customer—China now owns 24% of the national debt—has a deficit, Congress needs to decrease spending or create sufficient revenue to close its budget shortfall.  Otherwise Congress will unknowingly levy a tax on the poor.

That’s a recipe for one very bad banana.

William Leich, Dissenting:
The inflation rate from May of 2008 to May of this year was -1.28%.  Given the assumption of the majority opinon—that inflation acts as a regressive tax on the poor—the past twelve months should have been one of the best years to be poor since the Great Depression.

They weren’t.

That said, Mr Obama is doing what he can to trigger a recovery and transport more Americans from poverty.  Yes, one of the stimulus measures Messrs Obama and Bernanke are using is quantitative easing, and, yes, it will probably yield higher inflation, but this will probably also benefit the economy.

The deflation that the American economy has experienced over the past eight months has stifled any opportunity of growth.  Falling prices have given Americans incentives to delay purchases, thereby contributing to the recent increases in the personal savings rate.  Such savings, which have displaced aggregate demand, have created a self-fulfilling prophecy, where Americans delay purchases expecting deflation, and by delaying purchases create more deflation.  If Mr Obama doesn’t stop that vicious cycle it will ravage the economy.

But first, it will bankrupt the poor.  That’s because deflation, not inflation, functions as a regressive tax.

In proportion to their income, poorer Americans tend to carry more debt; richer ones tend to carry less.  Therefore when deflation spikes, the people who have the least capacity to repay their debts are forced to do so in dearer dollars.  When they can’t, they declare Chapter 7 bankruptcy.

No right-minded economist would argue that high rates of bankruptcy aid economic recovery.  What a right-minded economist will argue is that they erode the trust of lenders, which can, in turn, prompt a credit crisis.  Therefore from an economic standpoint, the cost of high inflation is a small one compared to the costs of deflation.

Whether or not China decides to buy Treasuries the next time they are auctioned, the Treasury will be able to finance the 2010 budget deficit, either through European demand for Treasuries or quantitative easing.  Indeed, if Mr Geithner chooses the latter path, Mr Bernanke and the Federal Reserve ought to have their hands on the dial, ready to raise the federal funds rate at the first sign of runaway inflation.

Until then, they should worry about deflation and recession, and Congress should pass Mr Obama’s budget—$1.17 trillion deficit and all.  A little inflation could go a long way.

The subprime mortgage crisis that became the financial crisis that became the recession that became the Great Recession wasn’t a consequence of market failure or misguided risk-taking.  Rather it was the result of individuals—bankers and homeowners—behaving like individuals at the expense of the broader economy: exploiting bankruptcy laws that mitigated their own risk, not by removing it, but by imposing it on third-parties.

Subprime mortgages are called “secure” because their loan value is designed not to exceed the value of the property.  This means that if a homeowner becomes delinquent on a mortgage, the lending party can foreclose on the home and recover the loan’s entire value.  As long as real estate prices are static, banks don’t carry significant risk writing mortgages without down payments.

The problem is that this system depends on home values not falling below mortgage values.  When they do—when delinquent borrowers owe more than their houses were worth—creditors can be stuck with a deficit: their collateral—the house—is worth less than their credit—the mortgage—which means foreclosure doesn’t bring all of their money back.

Non-recourse loans, which protect borrowers and compose the majority of American mortgages, compound the problem.  These loans stipulate that debtors whose houses have been foreclosed on have no responsibility to pay the remainder of the mortgage if one exists.  In other words, if the value of Mike’s house drops enough that his mortgage is larger than his home’s value and he stops paying his mortgage, his bank can foreclose on his him, but can’t seize his car or his television.

By defaulting on his mortgage and walking away, Mike earns money.  By continuing to pay the mortgage, Mike overpays for his house.

As the last eighteen months have shown, the bank isn’t the real loser in this arrangement.  After all, the bank can declare Chapter 7 bankruptcy protection and its debts become an externality forced on its creditors—the largest of which is often the federal government, attempting to avoid bankruptcy among large financial firms by loaning them money.

Banks realized that bankruptcy was a possibility, and, knowing that bankruptcy laws had them covered, made a calculated decision to trade risk for return.

In finance, risk is directly related to profit—the riskier the borrower, the higher the demanded interest rate.  The more risks a firm is willing to take, the more it can earn.  Because bankruptcy protection shelters irresponsible risk-taking, banks have an opportunity to take more of it.

Limited liability laws mean employees and owners of defaulting companies can’t be pursued by the companies’ creditors.  Thus when payment bonuses are structurally related to immediate profit, financial managers can accept excessive gambles, earn excessive payouts, and, worst-case scenario, lose their jobs when their gambling leads their employers into failure.  The more likely situation seems to be that the Federal Reserve saves the companies and most managers’ jobs with them.

Consider, too, that there’s something in this for borrowers.  If Mike, in an alternate scenario, has no mortgage and is having trouble selling his house, he may be able to find a bank that overvalues it and offers him a non-recourse mortgage with a five percent down payment.  Once he signs the mortgage he can ditch the property and walk away with the money.  That the bank can’t recover the value of the mortgage by selling the house isn’t Mike’s liability.

And yet it could unhinge the economy or necessitate a taxpayer-funded bailout.  If Congress wants to avoid future bailouts, it needs to reform bankruptcy laws so that they don’t allow for individuals to profit from risks that were forced upon the entire economy.  Otherwise bankers and homeowners will continue to abuse the spread between personal risk and economic dangers.

Indeed, if individuals behaved with macro-economic outcomes in mind, recessions wouldn’t exist; Americans wouldn’t have overspent when they should have been saving and wouldn’t be saving now, when they ought to be spending.  However individuals largely look to individual outcomes, and these outcomes have awoken the bears on Wall Street, and it’s the taxpayers who are being mauled.  It’s open season.

Nicole Adams, Concurring in part, dissenting in part:
The moral hazard argument set forth in the opinion—that if Mike finds himself upside-down on his non-recourse mortgage he will declare bankruptcy—is flawed.

Aside from social stigma, bankruptcy comes with a number of costs that the opinion doesn’t account for—among them that it bars the declarer from receiving credit in the future.  Given credit’s importance in the American lifestyle, from the bridge loans that lubricate month-to-month business to personal mortgages to credit cards, losing credit is a massive cost.  And not one that Mike, or another rational American, would endure to avoid overpaying by a few thousand dollars for his house.

Still, the issue of businesses balancing risk with return is real, and our bankruptcy laws and limited liability laws help alleviate the personal risks of reckless financial behavior, encouraging finance workers to pursue return even if that means putting the health of the economy in jeopardy.

As the opinion states, the Federal Reserve ought to allow large banks to fail.  That creates job risk for their employees.  Congress ought to limit chapter eleven bankruptcy protection, so as to avoid companies exploiting it as a convenient restructuring technique made necessary by bad decisions.

Non-recourse mortgages, however, need to stay.  Particularly in current times, where homeowners are, as the opinion warns, getting mauled by the bears of real estate meltdown, the government can’t take away their clothes.

The bill was fresh from the Philadelphia headquarters of the United States Mint; what the economist thought was a piece of counterfeit currency was actually bailout money, planted on the other side of the asphalt for the banker who the federal government knew didn’t accept the idea of market efficiency.

President Obama and his administration predicted the banker would reason that if the efficient-market hypothesis (EMH)—the theory that the prices at which all financial assets are traded reflect all known information—held true, then commodity prices never would have spiked in the summer of 2008, real estate prices wouldn’t have increased by 50% from 2000-2007 and since lost those gains, and the “dot-com bubble” wouldn’t be a case study on human psychology applied to economics.

Although many economic theorists still hold that investors are rational, and use the EMH as evidence that stock prices mirror real stock values and that outperforming the market is therefore impossible through any means other than luck, a growing number of financial economists are beginning to doubt the EMH.  Over the past fifteen years, free stock-trading websites have made available information that was previously difficult, if not impossible, to find.  And yet an increase in real-time financial information has correlated with an increase in bad investing—the dot-com bubble, the oil speculation bubble, and the American housing bubble have all come since then.

Because the price of a share of AOL in 1999, a barrel of oil last July, and a two-bedroom Albuquerque condominium in 2007 had little relation to their actual or potential value, something other than market efficiency must have been at work.

The EMH ignores the fact that humans aren’t good at calculating risk; it’s why we make bad bankers, and why we need to tame our actions by leaning on protocols like laws, etiquette, and ethics to govern our decisions.  But most importantly, it’s why we are subject to the herd mentality that creates the greater fool in the greater fool theory—the man who became a first-time homeowner three years ago or who bought copper last year because it’s month-to-month increases were seemingly guaranteed to continue.

Homo economicus—the “economic human” —doesn’t exist.

Herd mentality does, and it’s leading politicians to the wrong solutions at the wrong times.  Now, when every major investment bank has been closed, General Motors (GM) and Chrysler are in and just out of bankruptcy court, and most major Wall Street banks are in the red, Mr Obama has dismissed GM’s chief-executive, the 111th Congress has passed legislation regulating executive pay, and the president’s administration is working with Congress to force banks into freeing up the funding they received in the Troubled Asset Relief Program.

An investor doesn’t need advice after he’s lost all his money in a speculative bubble; he needed it when he was buying the “sure thing” peacock feathers stock.  Just so, business needs government regulation most during periods of economic growth and least during recession.  While the economy is expanding, lending practices can get sloppy, salaries can become bloated, and undue optimism can lead managers to taking on excessive risk.  Here, at the bottom of the business cycle, banks currently funded by the government are being run how they should have been years ago, lending cautiously and dismissing failing executives like the criminals they are— are now and always have been.

It may be difficult for Mr Obama and his Congress to understand that they aren’t needed during this time of crisis—or rather that their regulation isn’t.  It will surely be more difficult for them to explain that to outraged voters.  But look at the numbers—America’s personal savings rate, 7%, is higher than it has been in fifteen years and average CEO salaries are lower than they have been in nearly that long; the recession is making us all better calculators.

It will be several years into the future, in a world of rising stock prices, when one homo economicus will cry that an industry’s profits are unsustainable or its businesses overvalued.  Then Mr Obama will have a problem best fixed through government intervention.  May he fix it before the herd catches up with its own foolishness.

William Leich, Dissenting:
In truth, the bubbles of the last decade aren’t evidence that the market efficiency no longer applies to investing.  Rather, it applies more than ever; the availability of information has brought the EMH closer to reality.
And as the acceleration of information helps businessmen and investors make better decisions at both ends of the business cycle, regulation becomes a necessity at both ends.

Now, when over 9.4% of Americans are unemployed, Mr Obama and his Congress have the political mandate to re-regulate the financial system.  They ought to embrace this opportunity to pass permanent caps on executive pay—albeit with a cost-of-living adjustment—and tighten rules on asset leveraging, short selling stocks, and trading credit derivatives like credit-default swaps.

The latter three of those financial practices export risk from the party engaging in them to the broader system as a result of bankruptcy laws.  Of course, where such negative externalities exist, people will exploit them until forced to stop.  The federal government could regulate the practices either through higher required reserve ratios or by taxing them.

Either way, regulation needs to be imposed to discourage individuals participating in systemic risk-taking.  This is regulation that can’t wait for the next recession or the next depression.  Whether or not Mr Obama believes in the EMH, he ought to believe in a certain number: it’s 5,800, the number of points the Dow Jones Industrial Average has fallen since October of 2007.  That’s the price America paid for under-regulation.