Stanley Fischer: How Far on Financial Reform?

In the aftermath of the Great Recession, it seemed blindingly clear that the financial sector needed reform. But what kind of reform was needed, and what progress has been made? Stanley Fischer takes on these questions in the 2014 Martin Feldstein Lecture, "Financial Sector Reform: How Far Are We?" published in the NBER Reporter (2014, vol. 3).

Everyone in academic economics knows who Fischer is, but for those outside, he's a man with an
extraordinary resume. He is currently vice-chairman of the Federal Reserve. Before that, he was governor of the Bank of Israel for eight years. Before that, at various times, he was chief economist at the World Bank, first deputy managing director of the International Monetary Fund, vice chairman at Citibank, and a very prominent economics professor at MIT. His Fischer's quick summary of the nine main items on the financial sector reform agenda:

Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors. The programs - national and international - covered some or all of the following nine areas: (1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity" (2) to strengthen the quality and effectiveness of prudential regulation and supervision; (3) to build the capacity for undertaking effective macroprudential regulation and supervision; (4) to develop suitable resolution regimes for financial institutions; (5) to strengthen the infrastructure of financial markets, including markets for derivative transactions; (6) to improve compensation practices in financial institutions; (7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs; (8) to find appropriate ways of dealing with the shadow banking system; and (9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.

In his talk, he focuses on three of these items: "Rather than seek to give a scorecard on progress on all the aspects of the reform programs suggested from 2007 to 2009, I want to focus on three topics of particular salience mentioned earlier: capital and liquidity, macroprudential supervision, and too big to fail."

Capital ratios have been substantially increased, which means that banks will in the future have a bigger buffer the next time their loan portfolio turns unexpectedly bad. Here's Fischer:

The bottom line to date: The capital ratios of the 25 largest banks in the United States have risen by as much as 50 percent since the beginning of 2005 to the start of this year, depending on which regulatory ratio you look at. For example, the tier 1 common equity ratio has gone up from 7 percent to 11 percent for these institutions. The increase in the ratios understates the increase in capital because it does not adjust for tougher risk weights in the denominator. In addition, the buffers of HQLAs [high-quality liquid assets] held by the largest banking firms have more than doubled since the end of 2007, and their reliance on short-term wholesale funds has fallen considerably. At the same time, the introduction of macroeconomic supervisory stress tests in the United States has added a forward-looking approach to assessing capital adequacy, as firms are required to hold a capital buffer sufficient to withstand a several-year period of severe economic and financial stress. The stress tests are a very important addition to the toolkit of supervisors, one that is likely to add significantly to the quality of financial sector supervision.

The proposed changes in macroprudential regulation (a concept previouslyintroduced and discussed here and here on this blog) are at best incomplete so far.

As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among the major regulators, the Financial Stability Oversight Council (FSOC). Don Kohn ... sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn's cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body.

What about the efforts to address the "too big to fail" problem, where large financial firms that have taken big risks and earlier earned large profits then need to be bailed out by the government, because they are so large and so interconnected to the rest of the economy that their failure could lead to even larger public costs?

One can regard the entire regulatory reform program, which aims to strengthen the resilience of banks and the banking system to shocks, as dealing with the TBTF [too big to fail] problem by reducing the probability that any bank will get into trouble. There are, however, some aspects of the financial reform program that deal specifically with large banks. The most important such measure is the work on resolution mechanisms for SIFIs, including the very difficult case of G-SIFIs [global systemically important financial institutions]. In the United States, the Dodd-Frank Act has provided the FDIC with the Orderly Liquidation Authority (OLA) - a regime to conduct an orderly resolution of a financial firm if the bankruptcy of the firm would threaten financial stability. ...

Work on the use of the resolution mechanisms set out in the Dodd-Frank Act, based on the principle of a single point of entry, holds out the promise of making it possible to resolve banks in difficulty at no direct cost to the taxpayer — and in any event at a lower cost than was hitherto possible. However, work in this area is less advanced than the work on raising capital and liquidity ratios. ... [P]rogress in agreeing on the resolution of G-SIFIs and some other aspects of international coordination has been slow. ... 

What about simply breaking up the largest financial institutions? Well, there is no "simply" in this area. ... Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms? ... That is not clear, for Lehman Brothers, although a large financial institution, was not one of the giants — except that it was connected with a very large number of other banks and financial institutions. Similarly, the savings and loan crisis of the 1980s and 1990s was not a TBTF crisis but rather a failure involving many small firms that were behaving unwisely, and in some cases illegally. This case is consistent with the phrase, "too many to fail." Financial panics can be caused by herding and by contagion, as well as by big banks getting into trouble. In short, actively breaking up the largest banks would be a very complex task, with uncertain payoff.

Fischer's overall tone seems to me cautiously positive about how financial reform has proceeded. My own sense is more negative. By Fischer's accounting, capital ratios have clearly improved, but macroprudential regulation and avoiding too big to fail remain works in progress.

As I have pointed out  before on this website, the Dodd-Frank Act of 2010  required the passage of 398 rules, and a little more than half of those rules have been finalized in the last few years. But to be clear, a "finalized" rule doesn't actually mean that businesses have figured out how to comply with the rule, and the rule itself may still be under negotiation. In certain areas from Fischer's list of rule, like #8 concerning the risks of shadow banking (for discussion, see here and here) and #9 concerning credit rating agencies (for discussion, see here and here), Dodd-Frank required almost no changes at all. I understand that financial reform is like changing the course of an enormous ocean liner, not like steering a bicycle. But we are now six years past the worst of the crisis in 2008, and much remains to be done.

Oikonomia, Revisited

My knowledge of ancient Greek is not significantly different from zero, but every student of economics at some point runs into oikonomia, the root word from which economy and economics were later derived. For example, in describing the etymology of "economy," the Oxford English Dictionary writes that it derives from "ancient Greek οἰκονομικός practised in the management of a household or family, thrifty, frugal, economical." 

To the modern ear, the idea of economics as having roots in "household management" makes some intuitive sense: after all, a number of modern economic models are built on the idea of a household that seeks to maximize its utility, subject to constraints of income and/or time. However, Dotan Leshem suggests that this easy parallel between what the Greeks meant by household management and modern microeconomics is rather misleading. He provides some additional context and insight for the term in "Oikonomia Redefined," which appeared in the Journal of the History of Economic Thought, March 2013 (35: 1, pp 43 - 61). The journal is not freely available on-line, but many readers will have access through a library subscription. Leshem describes a work written by Xenophon, roughly dated to about 360 BC:

The first to propose a definition of oikonomia—the management and dispensation of a household—was Xenophon. He did so in the concluding chapter of the theoretical dialogue of the Oikonomikos (the Oikonomikos is composed of two dialogues: the first is theoretical, while the second focuses on the art of oikonomia. ... Xenophon’s definition is composed of four building blocks, or sub-definitions: i) oikonomia as a branch of theoretical knowledge; ii) the oikos as the totality of one’s property; iii) property as that which is useful for life; and iv) oikonomia as the knowledge by which men increase that which is useful for life. Clarifying the meanings of the sub-definitions by a close reading of ancient Greek texts will allow me to argue that the ancient Greek philosophers understood oikonomia as encompassing any activity in which man, when faced with nature’s abundance or excess, acquires a prudent disposition that is translated into practical and theoretical knowledge, in order to comply with his needs and generate surplus. The surplus generated allows man to practice extra economic activities such as politics and philosophy. Excess in the definition proposed is an attribute of nature, which is assumed to be able to meet everyone’s needs and beyond, if economized prudently. Surplus, on the other hand, is the product of people’s prudent economizing of nature’s excess that is not used for securing existence.

To get a grip on this earlier notion, it's useful to remember that the idea of a "household" was an expansive one in the times of ancient Greece: indeed, it included all property of the well-to-do in a way that also encompassed what we would now think of as production and firms. This broad idea of the household was called the oikos, which was then viewed as a part of the polis, or public sphere.

The fundamental economic challenge, according to the ancient Greeks, was to strike a balance. On one side, too little emphasis on economics meant an inability to provide the surplus that would enable some people to live the good life of politics and philosophy. On the other side, too great an emphasis on economics could lead to a pursuit of luxurious living, an outcome which also would interfere with pursuit of the good life. Here's how Leshem describes Xenophon on this subject:

In the same vein, Xenophon, who explored the nature of wealth in the first two chapters of the Oikonomikos, is also preoccupied with setting the right limits to engagement in economics without directing surplus either into luxury or back into the economy. He does so by presenting two obstacles to man’s accumulation of wealth. Both are the outcome of self-enslavement to excessive desires instead of need satisfaction. The first takes place when someone is immersed in non-economic activities that prevent him from ‘‘engaging in useful occupations,’’ meaning that he is wholly taken up with activities that prevent him from economizing his life. Such total avoidance of economizing, in its meaning of utilizing usable things, is presented as a sort of bondage. Put differently, evading a prudent disposition causes the loss of the conditions enabling a good and happy life. The second obstacle to wealth accumulation arises when one immerses in the economic sphere, having enslaved oneself to desires:

[Xenophon writes:] "And these too, are slaves, and they are ruled by extremely harsh masters. Some are ruled by gluttony, some by fornication, some by drunkenness, and some by foolish and expensive ambitions which rule cruelly over any men men they get into their power, as long as they see that they are in their prime and able to work . . . mistresses such as I have described perpetually attack the bodies and souls and households all the time that they dominate them."

This second kind of self-enslavement is not to be found in avoidance of economic
activities and the lack of prudent disposition when using things. Instead, it is to be
found in the failure to set boundaries to the economic sphere and, as a consequence, to fully immerse oneself in it. Such full immersion is presented as a lack of ability
to generate extra-economic surplus. It is here where the other side of oikonomia’s
definition as prudent conduct makes its appearance: besides utilizing the thing
acquired for the sake of existence, its prudent use generates extra-economic surplus.

This modern notion of economics is rooted in the idea that we all face scarcity of time, money, and energy, and thus need to make decisions involving tradeoffs. As Leshem points out, this ancient Greek notion is actually more rooted in an idea that we face an issue of abundance: how to bring that abundance to fruition, and how to prevent ourselves from giving into luxurious living. Because the purpose of economic life is to create this extra-economic surplus, the goal can be achieved either by increasing production, or by keeping the level of consumption low enough that a comfortable surplus will persist. Leshem writes;

 "As can be seen, the problem arising when supplying the needs of the oikos is not how to deal with scarce means. It is, rather, how to set a limit to engaging in economic matters altogether, since nature possess excessive means that can supply all of people’s natural needs, as well as their unnatural desires. On the other hand, if economized prudently, this excess can be used to generate surplus. It can supply the needs of all the inhabitants of one’s oikos or polis, and free some of its members from engaging in economic matters to experience the good life, which is extra-economic."

Pulling these various elements together, Leshem sums up Xenophon's definition in this way (Greek words and page numbers omitted):

Xenophon’s definition of the oikonomia, as ‘‘a branch of theoretical knowledge . . . by which men can increase household . . . which is useful for life . . .’’  can be reformulated into: oikonomia is the prudent management of the excess found in man and nature in order to allow the practice of a happy life with friends, in politics, and in philosophy. We can see that the two definitions are interchangeable; oikonomia is the management of the oikos. The oikos itself equals wealth, in turn to be defined as everything useful for life. ...  The definition of wealth is compatible with the definition of the oikonomia as the prudent management of needs satisfaction in order to generate surplus leisure time (which was perceived by Aristotle as a precondition for the attainment of happiness).

Up to this point, the notion of economics and the "good life" of politics or philosophy seem like a conception limited to the upper sliver of property owners. Indeed, there is an interpretation of Greek economic philosophy often associated with Aristotle, which still has echoes today, which holds that economic life is by definition without virtue, and true human virtue comes only from noneconomic areas of life like public life and philosophy. Taken to an extreme, this view would hold that those who put too much time and energy into work cannot be virtuous. An alternative modern view, often associated with John Locke, holds that economic work is a transformative interaction with the natural world through which humans create their own autonomy and virtue. (Here is an essay of my own thoughts on interactions between economics and virtue.) 

Leshem argues that while scholars of ancient Greek economic thought used to see a disjunction between economic life and a virtuous life, with the virtues of politics and philosophy largely limited to those in high positions, the more recent literature has take an broader view. He writes:

"In addition, contemporary literature persuasively presents the oikos as a diversified domain in which there exist all kinds of human relations besides despotic ones. They stress the friendship between husband and wife, it being for the sake of happiness and not just as a means to support the polis, the role of education of children within the household, the different kinds of slaves, the use of other means of communication beside violence, and the household’s existence in and for itself. In this depiction, not only the master, but many participants in the household, can demonstrate virtue, doing so within its bounds."

Overall, the concept of economic life among the ancient Greeks was not built on individuals and firms interacting in markets for goods, labor and capital. It is not built on a fundamental issue of facing scarcity and decisions that involve tradeoffs. Instead, the building block is the role of the household or oikos as a building block for society as a whole, and for enabling people to live a virtuous life outside the economic realm. Here is how Leshem sums up the difference between the economic theory of the ancient Greeks and modern economic theory:

[T]he differences and the resemblance between contemporary and ancient Greek economic theory are rather marked. Both define the economic sphere by the disposition people demonstrate (in the former—of prudence; in the latter—of rationality), which is translated into the theoretical and practical knowledge people demonstrate in economic activity. Moreover, both say that everything that people utilize in order to satisfy their needs/desires and to generate surplus is part of the economic domain, and not (just) material wealth. But, while in ancient economic theory, acquiring this disposition was seen as the expression of an ethical choice, in contemporary theory, the individual’s doing so is taken as a given, so that people’s rational disposition can be inferred from their revealed preferences. 

The two economic theories embody distinct ontologies: while ancient economic theory held that humans face abundance and excessive means in the economic domain, contemporary economists hold that it is only scarce means that are available there. As for the designation of the surplus generated, in the ancient theory it is a surplus of leisure time that allows the master/citizen to participate in politics and engage in philosophy, while in the contemporary theory ... it is to be turned back to the economic domain, as a source for growth, or, as pointed out by critics of contemporary consumerism, into luxurious consumption.

The Economics of Water in the American West

Fresh water doesn't get used up in a global sense: that is, the quantity of fresh water on planet Earth doesn't change. But the way in which the world's fresh water is naturally distributed--by evaporation, precipitation, groundwater, lakes, and rivers and streams--doesn't always match where people want that water to be. The man-made systems of water distribution like dams, reservoirs, pipelines, and irrigation systems can alter the natural distribution of water to some extent. But the American West is experiencing a combination of drought that reduces the natural supply of water and rising population that wants more water. Even with drought, population pressures, and environmental demands for fresh water, there is actually plenty of water in the American Southwest--at least, if the incentives are put in place for some changes to be implement by urban households, farmers, water providers, and legislators.

For an analysis of the issues and options, a useful starting point is a set of three papers published by the Hamilton Project at the Brookings Institution:

• Melissa S. Kearney, Benjamin H. Harris, Brad Hershbein, Elisa Jácome, and Gregory Nantz, "In Times of Drought: Nine Economic Facts about Water in the United States." 
• Newsha K. Ajami, Barton H. Thompson Jr., David G. Victor, "The Path to Water Innovation."
• Peter W. Culp, Robert Glennon, and Gary Libecap, "Shopping for Water: How the Market Can Mitigate Water Shortages in the American West."*

Here's a figure from Culp, Glennon, and Libecap showing the U.S. drought situation, concentrated in the southwestern United States: 

These southwestern states have also experienced dramatic population growth in recent decade. Of the regions of the United States, these are the states with the highest population growth and the lowest annual rainfall even in average times. Here's a figure from Kearney, Harris, Hershbein, Jácome, and Nantz:

Here's my master plan for how to address the water shortfall, drawing on discussions in the various papers. 

1) Reduce the incentives for outdoor watering by urban households in dry states. 

If  you had to guess, would you think that urban households in dry states of the American southwest use more or less water than other states? In general, these households tend to be heavier users of water. Here's a figure from Kearney et al., who report (citations omitted):

Outdoor watering is the main factor driving the higher use of domestic water per capita in drier states in the West. Whereas residents in wetter states in the East can often rely on rainwater for their landscaping, the inhabitants of Western states must rely on sprinklers. As an example, Utah’s high rate of domestic water use per capita is driven by the fact that its lawns and gardens require more watering due to the state’s dry climate. Similarly, half of California’s residential water is used solely for outdoor purposes; coastal regions in that state use less water per capita than inland regions, largely because of less landscape watering . . .

There are a variety of ways to reduce outdoor use of water: specific rules like banning outside watering, or limiting it to certain times of day (to reduce evaporation); the use of drip irrigation and other water-saving technologies; and so on. For economists, an obvious complement to these sorts of steps is to charge people for water in a way where the first "block" of water that is used has a relatively low price, but then additional "blocks" have higher and higher prices. 

Here's a figure showing average monthly water bills across cities. Los Angeles and San Diego do rank among the cities with higher bills, although the absolute difference is not enormous. But again, the point here is not the average bill, but rather that those who use large amounts of water because they want a green lawn and a washed-down driveway should face some incentives to alter that behavior. 

2) Upgrade the water delivery infrastructure. 

One hears a lot of talk about the case for additional infrastructure spending, but much of the focus seems to be on fixing roads and bridges. I'd like to hear some additional emphasis on how to fix up the water infrastructure system. As Ajami, Thompson, and Victor note: 

"Water infrastructure, by some measures the oldest and most fragile part of the country’s built environment, has decayed. ... Water infrastructure—including dams, reservoirs, aqueducts, and urban distribution pipes—is aging: almost 40 percent of the pipes used in the nation’s water distribution systems are forty years old or older, and some key infrastructure is a century old. On average, about 16 percent of the nation’s piped water is lost due to leaks and system inefficiencies, wasting about 7 billion gallons of clean and treated water every day .... Metering inaccuracies and unauthorized consumption also leads to revenue loss. Overall, about 30 percent of the water in the United States falls under the category of nonrevenue water, meaning water that has been extracted, treated, and distributed, but that has never generated any revenue because it has been lost to leaks, metering inaccuracies, or the like ... " 

3) Let farmers sell some of their water to urban areas. 

For historical reasons, a very large proportion of the water in many western states, but especially California, goes to agricultural uses. Some of these uses combine relatively high market value and relatively low use of water, like many fruits (including wine grapes), vegetables, and nuts. But the use of water for other crops is more troublesome.  Culp, Glennon, and Libecap go into these issues in some detail. As one vivid example, they write: "In 2013, Southern California farmers used more than 100 billion gallons of Colorado River water to grow alfalfa (a very water-intensive crop) that was shipped abroad to support rapidly growing dairy industries, even as the rest of the state struggled through the worst drought in recorded history ..." 

There are a substantial number of legal barriers to the idea of farmers trading some water to urban areas, but the possibilities are quite striking. Here's a figure showing that 80% of California's water use goes to agriculture, with a substantial share of that going to lower-value field crops like alfalfa, rice,  and cotton. In agricultural areas, as in urban ones, there is often considerable scope for conserving water in various ways,  like targeting the use of irrigation more carefully, making sure that irrigation ditches don't leak while carrying water, and the like. 

Imagine for the sake of argument that it was possible with a comprehensive effort that combined shifting to different crops and water conservation efforts to reduce agricultural water use in California by one-eighth: that is, instead of using 80% of the available water, agriculture would get by with using 70% of the available water. The amount available for urban and/or environmental uses would then rise by half, from 20% to 30% of the available water. 

One approach they describe, implemented starting in 2002 in Santa Fe, New Mexico, required that any new urban construction had to find a way to offset water that would be used in that construction. 

As an example, developers could obtain a permit to build if they retrofitted existing homes with low-flow toilets. Residents of these homes welcomed the chance to get free toilets, and Santa Fe plumbers jumped at the opportunity for new business. Within a couple of years plumbers had swapped out most of the city’s old toilets with new high-efficiency ones. Water that residents would have flushed away now supplies new homes.  ... In short order, a market emerged as developers began to buy water rights from farmers. Developers deposited the water rights in a city-operated water bank; when the development became shovel-ready, the developer withdrew the water rights for the project. If the project stalled, the developer could sell the rights to another developer whose project was farther along. Santa Fe also enacted an aggressive water conservation program and adopted water rates that rise on a per unit basis as households consume additional blocks of water. Thanks to the innovative water-marketing measures, the conservation program, and tiered water rates, water use per person in Santa Fe has dropped 42 percent since 1995 ... 

4) Set up groundwater banks. 

Historically, most western states have allowed any property owner to drill a well and use groundwater without limit. But the groundwater reserves are slow to recharge, and with the drought and population pressures, they are under severe stress. Culp, Glennon, and Libecap explain (citations omitted):

Groundwater has been the saving grace for many parts of the water-starved West. Following the advent of high-lift turbine pump technology in the 1930s, many regions had access to vast reserves of water in underground aquifers that they have tapped to supply water when surface water supplies were inadequate. A recent study looked at data on freshwater reserves above ground and below ground across the Southwest from 2004 to 2013. It found that freshwater reserves had declined by 53 million acre-feet during this time—a volume equivalent to nearly twice the capacity of Lake Mead! The study also found that 75 percent of the decline came from groundwater sources, rather than from the better-publicized declines in surface reservoirs, such as Lake Mead and Lake Powell. Much of this decline occurred because some Western states, including California, have historically failed to regulate, or do not adequately regulate, groundwater withdrawals. As a result, groundwater aquifers are effectively being mined to provide water for day-to-day use. In response to the ongoing drought, California farmers continue to drill new wells at an alarming rate, lowering water tables to unprecedented depths ...In the San Joaquin Valley of California, excessive groundwater pumping caused the water table to plummet and the surface of the earth to subside more than twenty-five feet between 1925 and 1977 ..." 

Arizona has already been taking steps toward groundwater protection, both by limiting what can be taken out and by providing incentives to save water in the form of recharging groundwater (which avoids the problem of evaporation). 

Although not yet developed into a formal exchange, Arizona has been at the cutting edge in developing groundwater recharge and recovery projects and a supporting statutory framework to help enhance the reliability of water supplies. Arizona allows municipal users, industrial users, and various private parties to store water in exchange for credits that they can transfer to other users. Because water stored underground in aquifers is not subject to evaporation, groundwater that is deliberately created through recharge activity can be stored and recovered later. This recharge and recovery approach is facilitated by Arizona laws that restrict the use of groundwater in several of the state’s most important groundwater basins; these restrictions prevent open access to the resource. Restrictions on open access, combined with statutory and regulatory provisions that allow for the creation and recovery of credits, created the essential conditions for trade in stored groundwater. As a result, numerous transactions have occurred between various municipal interests, water providers, and private parties. 

California passed legislation last month to regulate groundwater pumping for the first time. 

5) More research and development on water-saving technologies. 

As Ajami, Thompson, and Victor discuss at some length, there is relatively little innovative activity in water conservation and purification, as opposed to, say, energy conservation and new sources of energy. They argue that part of the reason is that energy-providing companies compete against each other, while most water companies are sleepy publicly-run local monopolies. Potential entrepreneurs have the ability to look at a lot of ways of producing and using energy, confident that if they come up with something useful, their invention will find a ready market. But entrepreneurs looking at various methods of water conservation will often find that their ideas apply only locally, or are hard to patent, or are hard to sell to water companies and users. Here's their figure comparing spending for energy and water innovation at a global and U.S. level. 

Drought is a natural problem. But the factors that determine how water is available get used represent an economic problem of the incentives and constraints that determine the allocation of a scarce resource.  In the American West, the institutional problems of water allocation seem to me even more severe than the natural problem of drought. 

* Full disclosure: I did comments and editing on the paper by Culp, Glennon, and Libecap, and was paid an honorarium for doing so. 

Political Polarization and Confirmation Bias

Election Day is coming up a week from tomorrow, on Tuesday. Are you voting for your beliefs about the beliefs, character, and skills of the candidates? Or are you voting the party line, one more time? Here's an article I wrote for the Star Tribune newspaper in my home state of Minnesota. I have added weblinks below to several of the studies mentioned. 

"It's my belief and I'm sticking to it:

In such a polarized atmosphere, you may want to examine pre-existing biases."

By Timothy Taylor




Part of the reason American voters have become more polarized in recent decades is that both sides feel better-informed.

The share of Democrats who had “unfavorable” attitudes about the Republican Party rose from 57 percent in 1994 to 79 percent in 2014, according to a Pew Research Center survey in June called “Political Polarization in the American Public.”

Similarly, the percentage of Republicans who had unfavorable feelings about the Democratic Party climbed from 68 percent to 82 percent.

Most of this increase is due to those who have “very unfavorable” views of other party. Among Democrats, 16 percent of Democrats had “very unfavorable” opinions of the Republican Party in 1994, rising to 38 percent by 2014. Among Republicans, 17 percent had a “very unfavorable” view of the Democratic Party in 1994, rising to 43 percent by 2014.

A follow-up poll by Pew in October found that those with more polarized beliefs are more likely to vote. The effort to stir the passions of the ideologically polarized base so that those people turn out to vote explains the tone of many political advertisements.

A common response to this increasing polarization is to call for providing more unbiased facts. But in a phenomenon that psychologists and economists call “confirmation bias,” people tend to interpret additional information as additional support for their pre-existing ideas.

One classic study of confirmation bias was published in the Journal of Personality and Social Psychology in 1979 by three Stanford psychologists, Charles G. Lord, Lee Ross and Mark R. Lepper. In that experiment, 151 college undergraduates were surveyed about their beliefs on capital punishment. Everyone was then exposed to two studies, one favoring and one opposing the death penalty. They were also provided details of how these studies were done, along with critiques and rebuttals for each study.

The result of receiving balanced pro-and-con information was not greater intellectual humility — that is, a deeper perception that your own preferred position might have some weaknesses and the other side might have some strengths. Instead, the result was a greater polarization of beliefs. Student subjects on both sides — who had received the same packet of balanced information! — all tended to believe that the information confirmed their previous position.

A number of studies have documented the reality of confirmation bias since then. In an especially clever 2013 study, Dan M. Kahan (Yale University), Ellen Peters (Ohio State), Erica Cantrell Dawson (Cornell) and Paul Slovic (Oregon) showed that people’s ability to interpret numbers declines when a political context is added.

Their study included 1,100 adults of varying political beliefs, split into four groups. The first two groups received a small table of data about a hypothetical skin cream and whether it worked to reduce rashes. Some got data suggesting that the cream worked; others got data suggesting it didn’t. But people of all political persuasions had little trouble interpreting the data correctly.

The other two groups got tables of data with exactly the same numbers. But instead of indicating whether skin cream worked, the labels on the table now said the data was showing a number of cities that had enacted a ban on handguns, or had not, and whether the result had been lower crime rates, or not.

Some got data suggesting that the handgun ban had reduced crime; others got data suggesting it didn’t. The data tables were identical to the skin cream example. But people in these groups became unable to describe what the tables found. Instead, political liberals and conservatives both tended to find that the data supported their pre-existing beliefs about guns and crime — even when it clearly didn’t.

In short, many Americans wear information about public policy like medieval armor, using it to ward off challenges.

Of course, it’s always easy to define others as hyperpartisans who won’t even acknowledge basic facts. But what about you? One obvious test is how much your beliefs change depending on the party of a president.

For example, have your opinions on the economic dangers of large budget deficits varied, coincidentally, with whether the deficits in question occurred under President Bush (or Reagan) or under President Obama?

Is your level of outrage about presidents who push the edge of their constitutional powers aimed mostly at presidents of “the other” party? What about your level of discontent over government surveillance of phones and e-mails? Do your feelings about military actions in the Middle East vary by the party of the commander in chief?

Do you blame the current gridlock in Congress almost entirely on the Republican-controlled House of Representatives or almost entirely on the Democratic-controlled Senate? Did you oppose ending the Senate filibuster back in 2006, when Democrats could use it to slow down the Republicans, but then favor ending the filibuster in 2014, when Republicans could use it to slow down Democrats? Or vice versa?

Do big-money political contributions and rich candidates seem unfair when they are on the other side of the political spectrum, but part of a robust political process and a key element of free speech when they support your preferred side?

Do you complain about gridlock and lack of bipartisanship, but then — in the secrecy of the ballot box — do you almost always vote a straight party ticket?

Of course, for all of these issues and many others, there are important distinctions that can be drawn between similar policies at different times and places. But if your personal political compass somehow always rotates to point to how your pre-existing beliefs are already correct, then you might want to remember how confirmation bias tends to shade everyone’s thinking.

When it comes to political beliefs, most people live in a cocoon of semi-manufactured outrage and self-congratulatory confirmation bias. The Pew surveys offer evidence on the political segregation in neighborhoods, places of worship, sources of news — and even in who we marry.

Being opposed to political polarization doesn’t mean backing off from your beliefs. But it does mean holding those beliefs with a dose of humility. If you can’t acknowledge that there is a sensible challenge to a large number (or most?) of your political views, even though you ultimately do not agree with that challenge, you are ill-informed.

A wise economist I know named Victor Fuchs once wrote: “Politically I am a Radical Moderate. ‘Moderate’ because I believe in the need for balance, both in the goals that we set and in the institutions that we nourish in order to pursue those goals. ‘Radical’ because I believe that this position should be expressed as vigorously and as forcefully as extremists on the Right and Left push theirs.”

But most moderates are not radical. Instead, they are often turned off and tuned out from an increasingly polarized political arena.



Timothy Taylor is managing editor of the Journal of Economic Perspectives, based at Macalester College in St. Paul.

Keeping Up with the Joneses on Energy Conservation

The phrase "Keeping Up with the Joneses" seems to have become firmly established in U.S. culture as a result of a prominent comic strip by that name which started in 1913 and ran for several decades.
Characters in the cartoon often referred to what the Joneses were doing but you never met them. Usually the term refers to a desire to imitate the higher and more conspicuous consumption levels of one's neighbors. But can a desire to follow the neighbors also be harnessed to energy conservation efforts?

Hunt Allcott and Todd Rogers offer evidence on that question in "The Short-Run and Long-Run Effects of Behavioral Interventions: Experimental Evidence from Energy Conservation," in the October 2014 issue of the American Economic Review (104:10, pp. 3003–3037). The AER is not freely available on line, but many readers will have access through library subscriptions. (Full disclosure: The AER is published by the American Economic Association, which also publishes the Journal of Economic Perspectives, where I work as Managing Editor.) They write:

We study a widely-implemented and highly-publicized behavioral intervention, the “home energy report” produced by a company called Opower.The Opower reports feature personalized energy use feedback, social comparisons, and energy conservation information, and they are mailed to households every month or every few months for an indefinite period. Utilities hire Opower to send the reports primarily because the resulting energy savings help to comply with state energy conservation requirements. There are now 6.2 million households receiving home energy reports at 85 utilities across the United States.

At some of the utilities, the Opower notices have been implemented as a randomized control trial, which makes it relatively straightforward to compare the behavior of those who receive the notices and those who don't. One can also use this data to look at questions like whether the notice might have a short-term effect that fades unless the reminders continue, or a longer-term effect that continues for a time and then fades as people get tired of receiving the notices. Here's an example of the front and back of a typical Opower notice:

What effect do these notices have? Allcott and Rogers report that when first receiving a notice, a number of consumers show a quick but short-term reduction in energy use. As people receive more notices, this cycle of reducing consumption and then bouncing back gets smaller. But the repetition of the message seems to have a longer-term effect after two years--that is, people's habits have changed in a way that lasts for several more years. In their words:

At first, there is a pattern of “action and backsliding”: consumers reduce electricity use markedly within days of receiving each of their initial reports, but these immediate efforts decay at a rate that might cause the effects to disappear after a few months if the treatment were not repeated. Over time, however, the cyclical pattern of action and backsliding attenuates. After the first four reports, the immediate consumption decreases after report arrivals are about five times smaller than they were initially. For the groups whose reports are discontinued after about two years, the effects decay at about 10 to 20 percent per year—four to eight times slower than the decay rate between the initial reports. This difference implies that as the intervention is repeated, people gradually develop a new “capital stock” that generates persistent changes in outcomes. This capital stock might be physical capital, such as energy efficient lightbulbs or appliances, or “consumption capital”—a stock of energy use habits ... Strikingly, however, even though the effects are relatively persistent and the “action and backsliding” has attenuated, consumers do not habituate fully even after two years: treatment effects in the third through fifth years are 50 to 60 percent stronger if the intervention is continued instead of discontinued.

One reason for having utilities encourage energy conservation is because it can be cheaper than building additional electricity generation plants, and facing the broader social costs of the environmental costs of such plants. Electricity in the US across all sectors of the economy now costs about 11 cents per kilowatt/hour, Thus, Allcott and Rogers look at the cost-effectiveness of sending Opower reports, defined "as the cost to produce and mail reports divided by the kilowatt-hours of electricity conserved."

They find that a one-shot Opower notice has has a cost effectiveness of 4.31 cents/kWh. Extending the intervention to two years costs more in sending out additional notices. But the continual reminders keep encouraging people to conserve, and also over that time people build up a pattern of reduced energy consumption. In their words, "The two-year intervention is much more cost effective than the oneshot intervention, both because people have not habituated after the first report and because the capital stock formation process takes time." Thus, the overall cost-effectiveness after about two years is about 1.5 cents/kWh.

After two years, it seems possible to slack off on the reminders, and to send them perhaps twice a year rather than with every monthly bill. This step reduces the cost of sending the reminders, but seems to keep about the same level of effectiveness in terms of holding down energy consumption. Indeed, households don't seem to get used to the reports, but seem to keep responding to the notices even after a third and fourth year. As they write: "However, it is remarkable how little cost effectiveness decreases after two years, suggesting strikingly little habituation."

I'm not surprised that these kinds of notices about how much electricity the Joneses are using have a short-run effect. But the surprise in these results is that people keep chasing the Joneses toward greater electricity conservation even after several years of receiving these notices. It makes one wonder if there aren't some other ways in which information and social pressure, discreetly and privately applied, might be used in the service of environmental goals.

Antitrust Goes International

In a globalizing world economy, it's perhaps no surprise that mergers and acquisitions are also crossing national borders more frequently--and that the risk of cartel-like behavior across national borders is also rising. The OECD lays out some background in its recent report, "Challenges of International Co-operation in Competition Law Enforcement."  As a starting point, here's a figure showing the overall upward pattern cross-border merger and acquisition deals in recent decades.

In some cases, these M&A deals raise eyebrows on their own. In other cases, there is a concern that companies may be acting together across borders in a cartel-like way without an explicit deal. Indeed, the number of international cartels that have been discovered has been rising in recent years. "The number of cross-border cartels revealed in an average year has increased substantially since the early 1990s. According to the Private International Cartel (PIC) database,34 about 3 cross-border cartels were revealed via competition authority decisions or prosecutions in an average year between 1990 and 1994. In recent years, from 2007 to 2011, an average of about 16 cross-border cartels has been revealed per year."

The last two decades have seen a rise in the number of countries with "competition laws" and antitrust authorities to enforce them.

"The spread of competition law enforcement around the world has been remarkable. At the end of the 1970s only nine jurisdictions had a competition law, and only six of them had a competition authority in place. By 1990, there were 23 jurisdictions with a competition law and 16 with a competition authority. The number of jurisdictions with competition authorities increased more than 500% between 1990 and 2013. As of October 2013, about 127 jurisdictions had a competition law, of which  120 had a functioning competition authority. ... The speed and breadth of the proliferation of competition laws and competition enforcers around the globe is the single most important development in the competition area over the last 20 years."

A main focus of the OECD report is the issues involved in coordinating the actions of competition authorities, who often have different legal standards, and I suspect in many cases may be more confrontational toward foreign companies than toward domestic firms. The U.S. is an active player in this area.

"According to Scott Hammond (former Deputy Assistant Attorney General for Criminal Enforcement), the Antitrust Division typically has approximately 50 international cartel investigations open at a time. Since May 1999, more than 40 foreign defendants have served, or are serving, prison sentences in the United States for participating in an international cartel or for obstructing an investigation of an international cartel. Foreign nationals from France, Germany, Japan, the Republic of Korea, Norway, the Netherlands, Sweden, Switzerland, Chinese Taipei and the United Kingdom are among those defendants. In the well-known vitamins case of 1999, for example, twelve individuals, including six European executives, were sentenced to serve time in US prisons for their role in the vitamin conspiracy. The automotive parts investigations exemplify the need for the Antitrust Division to co-operate with foreign counterparts. The investigation included search warrants executed on the same day and conducted at the same time as searches by enforcers in other countries. During the ongoing investigation the Antitrust Division coordinated with the competition law authorities of Japan, Canada, the Republic of Korea, Mexico, Australia, and the European Commission."

The number US Department of Justice antitrust cases with an international dimension has been rising over time. Indeed, international cases have for some years made up most of the fines collected by U.S. antitrust enforcement agencies. Here's a figure showing the number of non-U.S. companies prosecuted in cartel investigations by the U.S. antitrust authorities, and the share of antitrust fines received from these cases.

When companies act together to limit competition and to carve up global markets, it is just as harmful as when they do so in domestic markets--but it can be harder to monitor and enforce. The battle is already underway.

What Path for Development in Africa -- and Elsewhere?

As I've pointed out from time to time, the countries of  sub-Saharan Africa have been experiencing genuine conomic growth for the last decade or so, and not just in oil- and mineral-exporting countries, creating what is by the standards of developing economies an expanding middle class. But here comes Dani Rodrik to ask some realistic tough questions in his essay, "Why an African Growth Miracle Is Unlikely," written for the Fourth Quarter 2014 issue of the Milken Institute Review. Rodrik also argues this case in "An African Growth Miracle?" given as the Richard Sabot lecture last April at the Center for Global Development.

As Rodrik readily acknowledges, many nations of Africa have seen  both sustained growth and positive reform of their economic institutions.

Sub-Saharan Africa’s inflation-adjusted growth rate, after having spent much of the 1980s and 1990s in negative territory, has averaged nearly 3 percent annually in per capita terms since 2000. This wasn’t as stellar as East Asia’s and South Asia’s performances, but was decidedly better than what Latin America, undergoing its own renaissance of sorts, was able to achieve. Moreover, the growth isn’t simply the result of a revival in foreign investment: The region has been experiencing positive productivity growth for the first time since the early 1970s. It should not be entirely surprising,
then, that the traditional pessimism about the continent’s economic prospects has been replaced by rosy scenarios focusing on African entrepreneurship, expanding Chinese investment and a growing middle class. ... 

Agricultural markets have been liberalized, domestic markets have been opened to international trade, state-owned or controlled enterprises have been disciplined by market forces or closed down, macroeconomic stability has been established and exchange-rate management is infinitely better than in the past. Political institutions have improved significantly as well, with democracy and electoral competition becoming the norm rather than the exception throughout the continent. Finally, some of the worst military conflicts have ended, reducing the number of civil war casualties in recent years to historic lows for the region.

But Rodrik's focus is not on whether a per capita growth rate of 3% is sustainable. Given continuing investments in human capital, infrastructure investment and building better trade ties across the continent, Africa's economy's can continue to grow. The question is whether sub-Saharan African can experience a growth "miracle" similar to that of many nations around south and east Asia--Japan, Korea, China,  India, and others--where per capita economic growth veers up into the range of 7% per year or more, which is enough to double average living standards in a decade.

Here, Rodrik argues, Africa's prospects are shakier, because that kind of growth miracle requires some manner of structural transformation of the economy--and just how the nations of Africa might transform their economies in this way is quite unclear. How will Africa's jobs of the future be generated? Rodrik writes:

"To generate sustained, rapid growth, Africa has essentially four options. The first is to revive manufacturing and put industrialization back on track, so as to replicate as much as possible the now-traditional route to economic convergence. The second is to generate agriculture-led growth, based on diversification into non-traditional agricultural products. The third is to kindle rapid growth in productivity in services, where most people will end up working in any case. The fourth is growth based on natural resources, in which many African countries are amply endowed."

The problem with the manufacturing approach is that economic through a transformation that involves low-wage manufacturing is getting harder. Rodrik writes:

On the other hand, the obstacles to industrialization in Africa may be deeper, and go beyond specific African circumstances. For various reasons we do not fully understand, industrialization has become really hard for all countries of the world. The advanced countries are, of course, deindustrializing, which is not a big surprise and can be ascribed to both import competition and a shift in demand to services. But middle-income countries in Latin America are doing the same. And industrialization in low-income countries is running out of steam considerably earlier than was the case before. This is the phenomenon that I have called premature deindustrialization.

My own thinking here is that the issue isn't that manufacturing itself is going away, but that industrial robots are reaching the point where setting up a high-tech highly automated manufacturing plant is looking better and better compared to setting up a plant that relies heavily on low-wage human labor.

There are certainly lots of opportunities for increased productivity in African agriculture, but at least traditionally, improvements in the agricultural sector lead to fewer people working in agriculture. Perhaps the nations of Africa can alter this dynamic by moving into food processing and specialized products with a higher value-added (like wine and cut flowers), but it's hard to imagine building a growth and jobs miracle on the agricultural sector.

Many of Africa's workers are ending up in the service sector, like workers in countries all around the world. But at least so far, the services sector has not serve as the primary basis for a growth miracle in any country. Rodrik argues that the reason is that while a low-skilled agricultural worker can make an almost immediate transition to being a low-skilled manufacturing worker, the transition to a high-growth services sector often requires a wide range of complementary inputs. He writes:

Long years of education and institution-building are required before farm workers can be transformed into software programmers, or even call-center operators. Contrast this with manufacturing, where little more than manual dexterity is required to turn a farmer into a production worker in garments or shoes, raising his or her productivity by a factor of two or three. So raising productivity in services has typically required steady, broad-based accumulation of capabilities in human capital, institutions and governance. Unlike the case of manufacturing, technologies in most services seem less tradable and more context-specific (again with some exceptions such as cellphones). And achieving significant productivity gains seems to depend on complementarities across different policy domains.

Finally, a reliance on natural resources has been a part of the economic growth of many developed economies, like the U.S. economy in the late 19th and early 20th century, as well as in countries like the United Kingdom and Norway (with North Sea oil). However, in many other cases there seems to be a "natural resources curse"  in which the economy ends up overly focused on natural resources in a way that weakens its underlying growth in all other sectors.

Rodrik's bottom line is that while the nations of sub-Saharan Africa can surely continue to experience moderate rates of economic growth, it will need to invent its own path to find a growth miracle: "If African countries do achieve growth rates substantially higher than I have suggested is likely,
they will do so by pursuing a growth model that is different from earlier miracles, which were based on industrialization. Perhaps it will be agriculture-led growth. Perhaps it will be services. But it will look quite different than scenarios we have seen before."

I would add that the U.S. economy and the world face their own version of Africa's economic growth problem. In the U.S., the old-style manufacturing jobs have been steadily diminishing. We aren't likely to build the future of the U.S. economy primarily on growth in agriculture. Although the emergence of the U.S. economy as the world's oil and gas production leader should offer real benefits to the U.S. economy in the next couple of decades, it isn't likely to be enough to drive the bulk of the $17 trillion U.S. economy. The core challenge facing the U.S. economy is how to combine its own service-sector workers, especially its low- and middle-skill workers, with the new possibilities of technology in a way that leads to well-paid jobs, as well as to the kind of rising productivity and evolving skills that are behind a satisfying career path.

Women and Economic Development

Consider three ways in which a society or culture can deprive women of their ability to make their own decisions: the society can deny women control over household resources, it can condone wife-beating, and it can allow child marriage. According to a World Bank analysis of 54 developing countries 13% of women in these countries experience all three of these deprivations, and only 21% experience none of them.

The figure appears in Voice and Agency : Empowering Women and Girls for Shared Prosperity, co-authored by Jeni Klugman, Lucia Hanmer, Sarah Twigg, Tazeen Hasan, Jennifer McCleary-Sills,
and Julieth Santamaria.  Here is the list of 54 countries, by region: "East Asia and Pacific (Cambodia, Indonesia, the Philippines, Timor-Leste); Europe and Central Asia (Albania, Armenia, Azerbaijan, Moldova, Ukraine); Latin America and the Caribbean (Bolivia, Colombia, the Dominican Republic, Guyana, Haiti, Honduras, Nicaragua, Peru); Middle East and North Africa (Arab Republic of Egypt, Jordan, Morocco); South Asia (Bangladesh, India, Maldives, Nepal); Sub-Saharan Africa (Benin, Burkina Faso, Burundi, Cameroon, the Democratic Republic of Congo, the Republic of Congo, Côte d’Ivoire, Ethiopia, Gabon, Ghana, Guinea, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Mozambique, Namibia, Niger, Nigeria, Rwanda, São Tomé and Príncipe, Senegal, Sierra Leone, Swaziland, Tanzania, Uganda, Zambia, Zimbabwe)."

Of course, the three limitations on women above are not an exhaustive list. "Legal discrimination is pervasive. In 2013, 128 countries had at least one legal difference between men and women, ranging
from barriers to women obtaining official identification cards to restrictions on owning or using property, establishing creditworthiness, and getting a job. Twenty-eight countries—mainly in the
Middle East and North Africa and South Asia—had 10 or more differences. In 26 countries, statutory inheritance laws differentiate between women and men. In 15 countries, women still require their husbands’ consent to work. Other laws limit women’s agency in marriages and family life."

The case for equality of women is of course fundamentally rooted in considerations of justice and fairness and basic human decency. But it has an economic dimension as well. For example, "intimate partner violence" has substantial economic costs. As the report notes (citations omitted):

"Different models have been developed to estimate the economywide costs of IPV [intimate partner violence]. Although these models vary in their core assumptions, they generally take into account some combination of direct and indirect costs that are both tangible (and can be monetized) and intangible (which cannot be readily monetized). These estimates typically include costs related to service provision, out-of-pocket expenditures, and lost income and productivity. IPV incurs direct costs on services in the health, social service, justice, and police sectors. ...  Women exposed to partner violence in Vietnam have higher work absenteeism, lower productivity, and lower earnings than working women who are not beaten ... In Tanzania, women in formal wage work who are exposed to severe partner abuse (both lifetime and current) have 60 percent lower earnings."

Studies done in various countries suggest that the social cost of intimate partner violence can be comparable to or exceed what is spent on primary schooling in that country. 

Child marriage imposes economic costs as well, as the report notes:

Child marriage in developing countries remains pervasive, with one-third of girls being married before age 18 and one in nine being married before age 15 ... If present trends continue, more than 142 million girls will be married before the age of 18 in the next decade. And each year, almost one in five girls in developing countries become pregnant before age 18. The lifetime opportunity costs of teen pregnancy have been estimated to range from 1 percent of annual gross domestic product in China to as much as 30 percent in Uganda, measured solely by lost income. In developing countries, pregnancy-related causes are the largest contributor to the mortality of girls ages 15 to 19—nearly 70,000 deaths annually.

There is no magic bullet policy answer to improving the life opportunities of women. Legal and social changes that allow ownership of property, inheritance rights, credit opportunities, and more all play an important role. Raising the education level for teenage girls can be quite important:

"In Turkey, for example, extending the compulsory education age by three years changed parents’ and girls’ aspirations for the future—in just five years, the share of 15-year-old girls who were married fell by 50 percent and the probability of giving birth by age 17 fell by 43 percent ... Increasing incentives for girls’ schooling through CCTs [conditional cash transfers] can be an effective way to tackle regressive gender norms. This approach has been successful in Bangladesh, Pakistan, and Turkey, for example. ... Benefits to girls of staying in school can extend beyond the value of educational attainment, enhancing their agency in other ways as well. For example, in Malawi, a CCT targeting 13- to 22-year-old girls and women led to recipients staying in school longer and to significant declines in early marriage, teenage pregnancy, and self-reported sexual activity ..."

Opportunities for women to have paid work outside the home can also make a difference: "Expanding economic opportunities is a major policy challenge. Opportunities for women to work are opening up slowly at best in most regions—globally, women’s labor force participation has actually fallen slightly since 1990, from 57 percent to 55 percent."

Many of these changes will be facilitated or supported as women come to play a larger role in political institutions. As one example, the share of women in national parliaments has been rising in all regions of the world over the last couple of decades, as shown in the figure below. But glance over at the vertical axis, and you see that in no region does the share of women in the national parliament exceed 25%.

3% of U.S. Colleges Require Economics

According to the American Council of Trustees and Alumni, a non-profit that seeks to stir up higher education,  there are seven subjects "essential to a liberal arts education: literature, composition, economics, math, intermediate level foreign language, science, and American government/history." Thus, they decided to look at the graduation requirements of about 1100 U.S. colleges and universities, and see if or how the requirements matched their seven categories.

You can see school-by-school data here. Out of the 1100 schools, only 23 had requirements that covered all seven areas. Here's the overall count of how many schools required each of these subjects:

Of course, these kinds of counts are always dependent on the categories chosen, and the categories can be argued. My guess is that a number of schools might have, for example, a "social science" requirement rather than an "economics," or perhaps an overall history requirement rather than a "U.S history/government" requirement. Personally, I'm not the biggest fan of the old-time requirement for learning a foreign language, although that's an argument for another day. As I mentioned, ACTA likes to stir the pot.

That said, a list of requirements tells you something about what common experiences and subjects you can reasonably expect every college graduate to know something about.  It tells you something about the willingness of colleges and universities to nudge students just a bit out of their comfort zone. So it's bothersome to me that at about 80% of U.S. colleges and universities, students who wish to do so can avoid taking any economics, or any U.S. history and government.

Putting Terrorism Risks in Context

Counterterrorism policies are an acid test for anyone seeking to maintain a dispassionate attitude about costs and benefits. My gut reaction, which I suspect is shared by many, is that more spending to reduce the risks of terrorism is better. But John Mueller and Mark G. Stewart have taken up the gauntlet of reminding us that the core logic of costs and benefits applies here, too.  Their piece on  "Responsible Counterterrorism Policy" appears as Cato Institute Policy Analysis #755 (September 10, 2014).  Their article on "Evaluating Counterterrorism Spending" appears in the Summer 2014 issue of the Journal of Economic Perspectives (28:3, pp. 237-48), which is freely available online courtesy of the American Economic Association. (Full disclosure: I've been Managing Editor of the JEP since the first issue in 1987.) Their overall message sounds like this: 

[T]he United States spends about $100 billion per year seeking to deter, disrupt, or protect against domestic terrorism. If each saved life is valued at $14 million, it would be necessary for the counterterrorism measures to prevent or protect against between 6,000 and 7,000 terrorism deaths in the country each year, or twice that if the lower figure of $7 million for a saved life is applied. Those figures seem to be very high. The total number of people killed by terrorists within the United States is very small, and the
number killed by Islamist extremist terrorists since 9/11 is 19, or fewer than 2 per year. That is a far cry, of course, from 6,000 to 7,000 per year. A defender of the spending might argue that the number is that low primarily because of the counterterrorism efforts. Others might find that to be a very considerable stretch.

An instructive comparison might be made with the Los Angeles Police Department, which operates with a yearly budget of $1.3 billion. Considering only lives saved following the discussion above, that expenditure would be justified if the police saved some 185 lives every year when each saved life is valued at $7 million. (It makes sense to use the lower figure for the value of a saved life here, because police work is likely to have few indirect and ancillary costs: for example, a fatal car crash does not cause others to avoid driving.) At present, some 300 homicides occur each year in the city and about the same number of deaths from automobile accidents. It is certainly plausible to suggest that both of those numbers would be substantially higher without police efforts, and accordingly that local taxpayers are getting pretty good value for their money. Moreover, the police provide a great many other services (or “cobenefits”) to the community for the same expenditure, from directing traffic to arresting burglars and shoplifters.

Mueller and Stewart push for thinking about terrorism as one risk among many risks. For example, here's an table showing the risk of death from various causes over various time periods. 

Of course, terrorism is arguably a more frightening or terrible risk than other risks, and thus one can make a plausible-if-arguable case that it's worth spending more to save 100 lives from terrorist attacks than it is worth to save 100 lives from, say cancer or industrial accidents or traffic deaths. But saying that it makes sense to spend "more" against terrorism risks is not the same as arguing that terrorism risks should get a blank check. Mueller and Stewart also offer a cost-per-life-saved chart, which mixes together estimates of the effects of a number of past regulatory actions. 

One can quarrel with the specifics of these estimates in various ways. But overall, a sensible regulatory system should be seeking out ways to do more of the kinds of items that offer higher ratios of benefits to costs, and scaling back on the items that offer lower ratios of benefits to costs. Of course, this doesn't mean that all or even most counterterrorism spending is socially undesirable. But it does mean that when thinking about counterterrorism spending, we should be on the lookout for areas where resources might be redeployed more effectively. As one concrete example, Mueller and Stewart point out, the "Transport Security Administration’s Federal Air Marshal Service and its full body scanner technology together are nearly as costly as the entire FBI counterterrorism budget, but their risk reduction over the alternatives appears to be negligible." 

Indeed, the health risks of the body scanner technology may be greater than the terrorism risk they are preventing. They write: 

It involves the risk that body scanners using x-ray technology will cause cancer. Asked about it, the DHS official in charge, John Pistole, essentially said that, although the cancer risk was not zero, it was acceptable. ... Since the radiation exposure delivered to each passenger is known, one can calculate the risk of getting cancer from a single exposure using a standard approach that, although controversial, is officially accepted by nuclear regulators in the United States and elsewhere. On the basis of a 2012 review of scanner safety, that cancer risk per scan is about 1 in 60 million. As it happens, the chance that an individual airline passenger will be killed by terrorists on an individual flight is much lower—1 in 90 million. ... [T]he risk of being killed by a terrorist on an airliner is already fully acceptable by the standards applied to the cancer risk from body scanners using x-ray technology. But no official has drawn that comparison.

As Mueller and Stewart point out, we have in fact eased many rules about airplane travel in recent years, without people freaking out. For example, no one any longer asks if you packed your bag yourself and have had it with you at all time. Since 2005, air passengers have (technically) been allowed to take short scissors and knives on planes. Passenger no longer need to show identification at the airplane gate. The color-coded "alert" scheme has been ended. There has been a hiring freeze on "air marshalls" since 2012. The young (under 13) and the old (over 74) no need to take off their shoes when going through screening. The PreCheck system is allowing as many as half of all flyers, including many frequent flyers, to go through airport security without taking off their belts and shoes and jackets and removing liquids and laptops from their bags.

But despite these changes, in the U.S. as a whole, our approach to counterterrorism seems to largely ignore cost-benefit analysis. Indeed, Mueller and Steward cite a 2010 report done by a panel of outside experts making this point. Other countries seem able to make different choices about counterterrorism spending. 

"The United Kingdom, which faces an internal threat from terrorism that may well be greater than that for the United States, nonetheless spends proportionately much less than half as much on homeland security, and the same holds for Canada and Australia. ... It is true that few voters spend a great amount of time following the ins and outs of policy issues, and even fewer are certifiable policy wonks. But they are grownups, and it is just possible they would respond reasonably to an adult conversation about terrorism.”

Thoughts on High-Priced Textbooks

High textbook prices are a pebble in the shoe of many college students. Sure, it's not the biggest financial issue they face, But it's a real and nagging annoyance that for hinders performance for many students.

Here's how the U.S. Government Accountability Office (GAO) gave the basic facts in a 2013 report:

In 2005, based on data from the Bureau of Labor Statistics, we reported that new college textbook prices had risen at twice the rate of annual inflation over the course of nearly two decades, increasing at an average of 6 percent per year and following close behind increases in tuition and fees. More recent data show that textbook prices continued to rise from 2002 to 2012 at an average of 6 percent per year, while tuition and fees increased at an average of 7 percent and overall prices increased at an average of 2 percent per year.

A January 2014 report by Ethan Senack, published by the U.S. PIRG Education Fund and The Student PIRGs, pulls together and cites some of the evidence from recent years in a report called "Fixing the Textbook Market: How Students Respond to High Textbook Costs and Demand Alternatives." A sampling of his commentary:

According to the College Board, the average student spends $1,2001 per year on textbooks and supplies. That’s as much as 39% of tuition and fees at a community college and 14% of tuition and fees at a four-year public institution. ...  It is also important to note that just five textbook companies control more than 80% of the $8.8 billion publishing market, giving them near market monopoly and protecting them from serious competition. ... 65% of students said that they had decided against buying a textbook because it was too expensive. The survey also found that 94% of students who
had foregone purchasing a textbook were concerned that doing so would hurt their grade in a course. ... Nearly half of all students surveyed said that the cost of textbooks impacted how many/which classes they took each semester.

David Kestenbaum and Jacob Goldstein at National Public Radio took up this question recently on one of their "Planet Money" podcasts. They say: ""By popular demand: Why are textbooks so expensive?" For economists, a highlight is that they converse with Greg Mankiw, author of what is currently the best-selling introductory economics textbook, which as they point out is selling for $286 on Amazon. Maybe this is a good place to point out that I am not a neutral observer in this argument: The third edition of my own Principles of Economics textbook is available through Textbook Media. The pricing varies from $25 for online access to the book, up through $60 for both a paper copy (soft-cover, black and white) and online access.

Several explanations for high textbook prices are on offer. The standard arguments are that textbook companies are marketing selling to professors, not to students, and professors are not necessarily very sensitive to textbook prices. (Indeed, one can argue that before the rapid rise in textbook prices in the last couple of decades, it made sense for professors not to focus too much on textbook prices.) Competition in the textbook market is limited, and the big publishers load up their books with features that might appeal to professors: multi-colored hardcover books, with DVDs and online access, together with test banks that allow professors to give quizzes and tests that can be machine-graded. At many colleges and universities, the intro econ class is taught in a large lecture format, which can include hundreds or even several thousand students, as well as a flock of teaching assistants, so some form of computerized grading and feedback is almost a necessity. Some of the marketing by textbook companies involves paying professors for reviewing chapters--of course in the hope that such reviewers will adopt the book.

The NPR show casts much of this dynamic as a "principal-agent problem," the name for a situation in which one person (the "principal") wants another person (the "agent") to act on their behalf, but lacks the ability to observe or evaluate the actions of the agent in a complete way. Principal-agent analysis is often used, for example, to think about the problem of a manager motivating employees. But it can also be used to consider the issue of students (the "principals") wanting the professor (the "agent") to choose the book that will best suit the needs of the students, with all factors of price and quality duly taken into account.  The NPR reporters quote one expert saying that the profit margin for high school textbooks is 5-10%, because those books decisions are made by school districts and states that negotiate hard. However, profit margins on college textbooks--where the textbook choice is often made by a professor who may not even know the price that students will pay--are more like 20%.

The NPR report suggests this principal-agent framework to Greg Mankiw, author of the top-selling $286 economic textbook. Mankiw points out that principal-agent problems are in no way nefarious, but come up in many contexts. For example, when you get an operation, you rely on the doctor to make choices that involve costs; when you get your car fixed, you rely on a mechanic to make choices that involve costs; when you are having home repairs done, you rely on a repair person or a contractor to make choices that involve costs. Mankiw argues that professors, acting as the agents of students, have legitimate reason to be concerned about tradeoffs of time and money. As he notes, a high quality book is more important "than saving them a few dollars"--and he suggests that saving $30 isn't worth it for a low-quality book.

But of course, in the real world there are more choices than a high-quality $286 book and a low-quality $256 book. The PIRG student surveys suggest that up to two-thirds of students are avoiding buying textbooks at all, even though they fear it will hurt their grade, or are shifting to other classes with lower textbook costs. If a student is working 10 hours a week at a part-time job, making $8/hour after taxes, then the difference between $286 book and a $60 book is 28.25 hours--nearly three weeks of part-time work. I am unaware of any evidence in which students were randomly assigned different textbooks but otherwise taught and evaluated in the same way, and kept time diaries, which would show that higher-priced books save time or improve academic performance. It is by no means obvious that a lower-cost book (yes, like my own) works less well for students than a higher-cost book from a big publisher. Some would put that point more strongly.

A final dynamic that may be contributing to higher-prices textbooks is a sort of vicious circle related to the textbook resale market. The NPR report says that when selling a textbook over a three-year edition, a typical pattern was that sales fell by half after the first year and again by half after the second year, as students who had bought the first edition resold the book to later students. Of course, this dynamic also means that many students who bought the book new are not really paying full-price, but instead paying the original price minus the resale price. The argument is that as textbooks have increased in price, the resale market has become ever-more active, so that sales of a textbook in later years have dwindled much more quickly. Textbook companies react to this process by charging more for the new textbook, which of course only spurs more activity in the resale market.

A big question for the future of textbooks is how and in what ways they migrate to electronic forms. On one side, the hope is that electronic textbooks will offer expanded functionality, as well as being cheaper. But this future is not foreordained. At least at present, my sense is that the functionality of reading and taking notes in online textbooks hasn't yet caught up to the ease of reading on paper. Technology and better screens may well shift this balance over time. But even setting aside questions of reading for long periods of time on screen, or taking notes on screen, at present it remains harder to skip around in a computerized text between what you are currently reading and the earlier text that you need to be checking, as well as skipping to various graphs, tables, and definitions. To say it more simply, in a number of subjects it may still be harder to study an on-line text than to study a paper text.

Moreover, as textbook manufacturers shift to an on-line world, they will bring with them their full bag of tricks for getting paid. The Senack report notes:

Today’s marketplace offers more digital textbook options to the student consumer than ever. “Etextbooks” are digitized texts that students read on a laptop or tablet. Similar to PDF documents, e-textbooks enable students to annotate, highlight and search. The cost may be 40-50 percent of the print retail price, and access expires after 180 days. Publishers have introduced e-textbooks for nearly all their traditional textbook offerings. In addition, the emergence of the ereader like the Kindle and iPad, as well as the emergence of many e-textbook rental programs, all seemed to indicate that the e-textbook will alter the college textbook landscape for the better. However, despite this shift, users of e-textbooks are subject to expiration dates, on-line codes that only work once, page printing limits, and other tactics that only serve to restrict use and increase cost. Unfortunately for students, the publishing companies’ venture into e-textbooks is a continuation of the practices they use to monopolize the print market.