Friday, March 28, 2008

Presidental Candidates Economic Proposals

The last week or so the Democrat Presidential Candidates have made a number of statements about the economy and a few policy proposals, today I am going to take a little bit of time to examine some of them.

Senator Obama called for reworking regulatory frame work and “boosting” the economy with a 30 billion stimulus package and a long with that he made a few more proposals that we will look at in a moment. As anyone that reads my blog knows, stimulus package like this will have no little or no real effect on the economy, one reason being the size, 30 billion dollars sounds like a lot but it terms of size it less than one percent of the US Gross Domestic Product (GDP), GDP being the best measure of the size of a country’s economy. The second reason is those short term stimulus packages do not work because people and business in the economy know that they are short term and it does not change their long term spending and investment decisions, for a more in depth look at this, see my previous entries on the Presidents short term stimulus bills. Now lets look at some of his more specific proposals:

· Institutions that borrow from the government must be subject to federal oversight and supervision.

For the most part that is already the case; there is nothing new here and nothing that will prevent future economic down turns.

· Regulations for those institutions need to be updated

This is a good point and in many cases the regulation need to be reduced, but some how I suspect that he might be proposing new regulations. The problems with many government regulations, particularly ones on the financial markets, are that they are rarely efficient and often have a negative effect on the large economy and investors large and small. They often encourage the creation of new financial products to get around existing regulations; the derivative market in part was created because of this. Regulators and politicians in particular often have a poor understanding of new financial instruments and the cost and benefits that they bring to the economy, once again derivatives are a great example of this they often blasted as adding to the risk the of the financial markets or destabilizing them by politicians and some regulators, when in reality there is zero evidence that have made the market any riskier in the long or short run and they actually have a powerfully ability to allow people to protect themselves from risk by allowing investors, institutions, business and even farmers, who often used derivatives based off of farm products, to reduce their exposure to risk by diversifying or trading it away.

· The framework for overlapping and competing regulatory agencies needs to be streamlined

This is a good idea particularly if accompanies increased deregulation for many industries.

· Institutions need to be regulated "for what they do, not what they are"

This once again is a good idea

· A crackdown on trading activity that manipulates the markets is necessary

This is a stupid and impossible idea, for the first part there is a little evidence that anyone trading in the way, or even has the ability, to trade in a way that would manipulate the financial markets on a large scale. Yes you have insider trading that could manipulate the prices of a single stock or small group of stocks, but in the case of the large financial markets, you are talking about markets that are so large and diverse with some many people participating in it, that would be all but impossible for trading activities to manipulate the larger market.

The second problem is that even if such activities did exist, it would be all but impossible to identify these activities and it would problem end up with regulators or politicians going after legimate trading activities for political reasons, for example like when SEC regulators and some members of Congress attempted to heavy restrict the derivatives markets largely at the behest of Stock Exchanges and large brokerages, who profits were threatened by the derivative markets allowing people to trade stocks indirectly and get around the commissions that they charged. Had they succeeded the large economy and investors, particularly small ones, would have suffered as they would had to pay more to trade stocks, bonds and other financial products and the decline in the transactions cost associated with trading in financial markets that we saw during the 1990s and 2000s would probably not have happened.

· A process that identifies systemic risks to the financial system is needed

First here is a definition of Systemic risk - is the market risk or the risk that cannot be diversified away, as opposed to "idiosyncratic risk", which is specific to individual stocks. It refers to the movements of the whole economy. Even if we have a perfectly diversified portfolio there is some risk that we cannot avoid and this is the systematic risk

Systemic risk be it nature is very difficult if not impossible to correctly identify in far in advance and for these reason it has the ability to affect the financial markets, if it were easy to identify then investors would be able to effectively plan for it in most cases, as would business and the risk would be reduced or eliminated. For the government to be able to effectively identify systemic risks to the financial system, and for that matter the larger economy, you would have to assume that they have access to better information about future changes in the economy than the markets do, which there is little or no evidence for. This seems to go back to the old Keynesian ideas from the 1930s-1970s, that the government has the ability to manage the economy and prevent economic downturns, and this idea proved to be a failure and ended in the stagflation and economic downturn of the 1970s that continued to have negative effects into the 1980s. The more rapidly changing economy of the present and the better understanding of the markets, public and business of how government policy affects the larger economy makes the ability of the government to micromanage the economy even less likely now.

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