Economics on Basil Labib

A Closer Look at 'Inside Job'

gs454236@gmail.com (Basil Labib) — Thu, 12 Aug 2021 16:56:47 +0530

“Inside Job” is a 2010 documentary written, directed and produced by Charles Ferguson on the 2008 global financial crisis. It won the Oscar in the “Best Documentary Feature” category in 2011. Notwithstanding, it makes for an enlightening and thrilling watch that every citizen, who cares about where their hard earned money goes, should watch.

This documentary is not an easy watch that one can grab on a lazy afternoon comfortable on their couch. It has complex sounding terms and concepts that should keep one on the edge of their seat. As those financial experts makes the layman believe, “What we do is far more complicated for you to understand so you better leave us alone as we do it.” They are soft-headed people who will make one feel witless and run away with their money. That is exactly what happened in 2008.

Poster of Inside Job

Economics is a fascinating subject

Economics, the “dismal science”, is a fascinating subject because it aims to study the very fondation that runs our society: money. To me, it is a study of resource allocation (More on this in a future post). It is a set of the simplest ideas that sustain our lives. A small section of people deliberately obfuscate those ideas with cooked-up complex terms just to con everybody else.

Concepts at the root of the 08’ crisis that I have broken down to simple language and added examples to make them concrete:

Information assymmetry: It means when a party has more information regarding a transaction than the other party. A rampant example is the real estate industry where the agent has a more intimate knowledge of the market and the value of the property than you do and clearly, they have no incentive to act in your favor.
Incentives: The powerhouse of any transaction in a economy. I have an incentive to educate myself because I know I can earn more money that way. People basically get up in the morning and do any work (even go out and shoot somebody) because they have an incentive. Incentives drives all our actions, even non-economical. (Don’t proceed further if you get offensed easily) Think about your relationships. You may love your partner. But (really) deep down, it’s just an incentive to have something you don’t.
Value: The basic principle why any transaction is carried out is because you are valuable to the other party. Maybe you invented something, maybe only you can offer a service. The idea is, people should be paid proportionately for the value they create in society. Money is a measure and storehouse of that value. It is a token that says, “Yes, this person is entitled to redeem this much worth for anything else”. This is crucial.

That’s all there is at the core of the crisis. So, let’s dig into it.

How it happened?

A newspaper headline in the wake of the crisis

The following is a brief summary of what led to the housing market crash.

Deregulation in the financial market of the US from the 1980s

Following the Great Depression of 1930s, the financial market of the US was stable and secure due to government regulation. However, during and after the Cold War, few lobbyists started putting pressure on the Congress to deregulate those institutions. What it basically meant was remove restrictions on private banks and firms to use depositor’s (that is, you) money and invest them more freely. It made bankers more greedy and ambitious.

Explosion of derivatives

Think of derivatives as artificial products that banks can offer you. Traditionally, banks are generally involved in lending and borrowing money. But, bankers can devise creative “instruments” – agreements really, that can allow people to bet on anything. Rising crude oil prices, the bankruptcy of a company, or even the weather. Why? Because they get to keep the service charges. Those institutes began exerting power over the political system of the US and got a law passed that essentially banned regulations on derivatives.

Securitization

40 years ago, home buyers would go to a willing lender, ask them for money and then repay them on a fixed basis. Naturally, those lenders were very carefully as to who they lent their money.

Securitization is a concept whereby the lender has no fear of not being repaid. They simply sell their mortgages to an investment bank. Consequently, lenders started making riskier loans because they didn’t care if people don’t repay. Loans for over 90% of the home price started being offered.

Collateralized Debt Obligations (CDOs)

Banks would buy mortgages from lenders, package a lot of them into a CDO, and sell them to investors around the world who would be happy to have a steady flow of cash because who doesn’t pay their mortgages? You see, it’s just the same, boring “I have money. You don’t but you need it. Okay, let me give you my money but you promise to pay me that and some more” packaged in new wrapping foil. Only this time, those mortgages were subprime. Meaning they were bad debt. Those people had over 90% of the home price paid by the mortgage and so had no incentive to keep the house. The moment they couldn’t pay their bills, they can simply walk away because they had no stake in it.

Rating agencies

These are institutes, Moody’s, Standard and Poor’s and Fitch were the key players at that time, that independently assess a financial instruments risk, returns etc and give them ratings to assist the investor in making an investment in those products. The problem was, the banks were paying these agencies to give AAA, or triple A rating (highest rating, equivalent to a goverment bond in terms of security) to subprime CDOs. Why? Because how else will they sell those rotten apples? Further, the agency had no liability if those CDOs turned bad.

Predatory lending

Subprime loans carried higher interest rates. So, the banker had an incentive to offer you those products that maximized his profits, not caring if those borrowers would be able to pay those loans. This is predatory lending.

This cycle reinforced one another, pumping out more loans, feeding the bankers. Employees of major banks like Goldman Sachs, Bear Stearns, Merrill Lynch, Lehman Brothers among others were paid “bonuses”. People owned not one, but five houses. Expensive penthouses, private jets. They degraded to drugs. Prostitution was rampant (and these charges were shown as business expenses), among other things. These greedy, bald people saw money, an unrestricted environment to operate, and a way to extract money for practically creating no value. They were artificially creating these instruments that they knew were bad, bribing rating agencies, and selling them off for the profits. But, there is more.

Credit Default Swaps

AIG, the premier American insurance company, offered others to bet on certain events, such as the fall of a company, or debts going bad, asking them to pay a monthly premium for a return if their bet yielded. Few investment banks saw those CDOs will go bad and started betting against their success and simultaneously selling them off to investors citing they were excellent triple-A products! Moreover, others can speculate on these too. So, if something those CDOs do go bad, AIG is in big trouble. Such chain enforcements blew the crisis out of proportions. There is even more.

After a time, they saw that AIG will go bust trying to repay them after those CDOs go bad which they new were a certainty, so they began to insure themselves for being guaranteed payments from AIG in case the CDOs failed.

The destruction

Bankruptcy of Lehman Brothers, one of the major investment firms on Wall Street

People said $x was wiped out from the economy. But that is absurd. How can money be just wiped out in a flash? The truth is, there was no money to start with. Only on paper. There was no value backing that money. It was just a facade conjured by those bankers in their heads. What was the price?

Iceland went bust. Millions of migrant workers in China lost their jobs. Americans lost their savings, jobs, homes. Lehman Brothers dissolved. Stock markets around the world plunged. Nobody was lending any money. The financial system came to a stand still. Yes, pretty horrible for misaligned incentives, ghost value, and people not knowing what the hell they were doing.

From left: Henry Paulson, Chairman of Goldman Sachs and later Secretary of Treasury, US, Ben Bernanke, Chair of the Federal Reserve, and Timothy Geithner, President of Fed Reserve Bank of NY followed by Secretary of Treasury

Who were accountable? What happened to them?

All of them walked home smiling with severance, reimbursements and damages running in the millions. Most still serve on advisory boards, and board of directors of major companies.

Even, academic economists were incentivised to misdirect the community into believing certain facts that weren’t true and got compensated. After all, money runs the world. Not morals.

What is to come and what we should do

I personally believe, overall prosperity (and survival) of everyone depends on equal access to informational and consumer rights. As we enter the second quarter of the 21st century, the world economy will be even more closely knit. Corporations and firms will continue to act in their best interests. Economics and government policies have to stabilise this delicate balance of powers to ensure basic rights and progress for all.

It is only when we, the citizens, have accurate knowledge as to what goes “up there” that we can safeguard our interests, voice our opinions, and strengthen our opposition. The Internet had democratized knowledge and allowed unrestrained access to information for even the remotest sections of society. People must learn to leverage it effectively.

Notes from the Author

I have refrained from naming any person/persons specifically to avoid unnecessary finger pointing at each other. I encourage you to watch the documentary.
I apologise if any of the dates/years mentioned are wrongly quoted. All errors, typographical or otherwise, are my own.

Freakonomics: Should you read it?

gs454236@gmail.com (Basil Labib) — Sun, 25 Jul 2021 11:14:14 +0530

“Why do drug-dealers still live with their mothers?”
“Are Sumo wrestlers corrupt?”
“Legalized abortion led to decreasing crime rates”
“Are real-estate agents really acting in your best interest?”
“Does a child’s name have any effect on their lives?”
“Do parents really matter?”
“Are swimming pools more dangerous for kids than guns?”
“Why should teachers cheat?”

Freakonomics is a study of bizarre, mundane and exceedingly interesting questions. It employs the arsenal of mathematical sophistication to unearth truths and secrets that are hidden from plain sight. Written by an uncanny duo, Steven D. Levitt (the economist) and Stephen J. Dubner (the journalist) as part of an unexpected collaboration.

Our world is so bafflingly connected and complex, it takes sheer effort to identify correlation ( When two variables are connected), indicators (When one variable indicate an information about another) and causality (When one is really the cause of another).

The book warns that if morality dictates what people should do, then economics tells us what they really do. And no wonder, Levitt, a co-author, is a curious economist – a breed of closed-society intellegentsia who are trained to worship rationality over morality, prudence over emotions and numbers over talks because people may lie, numbers don’t.

Yes, Levitt is all that but more. He asks a lot of questions. His questions are a strange assortment of irrelevant (apparently) and outrageous. He had his share of unpleasantness and scorn because after all, even Levitt knows the bell curve of human intellectual distribution.

In a world dominated by people who loves to take sides, Levitt offers the rare third person perspective standing on a pedestal and presenting the true states of affairs. The book doesn’t build on any underlying theme – and perhaps that is the appeal. During an interview, someone asked Levitt “What is the unifying theme of your works?”. He was offered an answer by philosopher Robert Nozick,

“He’s twenty-six years old. Why does he need to have a unifying theme? Maybe he’s going to be one of those people who’s so talented he doesn’t need one. He’ll take a question and he’ll just answer it, and it’ll be fine.”

My thoughts on morality:

People tend to be good, generally. But only if their goodness is recognized and rewarded. If there is a bigger incentive for them to cheat or be bad and/or be assured they won’t be held accountable, they will become bad. There are always outliers, like in any discussion on economics. That is, people who are good just because that’s what they are.

In conclusion

Economics, at its barest, is understanding how people get what they want or need. Incentives strongly dictate human behavior (moral? eh, that’s debatable). Conventional wisdom is more often wrong than right. Measurement of data and its interpretation is essential.

I personally enjoyed reading this book.

Is Governance Really So Difficult?

gs454236@gmail.com (Basil Labib) — Thu, 15 Jul 2021 13:15:37 +0530

Why is taking economic decisions at a national level such a tantalizing task? Why do government policies fail (sometimes miserably)? Why are people still living on the streets under BPL?

You can expose yourself to an array of criticism and theories spun by supposedly thoughtful individuals at any cafe. These folks go on blurting how the present is worse than a decade ago and on and on. I had heard about their side, I wanted to know about the other side too.

Does anybody know how to govern? How to implement schemes and incentive programs to propel a nation to zero inequality, equitable distribution and a teeming economy? The truth is, nobody knows. Neither the cafe hotshot nor the Chief Economic Advisor to the President. It is because systems such as human society are bafflingly complex. Let me share a simple scenario that highlights how incentives can play out in the real world.

A Tale of Two Companies

Logical behavior of rational humans acting in their own best interest end up making the situation worse off for all — Prisoner’s dilemma.

Imagine a town that is infested by rats. To solve the rat problem, two companies are formed. One sells rat traps and the other sells rat poison. Sales were good and gradually, the rat population started to dwindle.

For sake of argument, let’s say a rat trap sells for $100 and rat poison for $50. The town has 1000 customers, 500 of which go to Rat Poison Company (RPC) and 500 buy from Rat Trap Company (RTC).

Company	Share of market	Number of customer * Profit per customer	Total profit
Rat Trap Company (RTC)	50%	500 * $100	$50000
Rat Poison Company (RPC)	50%	500 * $50	$25000

Both companies have a share of the market based on marketing, customer preference and most importantly, the financial demography of the town (which basically means those who can’t afford expensive goods won’t buy it).

But one day, the manager at RTC had an ingenious idea. He summoned the manager of its rival RPC to a secret meeting and coolly laid out his plan before him. By the end of their secret meeting, both parties were shaking hands and grinning sheepishly.

To everyone’s surprise, the sales of RPC started declining. And it didn’t recover. In fact, RTC ended up dominating the market. Why? The potency of rat poison produced by RPC was decreasing thereby making them ineffective to kill rats. And because rats were an imminent mishap to the town in the absence of a preventive measure, those who used rat poison were forced to switch to rat traps.

This raises the very interesting question, why did RPC allow itself to suffer lose and possibly bankruptcy? Can you figure out what is happening here? (Hint: Think incentives).

Here is what happened at that secret rendezvous of the competitors. RTC stated flatly that because they were competing for market dominance, both of them were depriving themselves of potential profit. So, they asked RPC to deliberately reduce the effectiveness of their poison. This will force all customers to buy rat traps because they cannot do without.

Company	Share of market	Number of customer * Profit per customer	Total profit
Rat Trap Company	100%	1000 * $100	$100000
Rat Poison Company	0%	0 * $50	$0

Rat Trap Company promised RPC to give them $35000/mo as reimbursement. RTC pockets an additional $15000 and RPC gets an additional $10000 without doing anything. The companies walk home not only pulling money from thin air but also becoming brothers in conspiracy. This is the reason why the rivals were shaking hands and grinning at the confidential meeting.

Is this optimal?

As morally upsetting and conventionally twisted this arrangement might seem, according to an economist, it is a perfectly justified case of how firms act in ways to optimize profit. Why? Because incentives!

She might even approve of this strategy but she won’t. Because the firms actions don’t play out in a vacuum. They affect everybody in the real world. So, is this arrangement bad? Yes. Very bad.

As there is virtually no competition to RTC, they can establish a monopoly and charge whatever they want. This is detrimental to the customers who are forced to pay more because of their constrained circumstance (the rat problem). Money that should pay electric bill goes to buy traps. Hospital bills for Uncle Sam’s treatment goes unpaid. You get the point.
Lack of competition stifles any attempt at innovation. People look for better ways to do things in the hopes of making profits off a successful venture (an invention, a discovery etc). Innovation creates real value in society. Lack of innovation will lead to a dead-end of real value growth, making everybody in the town worse off in the long run.
Concentration of wealth. Money that should go to pay for a youth’s college is going into the hands of RPC and RTC. Wealth inequality is almost always an indicator of a poor economy. Because, people can’t get exponentially productive and if earning is a measure of one’s productivity, how are a selected few earning exponential gains especially when the town cannot afford to send kids to college? (Note: Exponential gain in itself is not an anomaly, especially in a highly advanced society. Think Zuckerberg creating Facebook. That was instantaneous creation of a lot of value and simultaneously, a fountain of exponential profit for Mark).

This is something I cooked up but it is not hard to see how such incentive driven behavior can affect others, the people and the environment. Such behavior plays out all the time across thousands of companies and firms in inconceivable ways. The real question is, Can we do any better at understanding this web of intricacy?

I was motivated to think about incentives while reading the newspaper today. Hilsa, a sought-after fish species, swims to the river to lay eggs in still water and then swim back to the sea. Newborn Hilsa then join the sea later. Fishing of young Hilsa is banned around the Bay of Bengal. However, due to skyrocketing petrol prices, fishermen are unable to keep up their profits. That further supplemented by Covid induced demand slash has forced them to break law and fish in the river or near the shores thereby depleting the young Hilsa population fiercely who are caught in finer fishing nets while swimming back to the sea. Seemingly unrelated, eh?

In conclusion

I found sharing these scenarios fruitful because they concisely highlight how is it not obvious to anticipate human behavior.

It is buffoonery to criticise someone without prior knowledge of all facets relevant to the case. With that note, governments (good governments at least) always optimize their decisions in the long-run. And at the hazard of sounding obvious, behavioral economics is a fucking awesome subject to study!

Economics on Basil Labib

A Closer Look at 'Inside Job'

Economics is a fascinating subject

How it happened?

The destruction

Who were accountable? What happened to them?

What is to come and what we should do

Notes from the Author

Freakonomics: Should you read it?

My thoughts on morality:

In conclusion

Is Governance Really So Difficult?

A Tale of Two Companies

Is this optimal?

How is Hilsa population related to rising petroleum prices?

In conclusion