The Becker-Posner Blog

Fluctuations in Oil Prices, Speculation, and Strategic Reserves-Becker

 

The International Energy Agency (IEA) recently coordinated the release onto the oil market of some of the strategic oil reserves of the United States, Japan, and ten other countries that hold reserves. The release was motivated by the rapid run up in oil prices from about $95 a barrel at the beginning of 2011 to over $120 a barrel in April of this year. I will discuss the fundamental determinants of the sharp fluctuations in oil prices, the role of “speculators”, and why it was unwise at this time to release oil from these reserves.

After the initial huge increase in oil prices following the Arab oil embargo in 1973, the magnitude of the fluctuations in these prices has been impressive. In 2008 dollars (i.e., adjusted for inflation), prices were about $40 a barrel in 1973, rose to $75 in 1981, fell to around $20 in the mid 1980s, and then stayed low until the early part of this century. These prices rose spectacularly to reach over $140 a barrel before the financial crisis hit, then fell sharply, and they have been recovering rapidly since the world economy again began to grow more rapidly.

Fundamentals in the oil market, that is, the supply and demand for oil, explain the vast majority of the large fluctuations in oil prices. Demand for oil changes over time because of recessions that reduce world output and hence demand for oil, and also because of world economic growth, especially in the developing world. Economic development raises oil demand because the demand for cars, and hence gasoline, increases rapidly with development, and because manufacturing and other sectors increase their demand for oil-based inputs.

To get a feel for the effects of demand changes on oil prices, consider a 3% increase from one year to the next in world demand for oil. The induced increase in price depends on how responsive (or elastic, in economists’ terminology) is the quantity of oil produced to higher oil prices. Oil production is not easily increased in the short run, especially with Opec controlling about 35% of the world supply of oil. A typical estimate of the short run world supply elasticity for oil is quite low at about 0.1. This number means that to induce a 3% increase in the supply of oil would require a 30% increase in oil prices, which is ten times at large as the increase in world demand. This example shows that the low elasticity of supply implies that even modest changes in the demand for oil have very large effects on its price.

The sensitivity of oil prices to underlying shifts in the fundamentals is made even greater by the fact that the short-run elasticity of demand is also about 0.1. To show the effects of such low demand elasticity, suppose world production of oil falls by about 1.5%. This is about the magnitude of the reduction in world supply from the civil war in Libya that cut its daily oil output from 1.4 million barrels of oil to about 200,000 barrels. For world consumption to fall by a mere 1.5% would require a 15% increase in price, given the very low demand elasticity for oil.

The actual fluctuations in prices due to shifts in supply and demand would be smaller than in these examples. When Libyan production fell and oil prices rose, other oil producers raised their supply of oil to take advantage of the higher prices. But since the overall supply elasticity is also very small, that response was small, so that oil prices still rose by a lot. Similarly, when world demand for oil grows by 3% and oil prices increase, demand for oil falls because of the higher prices. However, since the elasticity of demand for oil is also low, that response is limited, so that oil prices would still rise by a lot. A general analysis of market equilibrium shows that given supply and demand elasticities of 0.1, the percentage increase in price, after taking account of all these adjustments, would still be 5 times (rather than 10 times) the reduction in supply or increase in demand.

Moreover, both supply and demand for oil are more responsive to prices over longer time periods. This implies that the price rise due to more permanent falls in supply would initially be quite high, but they would get smaller over time. A higher maintained price of oil induces consumers to economize on the use of oil by buying fuel-efficient cars, by carpooling, and by driving fewer miles. Companies would substitute gas, coal, and other energy sources for oil. Similarly, on the supply side, higher long run oil prices induce greater efforts to discover new oil fields, whether deep under the sea, or in other remote places. Inefficient oil fields would also be brought back into production since their higher costs would be covered by higher oil prices.

Of course, speculators also are active in the oil market. They may buy oil futures in the expectation that oil prices will increase in the future, or sell oil futures-go “short”- hoping that prices fall in the future. If their expectations are correct, they help stabilize oil prices by increasing supply when prices are rising, and raising demand when prices are falling. Put differently, speculation tends to be stabilizing when speculators are making money because they have correct expectations about price movements, and destabilizing when they are losing money because their expectations turn out to be wrong. Given that the fundamentals imply large price movements from rather small shocks to supply and demand, and that successful speculation tends to moderate price movements, it is hard to believe that speculation has played a major role in causing the large swings in oil prices.

When the IEA countries on June 23 agreed to sell 60 million barrels (half by the US) from their oil reserves over the subsequent 30 days, it basically acted as a speculator on oil prices. Since oil was in plentiful supply then at about $110 a barrel, the only economic, as opposed to political, justification for the move was the belief that the IEA countries thought oil prices were too high and would be falling in the future. Perhaps these countries are privy to special information not available to private participants in the oil market about the recovery of Libyan oil production over the next few months, and about whether the unrest in the Middle East and North Africa would spread to other major oil producers in that region. Special knowledge is required to justify the IEA’s intervention because otherwise that information would already have lowered the price of oil. Such special knowledge does not seem likely, given that the unrest itself caught all the major governments (and private participants) by surprise.

Moreover, government oil stocks should not be used with the intent to profit from special information. Instead the information should be made public (if not based on politically sensitive information). Strategic reserves should be a hedge against supply disruptions during wartime or other crises when oil is not readily available even at so-called market prices. The only two previous interventions by the IEA were due to large supply shocks: the Persian Gulf War in 1991, and the effects of Hurricane Katrina, although the world oil market continued to function without major supply disruptions during these crises. The oil market is presently functioning very well, despite the high price of oil, so there is no good economic case for selling oil from strategic reserves at this time.

Releasing Oil from Reserves—Posner

Becker is right to emphasize the role of demand and supply elasticities (how price responds to changes in demand and supply) in the startling fluctuations in the price of oil and oil derivatives such as gasoline, to deemphasize the role of speculation in those fluctuations, and to point out the social utility of speculation. 

If the responsiveness of supply to an increase in demand is sluggish, price will rise steeply in the short run, to ration the limited supply among the clamoring demanders—and it will rise especially cheaply if the demanders would rather pay a high price than do without. If demand falls, price will plummet if supply is sluggish, because supply will not fall proportionately to demand—there will be oversupply. An exogenous increase in supply will cause price to drop sharply because inelastic demand implies that price must fall very far to attract purchasers for the additional demand, and thus clear the market. Increased demand or reduced supply will also have sharp effect, though in the opposite direction. So the dramatic fluctuations in oil prices that Becker documents do not require the assumption of nefarious activities by speculators. 

And, as Becker also points out, those activities are not, in general, nefarious. Without speculation, the only information about values would be supplied by the actions of suppliers and consumers and others in the chain of distribution from producer to ultimate consumer. With speculation, information is often supplied by persons and firms that buy or sell on the basis of their opinion of how prices will change. 

Yet speculators can destabilize markets. Speculators are interested in price changes, and know that price changes are driven in part by other speculators. In an asset-price bubble, speculators (and others) buy in the expectation of rising prices, and may believe that the asset is actually overpriced yet they keep buying because they think that other market participants believe (erroneously) that it is still underprice. 

The decision of the United States and other countries that have governmental oil reserves to release a total of 60 million barrels of oil (half of it from the Strategic Petroleum Reserve, which is what the U.S. government’s reserve supply of oil is called) could be a shrewd speculation on oil being overvalued. If it is overvalued, prices will fall, so by selling now the countries will receive more income than if they waited. The sale itself, by increasing supply, will reduce the price of oil; these countries are net importers of oil and so would benefit from lower oil prices. 

But this is implausible; there is no reason to think oil overvalued. The current high prices reflects the loss of about a million barrels a day of Libyan oil because of the civil war in that country. The reduction is small as a percentage of world output, but the low elasticity of supply enables a small reduction in supply to have a big impact on price. By the same token, the modest release from the reserve—two million barrels a day for 30 days—may have a dramatic though short-term effect on oil prices, an effect that would be extended if we and other countries continued to release reserves. Our Strategic Petroleum Reserve contains more than 700 million barrels, so we could release a million barrels a day for a year and still have almost half the current reserves. 

But what is the point of reducing our reserves? They have after all value as a hedge against catastrophic hits to oil supply, such as were caused by Hurricane Katrina and the BP Gulf of Mexico mishap. One possibility is that it is another short-term stimulus measure, such as “cash for clunkers” and the various mortgage-relief programs. The effects of these measures is slight, because businesses and consumers realize that they are short term and so merely alter the timing of purchases rather than increasing aggregate spending. But with the 2012 elections approaching, the Administration has an incentive to create even short-term bursts of prosperity. Consumers are extremely conscious of gas prices because of the frequency with which gasoline is purchased and the frequency with which the retail prices changes, which increases consciousness of gas prices relative to other consumer products. Hence a sudden, sharp drop in gas prices as a result of an increased supply of oil can create a feeling, but only a transient one, of improved economic prospects.

Why the economic recovery is lagging—Posner

The U.S. economy is stagnant; the proposition that we had a mere “recession” which “ended” two years ago, is, like the terminology of sovereign default (“debt restructuring”), just an exercise in euphemism. Real (that is, inflation-adjusted) GDP per capita has declined by almost 3 percent since 2007. (This is on the assumption that the first-quarter 2011 increase in GDP at an annual rate of 1.8 percent, not adjusted for inflation or population growth, will be the full-year real per capita increase—in fact, if unadjusted GDP grows by less than 3 percent for the year as a whole, the real per capita GDP will decline.) At the same time, the national debt has soared (it is currently $14.3 trillion, of which $9.7 trillion is “public debt”—that is, debt owed bondholders rather than social security annuitants and other entitlement holders), and unemployment exceeds 9 percent, with about half the unemployed not having worked for at least six months. 

The sharp and rapid decline of the economy that began with the financial crisis of September 2008 was expected to be followed by a sharp and rapid rise (making for a V-shaped economic cycle) when the crisis was resolved by the bank bailouts and other emergency measures taken by the Federal Reserve and the Treasury Department in the fall of 2008, and by the $878 billion stimulus enacted by Congress in February 2009. The economy did pick up in the fall of 2009, but progress since has been fitful. 

Causal analysis is the Achilles heel of business-cycle economics. National economies are so complex, and so different from each other and over time (making cross-sectional and time-series analyses of business cycles inconclusive), that it is rare that a phase in the cycle can be explained satisfactorily, especially if an estimate of magnitude rather than just of direction is desired. 

For what it's worth, I think the major impediment to economic growth at present is uncertainty on the part of the key economic actors, namely businessmen and consumers. Businessmen are hesitant to hire and invest and consumers to spend, in both cases because of uncertainty about their economic prospects. 

I use “uncertainty” in the sense in which the economists Frank Knight and John Maynard Keynes distinguished between risk and uncertainty. Risk was a probability that could be estimated, uncertainty a risk that could not be estimated. The distinction is unpopular among economists because a nonquantifiable risk greatly complicates statistical analysis of economic phenomena, but it seems to me a real and important distinction when one is dealing with the business cycle. And there is a growing literature in economics on “ambiguity aversion,” by which is meant aversion to uncertainty in the Knight-Keynes sense. 

When a businessman has to decide whether to invest in a new product or a new plant or other facility, with the success of his decision dependent on future revenues and costs, there is bound to be an irreducible element—and possibly a very large element—of uncertainty; and likewise when a consumer has to decide on a major purchase, such as a house, or whether to seek a new job, or marry, or move to another part of the country, or retire, or seek more education. Any decision the success of which depends on future events is likely to involve uncertainty. And a common and usually sensible respond to uncertainty is simply to postpone the decision in the hope that the uncertainty will dissipate as new information becomes available. But the more postponement there is of investment, hiring, purchasing, and other economic decisions, the lower the level of economic activity. We observe this today with the enormous cash balances that large firms have accumulated and the drooping demand for houses. 

The greater the uncertainty, the less forward-oriented economic activity there is likely to be, with adverse effects on investment, employment, and consumer spending. At present the U.S. economy is afflicted with at least five major sources of uncertainty. One is the economy of the eurozone. If Greece defaults on its public debt, which remains a possibility in the near future (a year or two years from now), this may have a domino effect. The dominos are not just the other weak eurozone countries—Ireland, Spain, Portugal, and Italy—but also the French and other European banks that are heavily invested in those countries and the American banks and (especially money-market funds) that are heavily invested in European banks. 

Second is uncertainty about whether and on what terms Congress will raise the U.S. public-debt ceiling. Default is unlikely, but no one knows what deal the Republicans and Democrats will strike to avert default. Undoubtedly it will involve significant cuts in federal spending, and these cuts will hurt numerous businesses and individuals. 

Third is uncertainty about federal regulation of the financial and health sectors. The ambitious health-care and financial-regulation reform statutes enacted by Congress in 2009 are very long and complicated, but at the same time incomplete—completion of these regulatory edifices was delegated to regulatory agencies that have not come close to finishing their work. No one can know how tightly banks and other financial institutions are going to be regulated or how the price of health care is going to be affected; and the cost and availability both of credit and of health care are of immense concern to businesses and individuals alike. 

Fourth is a widespread suspicion in the business community that President Obama is in the pocket of the labor unions, is viscerally hostile to business, and is entirely focused on winning reelection. The suspicion is (in my opinion) greatly exaggerated, but is real. 

Fifth, there is a sense that politicians the world over, notably including the United States, are preoccupied with the very near term and are simply postponing the day of reckoning with the world’s economic problems that grew out of the financial crisis of September 2008 and the ensuing global economic crisis, which is still with us. The Greek example is a good one. Because Greece is stuck with the euro, it cannot climb out of its economic hole by devaluing its currency, a tried and true recipe for dealing with a severe economic downturn, because it increases exports and reduces imports, and both effects stimulate domestic employment. Greece as a result is broke, and if it had defaulted last year the eurozone might by now be in tolerable economic shape. Instead Greece seems about to receive a fiscal bandaid that will keep it going for a year or two, which means that any U.S. firm that has a stake in the eurozone and a planning horizon of at least a couple of years must cope with the uncertainty of Greece’s economic future. 

A parallel example is the efforts of our government to revive the housing market by providing relief to mortgagors; the efforts appear to have prolonged the depression of the housing market, which had it been allowed to hit bottom might be on the mend today. Similarly, the federal fiscal imbalance and mounting deficit are unlikely to receive more than bandaid treatment until the November 2012 elections; businesses and consumers will be tempted to hold their breath until then. Suppose that finally after those elections the government gets serious and closes the fiscal gap through some combination of higher taxes, reduced government spending, and programs designed sensibly or otherwise to stimulate economic growth. Because the gap is so large, and will probably be larger 16 months from now, and because the combination that will close it is likely to have profound and uneven economic consequences, many businesses and consumers alike will want to put many of their own economic plans on hold until they have a clearer idea of the terms of the gap-closing combination, which they may not have for years. 

I don’t want to give an exaggerated picture of the consequences of Knight-Keynes uncertainty. It does not paralyze economic activity, but it slows it down and may be a large factor in the current sluggishness of the U.S. economy.

 

The Slow Economic Recovery-Becker

The financial crisis produced the most severe recession since the end of World War II in all the important measures of economic performance, aside from unemployment rates. Unemployment peaked at 10.2% in 2009, whereas it peaked at 10.8% in December 1982 at the end of the deep recession that spanned 1981-82. The recovery from that earlier recession was rapid, as unemployment was down to about 7.5% by 1984, and GDP grew rapidly in 1983 and 1984. By contrast, as Posner indicates, GDP growth has been slow to moderate in the two years following the official end in 2009 of the past recession. Real GDP is about 10% below the level it would have been at if growth in GDP continued after 2008 at its long term rate of 3% per year.

At the height of the financial crisis, the media frequently had discussions of the “failure of capitalism”, and the need to radically rein in the private sector through extensive regulations and other government activities. The politically liberal Congress elected in 2008 along with President Barack Obama reflected these views. In addition to taking various steps to try to fight the recession, leading members of the new Congress, and President Obama as well, considered they had a mandate to reengineer the American economy through more radical government interventions (see the discussion of uncertainty and the recovery by Steven Davis, Kevin Murphy, and myself in the Wall Street Journal, January 4, 2010, “Uncertainty and the Slow Recovery”).

In addition to repeated attacks on American business, especially banks (some of the attacks on banks were well deserved), Congress passed an expensive stimulus package that did not stimulate much. The health care bill Congress passed seems likely to increase the cost to small and large businesses of providing health insurance for employees. Congressional leaders proposed high taxes on carbon emissions, large increases in taxes on higher income individuals, corporate profits, and capital gains as part of vocal attacks on “billionaires”. Many in Congress wanted to cap, or at least control, compensation of executives. Proposals were advanced to make anti-trust laws less pro-consumer, and more protective of competitors from aggressive and innovative companies. Congress passed and the president signed a financial reform bill that is a complicated and a politically driven mixture of sensible reforms, and senseless changes that have little to do with stabilizing the financial architecture, or correcting what was defective in prior regulations.

It is no surprise that this rhetoric and the proposed and actual policies discouraged business investment and slowed down the recovery. Yet, I had expected the recovery to speed up after radical approaches to the American economy were repudiated in the 2010 Congressional elections, when many of the more liberal members of Congress lost their seats. For a while the economy did began to pick up, as unemployment declined quite rapidly from hovering around 10% to about 9% at end of 2010, and GDP started growing faster. But then the economy stalled. The challenge is to explain the drift in the unemployment rate during the past several months, and the rather tepid growth in GDP that have raised fears of a “double-dip”.

Some of the slow-down in the American economy is undoubtedly due to problems in the world economy: the excessive Greece debt and other serious economic problems facing a slowly growing European Community, the nuclear disaster in Japan and the sluggishness of the Japanese economy, and the possible slowing of the rapid growth in both the Chinese and Indian economies. Another part is explained by the policies that slowed the early stages of the recovery, perhaps especially uncertainty about the effects of the financial reform act, and lack of clarity about the cost implications to business of the health care act.

I am persuaded that an important third part is due to concerns that the US will be unable to control its fiscal situation. The ratio of federal government spending to GDP grew from about 21% in 2007 to 25% in 2011, a very rapid change compared to the relative stability of this ratio during the prior 25 years. Unfortunately, there is not yet a strong enough will in Congress and by the president to lower this ratio during the coming decade. Indeed, with the looming enormous growth in entitlement spending, especially Medicare, the spending to GDP ratio could well increase sharply in the coming decade, along with the fiscal deficit and the federal debt.

Liberal Democrats continue to be reluctant to agree to big cuts in government spending. Many Republicans have come out against increasing any taxes, even though sensible tax reform toward a flatter and broader based income tax would raise the taxes paid by some taxpayers. The most attractive reform of Medicare put forward by any member of Congress is Paul Ryan’s proposal to provide grants to the elderly to buy health insurance, with the size of the grant falling with the income of the recipient (see our discussion of his “Roadmap” in posts for April 4, 2011). But Ryan’s Medicare proposal has been rejected not only by Democrats, but also by leading members of his own party.

To many investors, the future of the American economy looks dim and also uncertain. I am a perennial optimist about America, but even I have moments of serious doubts: not about the ability to solve these problems, but about the will to do so. The best way to get American fiscal and other economic problems under control, and thereby “stimulate” the economy, is to institute growth oriented policies that would increase the long-term growth rate beyond the 3% average annual GDP growth rate of the past 130 years. These policies include tax reform, cuts in entitlement spending, and more sensible regulations that are less dependent on discretion by regulators (see my post for December 6, 2010 for a discussion of these and other proposals).

 

“Capture” of Regulators by Fannie Mae and Freddie Mac-Becker

 

 Political economists describe the process whereby government officials end up being the servants rather than the masters of the firms they are regulating as the “capture” by the industry of their regulators. When regulators are captured, much of what they do is motivated, consciously or not, by a desire to help the companies they are regulating, even when the social goals that the regulators should pursue are very different.

 A famous illustration of capture is given by the way airlines were regulated under the Civil Aeronautics Board (CAB) from 1940 to 1978. Large airlines of those times, like American and Delta, naturally had a strong incentive to try to keep new airlines from entering the industry. As a compliant ally of the airline industry, the CAB did not approve one new interstate airline during this almost 40-year period. Many airlines entered the industry when President Carter abolished the CAB, and some of the old standbys, such as Pan Am and Eastern, ceased operations because they could not adjust to a competitive environment.

 An economically disastrous example of the capture theory is provided by the disgraceful regulation of the two mortgages housing behemoths, Fannie Mae and Freddie Mac, before and leading up to the financial crisis. In their fascinating recent book, Reckless Endangerment, Gretchen Morgenson and Joshua Rosner explore in great detail how Fannie Mae used political connections and intimidation of anyone who stood in their way to gain a highly dominant position in the residential mortgage market. The authors’ show that various government officials, including congressmen and presidential cabinet members, closed their eyes to what these two government-supported enterprises (GSE) were doing. They allowed them to take on enormous risks, while publicly defending their behavior as not being highly risky.

 

Fannie Mae was created in 1938 as a government enterprise that purchased mortgages from banks that loaned money to homebuyers. It eventually became a private investment company regulated by the government, where investors expected that the government would help out if these companies got into trouble. By the beginning of the crisis in 2008, Fannie and Freddie held or guaranteed about half of the United States’ $12 trillion of assets in the residential mortgage market. In September 2008, both Fannie and Freddie were taken over by the federal government when they became insolvent. The loss to taxpayers is likely to be in the hundreds of billions of dollars because many of the mortgages are subprime and of little value.

 Reckless Endangerment shows how the chief executive officers of Fannie Mae furthered the reach and reduced the regulatory control over their company by assiduously courting congressmen, Fed officials, the Congressional Budget Office, high-level officials of the U.S. Treasury, the Secretary of Housing and Urban Development, and major economists. The prominent and well informed congressman, Barney Frank, gets especially sharp criticism for his continual support of Fannie and Freddie while he was initially a member, and later chairman, of the House Financial Services Committee, the powerful committee charged with oversight of the housing and financial sectors. Barney Frank remained an unwavering supporter of Fannie and Freddie until 2010, when he admitted that they should have been more closely regulated. In a bit of irony, he is a principal author of the 2010 Dodd-Frank act that attempts to reform the financial sector mainly by giving even greater discretion to the regulators.

 Fannie and Freddie had so much money and political power at their disposal that it became risky for anyone to oppose what they wanted: large increases in their holdings of subprime and other mortgages, with no questions asked. Different government agencies that were supposed to either regulate or oversee these GSEs ended up as advocates instead. Well-known economists wrote favorable articles downplaying the riskiness of the holdings of Fannie and Freddie. These articles were sometimes published in journals or other publications sponsored by these companies.

 A few government officials were brave enough to risk the wrath of Fannie and Freddie. The authors give particular praise to June O’Neill (I am proud to say she is a former student of mine), who was then head of the Congressional Budget Office. A member of her staff wrote a report that was critical of the degree of risk to taxpayers from the assets held by Fannie and Freddie. These companies tried to get June to suppress the report- she refused- and then a few members of the House of Representatives in cahoots with Fannie and Freddie subjected her to vicious attacks when she steadfastly defended the report in testimony before Congress.

 The Fed also comes in for sharp criticism by the authors. One example discussed was a Boston Fed publication in October 1992 claiming that minorities were widely discriminated against in gaining access to mortgage credit. The media, many regulators, and some economists widely praised this study as offering definitive evidence of extensive discrimination against minorities in the credit market. Fannie Mae’s head, the politically astute James A. Johnson, seized on this reaction to promote a large increase in mortgages to poor residents of African-American and Hispanic communities with bad credit histories.

 Since I had written a book on discrimination against minorities in the economy, I was curious to see how the authors reached such definite conclusions about mortgage discrimination. I became convinced after reading their study that it was deeply flawed, and failed to show what they claimed about discrimination in the market for mortgages. The theory of discrimination against minorities implies that minority applicants for mortgages would need to have better credit records and higher employment stability than comparable whites in order to obtain mortgages. This suggests that default rates would be lower and profitability higher on loans to minorities.

 The study’s authors presented no evidence to support these implications of discrimination theory. All the circumstantial evidence, and some real evidence, showed just the opposite. I published my criticisms in a column for Business Week in 1993 (reprinted on pp. 119-120 in The Economics of Life, a collection of my Business Week articles). The Boston Fed and their supporters tried defending this article against my attack and those by others, but their arguments were weak. Nevertheless, the view persisted that the Fed had “proved” widespread discrimination in the credit market against minorities, and this helped justify an expansion of mortgage loans to families with low incomes and poor employment records.

 The Fannie and Freddie story does not demonstrate that government officials, congressmen, economists, and others who sang their praises were corrupt, although undoubtedly some were. But rather that powerful companies and industries can bring massive resources to bear in promoting their interests through lobbying, congressional testimony, financial support to help political candidates win elections, attacks on critics, hiring experts to promote their views, and in many other ways. The result is, as Simon Newcomb, an outstanding American economist and astronomer of the 19^th century, said a long time ago, “one cent per year out of each inhabitant would make an annual income of $500,000. By expending a fraction of {their} profit, the proposers of policy A could make the country respond with appeals in their favor…Thus year after year every man in public life would hear what would seem to be the unanimous voice of public opinion on the side opposed to the public interests” (p. 459 of his 1885 Principles of Political Economy).

 I am not claiming that the reckless behavior of Fannie Mae and Freddie Mac was solely, or even mainly, responsible for the financial crisis. Enormous blame must go to the commercial and investment bankers who took on vastly excessive risks that endangered their companies and the economy. Nevertheless, that officials charged with overseeing Fannie and Freddie protected the interests of the companies instead of the interests of taxpayers and the general public does not only offer resounding support for the capture theory. For this capture of regulators also inflicted great harm on taxpayers, the American and world economies, and many of the families who exposed their life savings to undue risks in the mortgage market.

 

 

 

Capture Theory and the Financial Crisis—Posner

The phenomenon of regulatory capture—the transformation of a regulatory agency into an anticompetitive tool of the regulated industry—is real, but I think Fannie Mae and Freddie Mac are more accurately regarded as examples, though no less unlovely, of something else: a capitalist-socialist hybrid. They were not regulatory agencies; until they collapsed during the financial crisis of 2008 and were taken over by the federal government, they were private corporations that had been chartered by Congress to promote home ownership. Their status as GSEs (government-sponsored enterprises) created an expectation that the government would guarantee their debts. This expectation enabled them to borrow at lower interest rates than other private corporations. They were supposed to promote home ownership by buying or guaranteeing home mortgages. They did that; they also pioneered mortgage securitization—in effect turning  mortgages into bonds, which are more liquid than mortgages and so could be sold all over the world, bringing more capital into the U.S. residential real estate market, thus promoting home ownership, just as Congress wanted. Because of the low interest rates they paid, Fannie and Freddie were immensely profitable until the financial crisis brought them down. 

As Becker points out, Fannie and Freddie were effective in obtaining congressional and presidential assistance to ward off threats to their activities and their profits. But I don’t think that that assistance, unseemly as it was, and perhaps corrupt as well, was the basic problem of Fannie and Freddie, or the cause of their collapse; nor do I think their collapse was of any great consequence for the nation. 

I don’t think there was ever a good reason to promote home ownership over renting (so I would favor the abolition of the deductibility of mortgage interest from federal income tax). It ties up a lot of the capital of individuals and reduces labor mobility. Maybe it makes for more responsible citizens by giving people a property interest, but there must be better candidates for federal largesse. And even if there were a good reason for government to promote home ownership, federal chartering of mortgage institutions would not be a sensible means of implementation. Are the external benefits of home ownership, if any, so great that the mortgage-interest tax deduction is not subsidy enough? True, the lower the interest rates that Fannie and Freddie paid to borrow money, the riskier the mortgage loans they would agree to underwrite by buying or guaranteeing the loans, but home ownership is not promoted in any meaningful sense by the granting of mortgages to people likely to default. 

Conservative critics led by Peter Wallison of the American Enterprise Institute lay on Fannie and Freddie a significant measure of blame for the housing bubble of the early 2000s and the ensuing financial crisis of September 2008. But these critics have not persuaded me. Private banks like Morgan Stanley and Goldman Sachs and Countrywide bought mortgages, securitized them, and sold interests in them (these firms also bought mortgage-backed securities created by other financial firms)—a sequence wholly separate from the activities of Fannie and Freddie. It was an immensely profitable activity, so there is no reason to think that had there been no Fannie and Freddie the volume of mortgage-backed securities would have been less than it was. Whether a market has X firms or X – 1 firm is unlikely to affect the volume of market activity. I don’t think Fannie and Freddie took more risks than their competitors; the difference is that they were more deeply committed to the housing market (that was their mission) than most other firms, so less likely to survive a housing bubble. 

The financial crisis might actually have been worse without Fannie and Freddie. They collapsed and were simply taken over by the federal government. Had their debts instead been debts of Morgan and Goldman and other private banks, those banks might have collapsed and been taken over by the federal government as well, providing daunting challenges to the government’s ability to run the banking system. The cost to society of the government’s taking over Fannie and Freddie is hard to estimate. The takeover resulted in a transfer payment to creditors of Fannie and Freddie from (ultimately) the federal taxpayer. Had there been no Fannie or Freddie, other mortgage companies would have had more debt, and the owners of that debt would also have been bailed out by the federal government, in all likelihood. 

Congress would do well to abolish Fannie and Freddie. But it won’t. The constellation of political forces that supports subsidizing home ownership is too strong. 

But if Fannie and Freddie are not at the root of the financial collapse and ensuing depression (as I insist we should call it, eschewing the tepid euphemism “recession”), this is not to exonerate the government. I would go so far as to contend that the government is entirely to blame for the crisis (see my book The Crisis of Capitalist Democracy [Harvard University Press, 2010]). The housing bubble was enabled to expand to bursting point by unsound interest rate policies followed by the Federal Reserve in the early 2000s, under the chairmanship of Alan Greenspan. Interest rates were kept too low, and because a house is a product bought mainly with debt, low interest rates reduce the cost of acquiring a house. The result was a surge in demand for housing, forcing up price because the housing stock cannot be rapidly expanded. (The Fed controls only short-term interest rates directly, but short-term interest rates influence long-term rates; moreover, interest rates on adjustable-rate mortgages are in fact short term, and those mortgages became immensely popular during the bubble, as they facilitated speculation on rising house prices.) House prices rose so steeply that the increases became self-sustaining (that’s the bubble phenomenon). The Fed and the other banking agencies were oblivious to the bubble, and the Fed (by then under Bernanke) made a disastrous error by allowing Lehman Brothers to fail after having led the banking industry to believe that the Fed would not permit a major bank failure—whereupon the industry lost all confidence in government policy. And finally financial deregulation had gone too far, enabling—and by virtue of competitive pressure compelling—banks and other financial firms to take risks that were excessive from a social though not private standpoint. 

But the role of Fannie Mae and Freddie Mac in all this probably was minor.

 

Legacy Admissions to Colleges and Universities—Posner

A great many colleges give preference in admission to children of alumni. (This includes public colleges because few colleges any more rely entirely on public funding.) It is widely believed, with some evidence, that alumni give more generously to their alma mater if their children are admitted to, and especially if, having been admitted, they attend, the college that they (the alumni) attended. This is the passionate belief of admissions officer, and if it were false it would have been abandoned, because it attracts a good deal of criticism. 

The “legacy” preference is not a mere tie breaker; as in the case of preferences for blacks, Hispanics, and athletes, it amounts in effect to pretending that the applicant had a substantially higher score on the Scholastic Aptitude Test than he or she actually had.

The preferences for blacks and Hispanics are defended on the ground (possibly spurious in most cases, reflecting pressure from government rather than educational theory) that they are better than their high-school records or SAT scores suggest, because of a disadvantaged upbringing; in fact the colleges, at least the elite ones, try to admit the nondisadvantaged members of these minorities because they are more likely to graduate. But the athletic and legacy preferences have strictly financial motivations. Alumni donations amount to some 28 percent of total college revenues, and both athletic prowess and admission of alumni offspring are considered important to alumni donations. 

The practice of favoring alumni children seems to be particularly strong in elite colleges, though statistics are hard to come by because most colleges will not reveal the admission rate of alumni children relative to the admission rate for applicants who do not belong to preferred minorities, are not good athletes, and are not alumni children. Not that such statistics would be meaningful by themselves, at least in the case of alumni children admitted to elite schools. By definition one of the parents attended such a school, namely the one their child has applied to; and given assortative matching in marriage, there is a good chance that the other parent went to the same, or another, elite school, as well. Hence their children are probably of above-average quality (unless their parents were second- or third-generation legacy admits), in which event they would be admitted at a higher rate than non-legacy applicants even without legacy preference. What one needs to know is how great the preference for alumni children is and therefore how many are admitted who wouldn’t be without the preference. We don’t know how great it is, but it must be significant; otherwise colleges wouldn’t bother to give the preference—most alumni children would be admitted without it. 

Admitting an applicant to an elite college because one or both of his parents went there is offensive in a nation whose constitution forbids the granting of titles of nobility. It confers an arbitrary advantage, based on ancestry rather than on merit or promise. The advantage is not primarily that the preferentially admitted student receives a better education; he may not, because the fact that he would not have been admitted without a preference suggests that he may not be a motivated or talented student; and you cannot make silk purses out of sow’s ears. But his degree from an elite college will open doors; prospective employers, even if they discover that an applicant is the child of an alumnus of the college he attended, will not know whether he was one of the alumni children who wouldn’t have been admitted had it not been for the connection. The student will also derive social benefits (prestige, maybe some extra refinement) and valuable contacts from hobnobbing with the other students; elite colleges have a disproportionate number of elite students. 

The same argument is made against allowing gifts and bequests by wealthy parents (or, more realistically, against light or no taxation of such transfers): that they confer an arbitrary advantage. It is further argued that they blunt the children’s ambition. But there are counterarguments, which cumulatively are compelling: heavy taxation of gifts and bequests increases consumption at the expense of investment; reduces parents’ utility and their incentive to work hard; weakens family bonds; and reduces constructive risk taking by young people by reducing the number of young people who have financial security. Abandoning legacy admissions would have much smaller effects. The major one would be a reduction in alumni giving, and no one knows how much of a reduction there would be, or the extent to which it could be offset by more vigorous solicitation of alumni donations. But the benefits from abolishing legacy admissions would also be slight, if I am right that one of the principal benefits to the legatees is social—the benefits from rubbing shoulders with elite students. For the students whom the alumni children displace at the elite schools still go to college. They just will drop down a notch in the college pecking order; and their presence in colleges at that level will be a boon to the other students in those colleges. 

Furthermore, if one asks who exactly will replace the alumni children if legacy admissions disappear, the answer—better qualified students—must itself be qualified by recognition that parents invest money to improve their children’s college admission prospects, and their investment may enable a somewhat less able applicant to be admitted in preference to an abler one. The parents may have financed a highly expensive elementary and high school education for their children at an elite private school, hired tutors for them, and financed extracurricular activites of the kind that impress admissions officers. The greater the inequality of income in the society—and it is very great in our society at present—the more that wealthy people will be able to gain access to elite colleges for their children, and by doing so underwrite the children’s future economic success and social prestige. 

This point suggests that, as long as colleges are private (including de facto private, which is increasingly the case with public colleges, many of which like the University of Michigan, receive only a small fraction of their money from the state), they will follow a business model, and a business model of education is inherently tilted in favor of applicants who may not be the most promising students, whether they are members of preferred minorities, athletes, children of very wealthy people even if neither parent is an alumnus (such children are favored by many colleges), children with an impressive resume attributable to a significant effect in their parents’ investment in them, or alumni children. Although most colleges—and all elite colleges—are nonprofit institutions, the only difference between most nonprofit institutions and for-profit institutions is that the former cannot distribute surplus revenue (profit) to the people who supply them with capital: there are no shareholders or dividends. They are no less competitive than private institutions. One can imagine a system in which all education, from kindergarten to graduate and professional school, would be financed by the government, but few would argue that such a system would be an improvement over what we have, even though what we have has many unattractive features. 

The ultimate question from an economic standpoint is whether legacy admissions create a harmful externality, which is to say impose a cost on society that the parties to the practice that causes the externality do not take into account. The college and its legacy admits like the practice of legacy admissions and do not want to change it; should they be forced to because of the harm the practice causes to other members of society? 

I think not. The harms are of two kinds. First, legacy admissions undermine the matching of the best students with the best colleges. That kind of “assortative mating” is probably most efficient from the standpoint of maximizing the gains from education; and education creates benefits for society as a whole. With legacy admissions, there are fewer places for the best students in the best colleges; some of those best are relegated to the next tier of colleges. On the other hand, students learn from other students as well as from teachers, and those “best” who are knocked down a tier thus benefit their fellow students in the second-tier colleges to which they are admitted. The net loss to educational efficiency caused by legacy may well be slight—it may even be negative if abolition of legacies would result in a significant reduction in alumni donations and therefore in college resources. 

Second, legacy admissions increase inequality, or at least may increase it (this qualification is explained below). Inequality, beyond a point we may have reached, is harmful to society as a whole; the enormous federal deficit is in part a result of efforts by the Bush Administration as well as the Obama Administration to offset wage stagnation and rsulting increased inequality by heavy borrowing to fund entitlement programs. But the increase in inequality brought about by legacy admissions is probably infinitesimal. Moreover, legacy admissions may actually reduce inequality, because the abler person pushed down to a lower-tier school may have lower lifetime earnings as a result, and if as is likely he is upper middle class, the reduction in his lifetime earnings will reduce inequality. 

I continue to find the practice distasteful. But I don’t think public intervention (which might take the form of federal and state regulations conditioning financial assistance to colleges on the abandonment of the practice) is warranted. 

Legacy Preferences Make a Lot of Sense, Up to a Point-Becker

A college’s policy of legacy admissions means that the children of graduates of the college are more likely to be accepted by the college when they apply than are other applicants with similar records. Such a policy has the biggest effect on acceptances by elite colleges, partly because they are the hardest schools to get into. Although many colleges do not reveal data on admissions rates of legacies compared to others, the limited data available indicate a large gap. For example, in 2008 Princeton admitted about 40% of all legacy applicants compared to less than 13% of other applicants. Dartmouth’s legacy acceptance rate then was more than twice that of other applicants. However, some of this difference is spurious because legacy applicants are generally better qualified since their parents are better educated and wealthier, and send their children to better schools.

As Posner indicates, legacy admission policies have been widely criticized as being unfair to non-legacy applicants who may have better records. Such a criticism has merit from a narrow perspective, but a legacy policy may in the longer run help both students and faculty. First of all, legacies may help to raise a school’s “harvest” rate; that is, the fraction of accepted applicants who decide to attend. Colleges and universities at all levels are competing against similar institutions for a limited number of qualified high school students. If different applicants look equally acceptable on the basis of their records, preference to the children or grandchildren of alumni may be warranted, even aside from financial considerations.

Acceptance rates by different applicants are a major uncertainty facing colleges as they try to achieve good entering classes. Since applicants with family links to a school are more likely to attend if admitted, that would make their admission more valuable than would the admission of equally able students without any family connections to that school. This type of reasoning implies that it would be desirable for schools to lower somewhat the admission standards for legacies since the loss to a school from admitting somewhat lower quality legacy applicants could be more than made up by higher acceptance rates from legacies. How much a school should lower its admission standards to accept legacies depends on the differences between the acceptance rates of legacies and those of other applicants, and on other factors.

Another common argument made for legacy admissions is the importance of alumni gifts to the quality of education a college offers. Private colleges and universities, and increasingly also the major public universities, rely greatly on gifts and endowments to finance their education programs. There is a strong tradition in the United States of “giving back” by alumni in the form of fnancial contributions. Alumni are by far the principle source of small to moderate gifts to colleges and universities, and they, along with private foundations, are the major source of very large gifts. Individuals who have given tens, and sometimes hundreds, of millions of dollars to institutions of higher learning almost invariably have graduated from, or at least attended, the institutions that received their large gifts.

Families that have more than one member who attended a particular institution of higher education tend to be more loyal to that institution than families with only a single graduate of that institution. Families with several graduates are more likely to attend alumni events and participate in alumni activities. In addition, a study of graduates of Middlebury College, a liberal arts college in Vermont, indicates that individuals with relatives who also attended Middlebury are more likely to provide financial support. Since financial support is crucial to the effective performance of any college, greater gifts along with higher acceptance rates from legacies, would give legacies an edge in deciding on admissions policies.

How much edge to give them should depend on how much more likely they are to provide significant financial support, how much higher are their acceptance rates when admitted, and how their other achievements compare to non-legacy graduates. The case for giving preference to legacies would be greatly weakened, and could even be reversed, if they were on the whole less successful than other graduates. I do not believe that is true, and a study of Duke undergraduates indicates that legacy admits perform about as well at Duke as other students who have parents who graduated from (other) colleges.