September 02, 2007

The Transformation of the Kibbutz and the Rejection of Socialism-Becker

Much has been written about the rejection of socialism by major powers like China and the former Soviet Union. But nowhere is the failure of socialism clearer than in the radical transformation of the Israeli kibbutz.

The kibbutz movement started in the early twentieth century in what was then Palestine by Zionist émigrés from Europe who were idealistic and utopian. Capitalism, industrialization, and the conventional family repelled these émigrés. Kibbutzniks, as they were called, replaced these fundamental aspects of modern societies with collective agriculture where all property was owned by the kibbutz, where adults were treated equally regardless of productivity, and they were rotated every few months among the various tasks that had to be performed on a farm, such as milking cows, planting crops, serving meals, and so forth. They considered the close-knit family to be a creation of capitalism, and substituted for that family structure communal dining, a fair amount of promiscuity, and separate communal living for all children, who were allowed only brief visits with their parents each day.

Several decades ago I spent a few days on such a traditional kibbutz located in the Negev desert, where I was a guest of married couple with two children. The husband was unusual for a kibbutznik because he was a trained nuclear physicist. They had a two room apartment-their two children lived in dormitories with the other children of the kibbutz- I met the children briefly on a couple of their daily visits to their parents. We dined communally on good food, and we watched a movie in the large dining hall afterwards.

Although my host had much more advanced training than other residents, that only gave him the right to spend a few months each year working at a nuclear facility that used his skills. The rest of the time he rotated like everyone else among the numerous menial tasks on the kibbutz. He was well paid for his outside professional work, but he had to hand over his pay to the kibbutz, and received the same benefits as everyone else. He was not happy with this arrangement, but since he grew up on this kibbutz he lacked the resources to buy an apartment and car, and make the other outlays required to move off the kibbutz into an urban environment where he could get a well paying job. For at that time, rent controls destroyed the rental market for housing, so young couples lived with their parents until they saved enough, or their parents gave them the money, to buy their own place. However, in this case, their parents did not have their own apartments since they too lived on a kibbutz, and they lacked the financial resources to help their children.

The kibbutz movement was motivated in part by the Marxian dictum of "from each according to his abilities to each according to his needs". By abolishing capitalistic organization, the founders expected members to live in contentment and harmony, and to work for the common good. However, from what I was told and could observe during my brief visit, there was not much harmony-jealousies abounded of those who were only a little better off, including my host because he was allowed to spend some time working at his profession off the kibbutz. Anger was also felt toward those who were considered slackers since they clearly lived off the labor of others. Since everyone ate, worked, and socialized together, small differences were magnified, and became festering sores. Nor were the family arrangements any more satisfactory since parents missed their children, and visa versa.

The kibbutz movement was very important in the creation of Israel, and in its early days of independence. Many military leaders came from the Kibbutz, perhaps because they were accustomed to communal living. A disproportionate number of the early political leaders and intellectuals also had a kibbutz background. But as the New York Times recognized in an article this past week, the socialist zeal that propelled the kibbutz movement in its early days has largely now disappeared. A trend that began more than 40 years ago accelerated in the 1980's as kibbutzim lost many young members, and they failed to attract enough new members. Many of them were forced into bankruptcy, and the future of this movement was exceedingly dim if they continued with their old ways.

The vast majority of the kibbutz that remained survived because they changed their ways. They expanded into industry and even real estate, they allowed a substantial degree of private ownership and private enterprise on the kibbutz, pay is no longer equal and is now significantly related to productivity, and parents and children live and eat together privately in their own homes. These changes may have prevented the Kibbutz movement from disappearing along with the many past Utopian experiments, but they did not prevent the kibbutz from becoming of little importance in the Israeli economy as Israel shifted toward privately owned high tech industry, and also toward privately owned farms, including cooperatives, for its much less important agricultural output.

The transformation of the kibbutz movement from avowedly socialist to mainly capitalist shows clearly in microcosm what happened in socialist countries. Although even in their most extreme moments these countries were never as radical as the kibbutzim since children continued to live and eat with parents, socialist countries too tried to divorce individual productivity from individual rewards. They also believed that self-interest was a relic of capitalism, and that they could change human behavior to produce "a new socialist man" by abolishing private property and reorganizing society. Instead of the small scale of a kibbutz, countries like China and the Soviet Union tried to created socialism on an enormous scale. Moreover, and this is crucial, while members of any kibbutz voluntarily joined and could leave at will, Russians and Chinese had no choice about whether they wanted to work on collective farms or in government run enterprises, and they could leave only with extreme difficulty and at personal risk.

Utopian socialistic experiments like the kibbutz movement, and countries that tried to create large-scale efficient socialism, all failed for the same reasons. They did not realize that while the zeal of pioneers, and the result of revolutions, could sustain a collectivist and other-serving mentality for a short while, these could not be maintained as the pioneers died off or became disillusioned, and as circumstances became less revolutionary. Basically, they ignored the evidence of history that self interest and family orientation is not the product of capitalism, but is human nature due to selection from evolutionary pressure over billions of years. Sure, there is abundant altruism toward one's family, and some altruism toward others, and the latter might sustain a society for a brief time. But it shows a depressing ignorance of history to believe that a little propaganda and the enthusiasm of some leaders can organize an effective long-term society on the basis of any altruism and desires of mostl persons to help institutions, such as a kibbutz or a country, rather than themselves and those close to them.

Posted by becker at 08:53 PM | Comments (21) | TrackBack (0)

The Kibbutz--Posner's Comment

There have always been communes, such as the Israeli kibbutzim, but they have usually failed, mainly because of free-rider problems. If wages are uniform, shirkers flourish; also, incentives to undergo training that would increase the value of one's output are blunted. Thus we read in the New York Times article of August 27 mentioned by Becker that "Mr. Varol was born on a kibbutz in the far north, but he left at 18. He is at peace in his new home, but bitter about the past. 'My parents worked all their lives, carrying at least 10 parasites on their backs,' he said. 'If they'd worked that hard in the city for as many years, I'd have had quite an inheritance coming to me by now.'"Yet, curiously, Varol's "new home" is one of the 30 percent of Israel's 250 or so kibbutzim that, accordingly to the Times article, remain genuine communes--that is, with collective ownership and equal wages, though the collective raising of children has probably been abandoned. (Curiously, Varol's kibbutz--Ein Ha-Shofet--was named in honor of Justice Brandeis, shofet being the Hebrew word for judge.) In trying to weaken the bond between parents and children, the founders of the kibbutz movement, echoing Plato, who in his sketch of an ideal communist state in the Republic had advocated the communal rearing of children, were acknowledging that parents' instinctual desire to advance their children was inconsistent with communal equality.

The kibbutz movement is almost a century old, and it is more remarkable that 30 percent of the kibbutzim are still communist than that 70 percent are not, although the Times article does not indicate the percentage of the total kibbutz population that lives in those "classic" communist kibbutzim or how complete their commitment to the kibbutz ideal actually is. An even more durable example of voluntary collectivist living that comes to mind is found in the Catholic monasteries and convents--and notice that it is too is founded on a realization that family ties are inimical to communal ordering. A kind of private quasi-collectivism persists in poor, disordered, or anarchic societies in which tribes and clans exercise functions that governments perform in wealthy societies.

The kibbutzim were founded as collective farms in a pre-mechanized agricultural economy. Because they were small, because the skill and effort of each of the members of a kibbutz could be readily observed and evaluated, because (really the same point) there was little specialization, because the danger posed by the surrounding Arab population created a strong sense of mutual dependence among kibbutz members, because many immigrants to what is now Israel did not have good employment options, and because of the mysterious Jewish enthusiasm for communist and socialist movements, free-rider problems could be contained, and so the "classic" kibbutzim, unlike most voluntary communes, and without the religious backing of Catholic monasticism, flourished for generations. Even so, kibbutzniks were never more than 7 percent of the Jewish population of Palestine. As the extraordinarily favorable conditions for voluntary collectivism waned, it was inevitable that the classic kibbutz system would fade.

The kibbutz in its original collectivist form gives us a glimpse of pre-political human society. In a society in which there is no effective central government, as was essentially the situation of the Jewish community in Palestine until Israel gained statehood in 1948 (and even afterwards, in frontier regions exposed to Arab terrorism), smaller groups will form for self-defense and the provision of other public goods, such as social insurance. Collective ownership and wage equality are ways of protecting each member of the collective from economic and other vicissitudes; "from each according to his ability, to each according to his needs"--the communist slogan actualized in the classic kibbutz--is then a method of social insurance. The difference between the uniform wage that every worker receives and the below-average value of a particular worker's output because of age, infirmity, wounds, or sheer inability is in effect a transfer, in the nature of insurance proceeds, from the other workers. But it is less efficient than the forms of private and social insurance that arise when there is a government that can enforce property rights and thus enable industries such as the insurance industry to function, and that can provide social insurance out of tax revenues.

Probably, then, human beings have both collectivism and individualism in the genes, enabling us to adapt both to environments in which collectivism is welfare-promoting and environments in which individualism is welfare-promoting.

Posted by Richard Posner at 08:32 PM | Comments (11) | TrackBack (0)

Infrastructure--Posner's Response to Comments

There were a number of good comments. I respond to a few here. One pointed out that the interstate highway system was largely built in the 1950s and 1960s, rather than continuously. As a result, it presents a "bloc obsolescence" problem necessitating heavy expenditures on maintenance and rebuilding--costs exacerbated by the unanticipated wear and tear resulting from the vast increase in usage of the system. This makes the problem of financing the necessary expenditures an urgent one.

Another comment points out perceptively that imposing tolls on users of the interstate highways could create a negative externality by deflecting users to non-toll roads, thus increasing congestion and wear and tear on those roads. That is an argument for tolling all roads--to which two objections are raised in comments. One is that tolls will be prohibitive on roads that are lightly traveled, assuming that their light traffic doesn't reduce maintenance costs to trivial levels (as it would not). What is true is that tolls will be kept down in order to avoid deflecting users of these roads to more congested roads, adding to the congestion on them. The second objection is that it is infeasible to impose tolls on busy commuter roads such as the Minneapolis bridge that collapsed, because it would slow down traffic too much. But this is a short-term objection. Technology is rapidly coming on line, and at rapidly falling cost, to enable tolls to be charged (and varied with time of day to minimize congestion) without need for toll booths, but instead through a system of sensors in the pavement and cameras overhead.

Posted by Richard Posner at 08:23 PM | Comments (3) | TrackBack (0)

August 26, 2007

The Infrastructure "Crisis"--Posner

The August 1 collapse of a bridge that carries Interstate 35W across a river in Minneapolis, which killed 13 people, has led to loud calls for greater expenditure on maintenance of America's hundreds of thousands of bridges and millions of miles of interstate highways. The federal highway system--the "Interstates," like I 35W--has a total length of about 50,000 miles, and though that is only 1 percent of the total highway mileage in the United States, it carries almost a quarter of the nation's total road traffic, amounting to some trillion persons a year, and half its truck traffic. Concern with inadequate maintenance has focused on the federal highway system. It should be noted, however, that although the system is federal, its components--the individual interstate highways--are owned mostly by the states, with each state owning the portion of the federal highway system that falls within it. The system is financed in part by federal and state gasoline taxes, in part by the general federal budget, and, though most of the Interstates are freeways, in part by tolls levied by the states.

The shock caused by the Minneapolis accident may seem excessive in light of these figures. A highway system that carries a trillion drivers and passengers a year is bound to experience occasional fatalities due to defects in highway design or maintenance as distinct from accidents due to driver negligence, vehicular defects, fog, and other conditions for which the highway system generally could not reasonably be thought responsible. Nor is it yet clear that the Minneapolis accident was due to deferred maintenance or other neglect. Current speculation is that it may have been due either to the installation of defective de-icing equipment or to the placement of construction materials used in a project to resurface the bridge's roadway.

Although the accident may turn out to have had nothing to do with neglect of the transportation infrastructure (mainly highways, though of course there are local roads as well and some bridges are for railways rather than highways), there has been a long-standing, although until the Minneapolis accident a low-visibility, concern with what the concerned call "America's decaying physical infrastructure." What could this mean?

A highway, like any other product, should be maintained at a level of quality at which marginal costs are equated to marginal benefits, including safety benefits. There is such a thing as making a product too safe. At the same time, there is a tendency to neglect the delay and wear-and-tear costs that are created by highways that have poor surfaces or that experience frequent lane closures due to the need to repair the road more often than if it were maintained properly.

So the question is whether the nation is spending too little on highway maintenance as judged by a cost-benefit analysis along the lines just suggested with proper emphasis on delay costs and a realistic assessment of expected accident costs. The American Society of Civil Engineers has rated more than a quarter of the nation's bridges as "structurally deficient or functionally obsolete," and has called for an expenditure of $1.3 trillion to repair or replace them as well as to deal with similar problems of roads and other infrastructure. But an engineering optimum is not the same thing as an economic optimum. There is no indication that the ASCE has conducted a cost-benefit analysis of its proposal. Considering the infrequency with which bridges collapse, the idea that more than a quarter of them are "structurally deficient or functionally obsolete" in a sense relevant to serious concerns about safety is implausible.

Not that it would be a surprise to find that the nation is spending less than the economically optimal amount on maintaining the highway system, bridges, and other infrastructure. Enormous recent growth in the total miles driven on the interstate system has not been matched by expansion of the system, resulting in a substantial increases in delay and also in wear and tear. The highway system has difficulty responding to a need for increased expenditures to preserve road quality and minimize delay because it is publicly owned, and is financed largely by taxes. Politicians have trouble raising taxes to pay for projects the benefits of which will largely be realized after the politicians' current term of office expires. Since accidents that are due to the collapse of a bridge or a highway segment, or some equally dramatic demonstration of a flaw in the highway system itself rather than a mistake by users, are rare, the likelihood of such an accident occurring within a politician's political time horizon is low. So there is an incentive to defer maintenance and thus live (slightly) dangerously rather than raise taxes, the effect of which will be felt by the taxpayer immediately. By the same token, rather than raise taxes to enable road repair or rebuilding that will avert any need for further maintenance for many years, politicians have an incentive to make frequent cheap repairs, even though the cumulative delay and accident costs (discounted to present value) may be great, rather than to take steps to reduce those delays and accidents after their term of office expires. Furthermore, while state taxes are paid by state residents, only part of the delay costs resulting from inadequate maintenance are borne by them because many users of the interstate highway system are nonresidents of the state that maintains its segment of the system poorly.

In short, there are systemic reasons to expect the interstate highway system to be undermaintained, although there is also a reason to expect it to be overmaintained: the interest of road builders, like civil engineers, in overengineering the highway system in order to increase their revenues. Yet it is possible that they maximize their revenues by frequent small repair and rebuilding projects rather than infrequent but costlier because more extensive ones. My guess is that the interstate highway system is undermaintained, but it is just a guess, and I would be grateful if some of the readers of this post have better information on the question.

Supposing that the maintenance of the system is not optimal, what might be done to bring it closer to the optimum? One possibility would be to privatize the system. Until the 1970s, it was believed that infrastructure services such as air transportation, rail and barge transportation, trucking, pipeline transportation, and even taxi service could be privately owned but had to be heavily regulated by government as "common carrier" services, with price and entry controlled by regulatory agencies. We now know better. Yet we treat highways, which are just another part of the transportation infrastructure along with airlines, railroads, and pipelines, as requiring not only tight regulation but public ownership. In fact limited-access highways are easily financed by user fees--tolls--and the advent of electronic toll collection (EZ Pass and similar services) has reduced, and will soon largely eliminate, the delay caused by having to stop and pay a toll. States have taken steps toward privatizing highways, including components of the interstate highway system, such as the Indiana Tollway. (See our posts of June 20, 2006.)

If the interstate highway system were privatized, there would still be a need to ensure uniform safety standards, signage, and so forth, although the responsibility for achieving the requisite commonality could largely be delegated to the owners themselves, since it would be very much in their interest that the interstate system be from the user's standpoint uniform. There would be a potential problem of monopoly, since for many drivers there is no good alternative to using the interstate system. But that problem could be minimized by the terms on which states leased the operation of their stretches of the interstate system to private companies. Private operators who skimped on maintenance would be subject to being sued in tort if accidents resulted and to having their leases terminated; and to the extent that deferred maintenance caused unnecessary delays and thus reduced the value of the use of a highway, the operator would not be able to charge as high a toll, and so there would be a market penalty for suboptimal maintenance.

Posted by Richard Posner at 07:03 PM | Comments (23) | TrackBack (0)

The Infrastructure "Crisis" Once Again-Becker

For at least the past three decades the media and others have been concerned about the "crumbling infrastructure" of the U.S. highways, including the roads and bridges. For example, as far back as April 1982, The Reader's Digest had an article entitled "Cures for America's Dying Highways". This concern led to a series of Federal acts over the subsequent 20 years that tried to help address safety and efficiency issues by providing additional funding for maintenance of roads and bridges through using revenues collected from the federal gasoline tax.

Given that total spending by state and federal governments amounts to over 1/3 of U.S. GDP, surely there are enough resources in government hands to provide excellent road infrastructure that produces efficient as well as safe travel. However, a problem in getting adequate resources to any important government activity is that they must compete with so many other demands on the very liberal overall budgets. In particular, spending on road safety has to compete against spending on medical care, retirement benefits, housing subsidies, public transportation, agricultural subsidies, and numerous other ways to spend government revenues. The most deserving forms of spending, such as highway safety, might get shortchanged as resources are spent on projects of questionable value, such as agricultural and housing subsidies, or social security benefits to well off individuals.

So is the present concern about safety of the infrastructure merited, or is it just a recurring reaction to the latest major accident, such as the bridge collapse in Minneapolis? As far as I can tell the evidence does not indicate a significant overall safety problem for American roads and bridges. For one thing, collapsing bridges and other defects in the infrastructure that cause serious accidents are very uncommon. The overwhelming fraction of all bridges in the country is in good or excellent shape. Of the huge number of bridges in this country-Illinois alone has over 30,000 bridges- only a little over 10 per cent are considered "structurally deficit" in the evaluations provided by the Federal National Bridge Inventory. Moreover, even this negative designation does not mean that these bridges are unsafe, but rather that they are in need of more frequent checkups to detect signs of any additional deterioration. Actually, few bridges are considered so unsafe that they have had weight limits imposed on the traffic using them.

Moreover, defects in infrastructure ranks far far behind driver and car defects as a cause of highway accidents. Even with the major advances in car quality during the past couple of decades, many cars on the road still have worn tires and mechanical defects that cause accidents. Clearly the most important cause of highway accidents are driver defects in the form of driving when under the influence of alcohol or drugs, bad eyesight, slow reactions, poor judgments, and limited driving skills. Drunk driving alone kills over 15,000 persons per year in the United States out of about 40,000 total annual deaths from automobile accidents. These data suggest that the bulk of any allocation of additional federal and state revenues to accident prevention devoted to highway safety should be spent on trying to reduce drunk driving, and discouraging driving by those who are prone to accidents.

Relative not only to poor countries like India with disastrous infrastructure, but also to rich countries like Great Britain and Italy, the American system of roads and highways is quite good, both in terms of accessibility and safety. That probably is an important reason why the U.S. has been slower than most other nations in privatizing more than a tiny part of its road system. Nevertheless, I agree with Posner that the U.S. should move aggressively toward privatizing many segments of that system (and other public activities as well).

An example of what can and should be done is given by the privatization of the Chicago Skyway, an 8-mile toll road that connects I-94 in Chicago to the Indiana Tollway. In 2005 the City of Chicago gave the Skyway Concession Company a 99-year lease to operate this skyway; the company paid almost $2 billion to the city for that lease. The privatization was actually motivated by the difficulties the city had in upgrading and repairing the skyway. The SCC collects and keeps all tolls and concession revenue, but it is responsible for all operating and maintenance expenditures.The agreement between the City of Chicago and this company is the first privatization of an existing toll road anywhere in the United States. So far it is working out extremely well, and might be the poster child for privatizations of other roads, although obviously more time is needed to see how the maintenance, efficiency, and tolls charged on the Skyway evolve in the future.

Posted by becker at 04:13 PM | Comments (7) | TrackBack (0)

Responses to Comments on Air Transportation and on the Credit Crunch--Posner

There were a number of interesting comments on these two posts, and it was especially interesting to hear from a number of pilots and air controllers with regard to the problem of deteriorating airline service. One controller straightened me out about the financing of the air control system--it is mainly by ticket taxes rather than airline fuel taxes. This is unfortunate, because number of tickets is a very crude proxy for scheduling that causes congestion which in turn increases the costs of the air traffic control system. Compare two airlines, flying the same number of passengers (hence selling the same number of tickets), but one flies large planes infrequently and the other small planes frequently. The second will cause more congestion but will not pay higher ticket prices.

I did not focus on solutions to the problem of air traffic congestion, but the logical solution would be some form of congestion pricing--for example a tax based on number of flights, which would create an incentive for fewer flights (with larger planes). This would be an efficient solution, however, only if consumer surplus would be greater with less delay but also less frequent flights, and that is a difficult calculation which as far as I know has not been made.

One commenter pointed out that my observation that the per-vehicle cost of gasoline is higher than the per-airline-passenger cost of aviation fuel, and that this retards the substitution of auto for air transportation in response to air traffic congestion, is incomplete. The proper comparison is per-vehicle-passenger gasoline cost, since if a vehicle has more than one passenger the gasoline cost per passenger falls.

Turning now and very briefly to the credit-crunch posting, one commenter complains that as a result of other people's reckless borrowing (and lending), he--a conservative borrower and investor--is experiencing a loss of market value of his home and of his stock portfolio; and so wouldn't it be appropriate for the Federal Reserve Board, if it could, to do something to alleviate his loss, for which he is blameless. I think not. Everyone's investments are at risk from unforeseen external shocks, and it would be infeasible for government to compensate everyone who experienced a loss as a result of those shocks. Even when average house prices are rising, the price of a number of houses will be falling; and the stock market gyrates quite apart from the occasional bubble.

Posted by Richard Posner at 02:39 PM | Comments (2) | TrackBack (0)

August 19, 2007

Should Central Banks Intervene During This Financial Crisis? Becker

The Fed, the European Central Bank, and the Japanese Central bank have all been pumping liquidity into the global economic system through easing borrowing in overnight money markets in order to stem the lending crisis brought on by heavy default rates on sub prime loans. The Fed on Friday also lowered the rate they charge to banks, and encouraged them to use this rate to borrow for longer than overnight, especially with sub prime loans as collateral for their borrowing.

By contrast, the British Central Bank has not taken any special steps, and the head of that bank, Mervyn King, and some other economists have argued that trying to stem the crisis by making loans cheaper and more available is an unwarranted bailout of financial institutions. This could create a risk-called "moral hazard"- which means in this situation that hedge funds and other financial companies might lend recklessly in the future in the expectation that they would be helped again by Central Banks if they get into trouble. Others have argued that the financial system has to go through a crisis to eliminate all the reckless investments that have been made during the past few years.

I have been a strong opponent of bailouts of individual companies since I do not believe in the "too big to fail" justification when applied even to large manufacturers, financial intermediaries, or service companies. In particular, I was against the Fed's putting pressure on private investors to bail out Long Term Capital during the financial crisis of the late 1990's. It would be a further mistake for the Fed or other Central banks to come to the assistance of hedge funds or other lenders that may be in financial difficulties because they excessively invested in assets of dubious value. They should bear the consequences of their mistakes. In particular, no assistance should be given to home lenders or others who might go bankrupt because it made an excessive number of highly risky mortgage loans to borrowers with dubious credit.

To be sure, in the environment of the past several years of very low interest rates, sharply rising housing prices, and new instruments for managing and aggregating risk, it is easy to understand why loans to finance home ownership spread to borrowers who in the past would not have been considered sufficiently credit worthy. Many of these loans have turned sour because interest rates have begun to rise sharply, especially on low-grade mortgages, and because of the steep slowdown in the increase in housing prices. Yet f the discussion of this experience typically forgets that most homeowners who can no longer meet mortgage payments and may have to sell their homes will get back more than they paid because housing prices remain well above what they were when they bought their homes with cheap loans.

So is laissez faire the right option in this case, and the Fed and other central banks should not offer any special help? I would have absolutely no doubts that this is the right policy if the major risk of the present situation were that some hedge funds and other financial institutions would experience sharp rundowns in their assets and even bankruptcy. However, the Fed's recent intervention was driven by the fear that the weakness in financial markets will spread to the real economy, and will adversely affect employment, investments, and general welfare in the United States. The same justification would apply to Europe and Asia as well. The avowed goal of such interventions would not be to help individual companies or borrowers, but rather to stabilize the complicated and interconnected economic system.

Such an approach by the Fed and other central banks is not foolish, and may be right, but I believe they should continue to be guided by the criteria that have served them very well during the past couple of decades. That is, their policies should be determined by rules dependent on broad developments in the economy: unemployment, the growth in GDP, and the inflation rate. Central banks should intervene by lowering interest rates only when these broad economic indicators begin to slip badly. Since unemployment continues at low levels, and inflation is still modest, the U.S. GDP growth rate is the only major indicator that has worsened- output in Europe, Japan, and most of the rest of the world has continued to grow at a brisk pace.

I conclude that central banks should be especially vigilant for signs that the damage is spreading to fundamental economy indicators, but should refrain from any special actions until that time. Otherwise, central bank policy would get confused between rules that depend on broad developments in the economy, and discretion that is affected by development in the housing market, the market for credit, or other specific markets.

Posted by becker at 08:21 PM | Comments (18) | TrackBack (2)

Against Bailouts--Posner's Comment

If a person's assets grow in value, he can borrow more against them, or expect a lower interest rate if he does not increase his borrowing (for then the lenders have more security). This is true of houses as of other assets. In a growing economy, with the amount of land available for housing more or less fixed, the value of residential property can be expected to increase--over the long run. But in the short run, asset prices may stagnate or even decline. In recent years, homebuyers have been willing to take on historically unprecedented risk in the form of 100 percent mortgages (on the subprime bubble, see my posting of June 24) and floating interest rates. As a result, if housing prices fall, a buyer can find himself with negative equity (that is, owing more than his house is worth) and paying a much higher interest rate than the rate prevailing when he bought the house.

Although a floating interest rate shifts risk from lenders to borrowers, lending without requiring a significant (or sometimes any) down payment imposes substantial risk on lender as well as borrower, since they have in effect a joint interest in the property that secures the loan. Moreover, the costs of foreclosure and resale are considerable and amplify the loss of value when housing prices fall and precipitate defaults.

Back in 2005, both the Economist magazine and the Federal Deposit Insurance Corporation, along with many others, warned that American housing prices were growing at unsustainable rates; the FDIC noted that in the five years ending in 2004, U.S. home prices had risen by 50 percent. There is a long history of housing busts following housing booms, and although generally in this country the booms and busts have been local rather than nationwide, Japan famously experienced an extremely severe nationwide drop in housing prices in 1990. One might have expected concerns with the possibility of a bust, given the housing bubble and risky lending, to drive up interest rates, but this did not happen, because lenders were willing to assume a very high level of risk. In part this was because the initial lenders could sell loan packages to hedge funds and other specialists in risk bearing.

The bubble burst, defaults ensured, interest rates rose--precipitating more defaults--and some lenders were wiped out. Finally the Federal Reserve Board stepped in and eased interest rates by providing additional capital to the banking industry.

The only justification for bailing out risk takers is to avoid a depression (or as it is politely called nowadays, a "recession", but, oddly, the worse the macroeconomic consequences of a speculative boom and bust, the stronger the argument for punishing the risk takers (which include both borrowers and lenders) by not bailing them out. The punishment should fit the crime (I use "crime" in a figurative sense); the worse the crime, the heavier the optimal punishment, setting aside issues of detectability. If the government relieves risk takers of the consequences of their risks, there is a divergence between social and private risk. An example is subsidized flood insurance, which leads to excessive building in floodplains.

There seems a particular perversity in making credit cheaper, since cheap credit fed the boom. Lower interest rates encourage borrowing and hence spending and also increase the price of imports by making the dollar worth less relative to other currencies. Moreover, government intervention to help lenders and borrowers invites further government regulation--for example limits on subprime lending. There is no more reason to discourage risk taking than to bail out the risk takers when the risks they have voluntarily assumed materialize.

The losses sustained by hedge funds in the bursting of the subprime bubble lend a note of irony to opponents of taxing them comparably to other investment companies. They argue that hedge funds play an essential role in bringing market values into phase with the underlying real economic values. It now seems that a number of hedge funds were caught up in a speculative frenzy, and that far from bringing about convergence between market and real values they enlarged the wedge between them.

Studies in cognitive and social psychology have identified deep causes for the overoptimism, wishful thinking, herd behavior, short memory, complacency, and naive extrapolation that generate speculative bubbles--and that require heavy doses of reality to hold in check. Any efforts to soften the blow will set the stage for future bubbles.

Posted by Richard Posner at 07:46 PM | Comments (16) | TrackBack (1)

August 12, 2007

Air Transportation Delay--Posner

This summer has seen a significant degradation in the quality of airline transportation in the United States compared with the recent past--substantial increases in delayed and canceled flights, in missed connections, in waiting time to the next flight to one's destination if one's original flight is canceled, in crowding in planes, in poor in-flight service, and in lost luggage. The delays have actually been masked by the airlines' practice of increasing scheduled times--for example, flights from Chicago to Washington, D.C. used to be scheduled to take an hour and a half, but now are scheduled to take almost two hours, yet still are late more often than when the schedule called for a faster trip.

Much finger-pointing has accompanied the degradation in service, and there is a movement afoot, well discussed in an article in the August 8 Wall Street Journal, for legislative intervention.

My guess (and that's all it is) is that the principal culprit is the difference between marginal and inframarginal consumers of a product or service that has heavy fixed costs (lumpiness). Let me explain what is actually a simple point. Competition compresses price to the intersection between demand and supply; think of the standard, simple demand-supply graph in which a falling demand curve intersects a rising supply curve. To the left of the intersection, the demand curve is above the price,. The space between the price and the demand curve denotes the existence of inframarginal customers (or quantities, but I'll disregard that detail), which is to say customers who would continue to buy the product or service even if its price were higher. They would do that because they value it more than the marginal purchaser does--the purchaser who would not buy the product if the price were any higher than competition has constrained it to be, because the marginal purchaser purchases at a price just equal to his demand, that is, to the value he attaches to having the product.

The difference between what the inframarginal purchasers pay (the market price, the same price paid by the marginal purchaser) and what they would pay (the schedule of prices traced by the demand curve above its intersection with the price) is referred to as "consumer surplus". In effect, it is value given away by the sellers to the purchasers. The sellers derive no profit from it. The only way they can increase their profits is to reduce their price, as that will attract more marginal customers; specifically, they will be customers for whom the value of the product is less than its current price but for whom the value of the product would exceed price if the price fell.

When price is at its competitive level, the sellers (unless they collude, and barring government intervention) can reduce price further only by increasing the quality of their product or reducing its cost. Reducing cost may require reducing quality, which will reduce consumer surplus. But the sellers' object is not to maximize consumer surplus, because they do not profit from it. So if reducing price by reducing cost (and therefore quality) attracts new customers because they are not as concerned with quality as the inframarginal customers are, the sellers may be better off even though their customers as a whole may be worse off.

What makes this a particularly attractive strategy for airlines to follow is that a large proportion of their costs are fixed, that is, are invariant to quantity of output. If a plane can carry 100 passengers, the cost savings from carrying a smaller number is trivial, unlike the cost savings to a retailer from selling fewer toothbrushes. (The analogy to the airplane is to intellectual property--a book, say. The fixed costs of the book will be very high relative to the cost of printing and distributing an additional copy, i.e., its marginal cost.) Even a very low price to passengers, if it fills the plane, may be profitable, because almost all the revenue goes to pay the heavy fixed costs of the plane, as in the case of the book but not the toothbrush. To the extent that an airline can price discriminate, it will, offering better service to the customers that are willing to pay for it. Hence first class and business class versus coach. (The analogy in intellectual property is to hardback versus paperback books, or to first-run versus subsequent-run movies.) However, there are limitations. If flights are canceled or delayed, all the passengers are harmed; if first-class seats are filled (for they are especially profitable to the airlines), it will be harder for first-class passengers to find a first-class seat on the next flight if their original flight is canceled; and so forth.

The inframarginal customers (I am one of them) are furious. Some of them are substituting other modes of transportation, such as car or train, for short flights, but that substitution is limited by the fact that fuel costs per mile, an increasingly high cost of driving, are actually lower for planes than for cars. At the top end of the income distribution, some airline customers are buying shares in private planes. In the middle, many are complaining to their Congressmen. In a curious way, this last response could be thought an effort to obtain legislative rectification of a market failure. For it is possible, if my analysis is correct, that aggregate economic welfare, in the form of the total combined consumer and producer surplus of airline transportation, has declined as a result of the airlines' competition for the marginal customer. However, it is extremely unlikely that such a market failure could be rectified by legislation at a cost equal to or greater than the benefits.

It might be asked why the quality of airline service has been falling recently, rather than having always been low (at least since deregulation, which by limiting entry and price competition encouraged airlines to compete by providing better service). The answer is that the costs of air transportation have been rising recently as a result of sharply higher fuel costs. So it is not that the airlines are actually reducing fares, as I assumed for purposes of simplifying my analysis--in fact they are raising them. But they are not raising them to the level necessary to maintain the previous quality of service, because if they did that they would lose their marginal customers.

Most markets adapt to differences in consumer preference by offering different qualities of product at different prices. But except at the very high end, where as I said some airline customers are switching to private planes and private charter services, this is not happening in the airline industry. The impediments include the network character of the industry, the fixed costs of airplane transportation, and the spillover effects of airline delay--the inability of airlines to adhere to their schedules complicates air traffic control.

Speaking of which, the airlines argue that the air traffic control system is antiquated and that this is contributing to air-traffic delay. I find this implausible, because the the system, though operated by the government, is 90 percent financed by taxes on aviation fuel. If the airlines want a better system, they should support rather than oppose higher taxes.

Posted by Richard Posner at 09:03 PM | Comments (27) | TrackBack (0)

Why Air Transportation Delays? Becker

The past few years, and especially this summer, has seen loud and frequent complaints against American airlines because of flight delays, cancelled flights, lost baggage, poor on-board service, overbooking, and other problems. Only 68% of airline flights were on time in June, down from 73 % a year ago, and complaints in June rose almost 43% compared with June 2006. Let me try to add to Posner’s fine discussion about why this has been happening.

It is no surprise that the quality of airline services declined after deregulation of air travel took hold in the 1980's. The Civil Aeronautics Board that controlled the airline industry prior to deregulation severely restricted the degree of price competition among airlines. So the main way available to airlines to attract customers from competitors was to offer higher quality services, such as better food, shorter check-in lines, more empty seats on a typical flight, and the like. After open competition on ticket prices became common due to deregulation, airlines naturally cut back on most of the services that had been provided because they could not compete on price. Of course, lower prices and greater competition made air travel available to millions of men, women, and children that would have been financially out of their reach under the old system.

That is, the greater price competition brought in the marginal customers that Posner considers who have lower incomes, and who are much less willing to pay for better services. To some extent, special airlines, such as the now defunct Peoples Airline and Southwest, began to cater to younger and lower income customers by having only cheaper economy seats, longer delays at check-in, simpler (if any) food, and more crowded flights. The major airlines, like American and United, tried to meet this competition while at the same time offering superior service to first class and business travelers. Indeed, under competitive pressure, they even improved some of their services to premier customers, including faster lines for them to get through security checks, special rooms where they could be more comfortable while waiting for flights, and faster baggage delivery. But even first class passengers could not avoid flight delays, break downs of air conditioning on planes, and other recurring problems in air travel.

One obviously important factor in the especially rapid deterioration of airline services during the past few years is the awful financial situation of practically all airlines- there are a few exceptions, such as Southwest. As bankrupt and other financially weak airlines struggled to stem their losses in the face of steep rises in the cost of fuel, they cut the number of employees serving customers either directly or indirectly, reduced the number of their flights, eliminated food on most of their domestic flights, and made multiple other reductions in services to reduce costs.

Another factor behind the deterioration in services during the past couple of years is the large increase in occupancy rates on planes. When planes are running at or near capacity, even small weather, security, or other shocks to the system can create major headaches. With high occupancy rates, it becomes difficult to rebook on other planes when flights are cancelled, baggage delivery is slowed and more baggage gets misplaced, the limited number of toilets on flights are more intensively used, and have become dirtier and more likely to clogg up, overbooking grows to a much bigger problem, and delays get longer even when the number of flights do not increase because some passengers and baggage are late for connecting flight. In many other ways as well, flights are just much more uncomfortable when all or almost all seats are occupied.

The inconvenience to customers of high occupancy rates is made worse by inflexible prices charged to airlines that gives them various rights at airports. For example, take off and landing fees for commercial and private planes are largely determined by the weight of an aircraft, are fixed in advance, and they are not sensitive to variations in the cost of using airports at different times. Weight-based fees encourage smaller planes to clog runways during peak periods whereas they should be encouraged to use off-peak times. If airports charged higher fees during busier times of the day and on busier days, and if they made some adjustments of fees when there is bad weather and other causes of delays, airlines would be induced to stagger their flights more than at present over a day and during the week, and perhaps even to adjust their schedules to expected to weather conditions. More flexible prices in turn would particularly help flights with the largest number of total passengers and more first class and business passengers since airlines would be willing to pay more for these flights in order to get them priority positions on take offs and landings.

Posted by becker at 04:21 PM | Comments (5) | TrackBack (1)