07 September 2008

3 Loopholes

James Madison is to me the hero of heroes among our founding fathers. He wanted to achieve a single objective; align the interests of the ruling policy makers with the interests of the general citizenry. His intended solution was to make the citizenry the ruling policy makers.

Given the communication limitations of his time, implementation of his plan had the citizens democratically elect a representative. Madison required the representatives to then be subject to frequent re-elections so that if the citizens believed their representative was not accurately representing their interests, he or she would be replaced by another candidate.

Madison wrote our constitution trying to ensure citizens interests would always be represented in the policy decisions. The antagonist of this objective was any group that might achieve power and then exercise it to retain power so that they could influence policy decisions for their own interest.

Madison called these groups factions, realized they were always circling the peoples' government looking for an opening, and therefore he had to make the Constitution, the foundation of our government, ironclad to their devices. For a more in-depth description of Madison, Alexander Hamilton, and John Jay's attempts to make our government impenetrable to factions and protect our policy from manipulation by a ruling minority, see The Federalist Papers.

The great news is that the resulting Constitution is the longest-running basis-of-power document for any standing government. Equally impressive, it is also the shortest in length. Our Constitution has stood the test of time, the challenges of a large, growing, and diversified nation all while providing its citizens unprecedented liberties. It has had to be amended, but remember, it grants power to amend itself in a peaceful method.

Now, 219 years later, if we look closely at its hull, there are at least 3 fissures; loopholes that have begun to allow the entry and proliferation of destructive factions. These vulnerabilities are known about, but are not necessarily easy to solve, especially by a governing body suffering from their effects.

These Constitutional loopholes that allow for culmination and abuse of power to effect policy for private interest are 1) Campaign Finance, 2) Gerrymandering of electoral districts, and 3) Committee-member ranking incentives.

I will attempt to explain each of these Constitutional fissures in turn in following posts.

03 September 2008

What's wrong with Cheap Insurance?

In continuation of 2 posts prior, Securities Trading: The Wild West.

I suggest that there is a problem with cheap insurance, in addition to the problems caused by lack of regulation in securities markets.

The problem with cheaper insurance is that people will buy more insurance, and thus our economy will suffer more from the 2 market failures caused by insurance: Moral Hazard and Adverse Selection.

Moral Hazard is the change in behavior caused by insuring. If I have health insurance, I will go to the doctor more often and incur higher health expenses for my insurance provider than I would have had if I were directly responsible for my own health expenses. If I have car insurance, I will be more likely to take a few more risks on the road. Or, if I am a company and am insured under higher costs, then I will take less effort to ensure lower future costs.

Due to private information, information unavailable to the insurance provider, individuals and corporations act slightly less responsible when they are insured. Unfortunate, but true.

Adverse Selection is the tendency for a disproportionate amount of those in need of insurance to buy insurance. Those who are unhealthy or have indications that they will be sick buy more health insurance. Health insurance providers try to control for this fact by analyzing your families medical history and charging you a higher premium if there is indication that you will suffer illness and cause them higher costs. Corporations that have inside information that their profitability will decrease are more likely to insure themselves by selling securities.

Again, due to private information, information advantage of the individual or corporation, insurance providers are at a disadvantage.

The moral of the story is that while it is good that companies have found cheaper means of insuring against risk through the securities markets, the proliferation of insurance does carry a non-negligible cost. More insurance means more moral hazard behavior (less rigorous investment in the future by corporations) and more adverse selection (more junk bonds/ more securities that wind up being worthless).

Identifying moral hazard and adverse-selection behavior econometrically has long been a daunting task. It requires estimation of a system of stochastic simultaneous equations. Progress has been made however, and as can be seen in my Public Finance project on Health Care (http://mastroresearch.googlepages.com/ , (private info in health care, on the right side)), is now identifiable.

Using similar techniques adapted to the securities markets, I believe that it can be shown that corporations trading a higher volume of securities experience lower stock returns. Similarly, in the field of International Finance, I purport that countries trading a higher volume of securities experience lower growth.

Overall, cheap insurance is good, but more intricate contract terms (like HMOs have implemented in the health insurance market) or regulations are needed in the securities markets to prevent our economy from taking two-steps forward and one-step back.