Follow The Money

See the WSJ article below of 4/2/2024

Why Treasury Yields Are Rising Despite Rate-Cut Expectations – (Paywall, Subscription Required for full post. Link opens in new window.)

It is an embarrassment of the poor education in economics possessed by leading journals’ feature writers particularly in modern macro economics when they opinion-ate on fundamental issues such as inflation. They seem to be unaware that current issues have rich legacies that identify clear policy dilemmas with important consequences.

In the late 1970’s and 1980’s, the “rational expectations” revolution plugged many of the holes in post WWII macroeconomics. There are, of course, many variations to take into account how and when the public incorporates public information into its expectations. Surely daily information on the economy is actually doing, and which policies are being implemented at Federal and State level must enter their expectations. It is quite reasonable to suppose that they take these data into account.

Those expectations have a meaningful, non-trivial impact on the decisions of private economic agents. The implications for inflation and deflation should not be ignored. Policy makers who ignore this aspect of the private sector’s behavior are doomed to make policy errors. We may well be on that course again.

We are now foundering in the wake of a Fed, determined to bring inflation rates down into the 2’s, while at the same time buying large parts of the Treasury’s massive issuance of debt that finances untempered, politically driven, Federal Budget deficits. In recent years the Federal Debt has doubled from 17 trillion to 34 trillion in response to this unrelenting bi-partisan appetite. The parties differ on who the winners and the losers should be, but they agree on view that the Federal Debt Level should never be a compelling reason to limit “what your country can do for you!” (The conclusion of JFK’s remarkable 1961 Inaugural has surely been forgotten in recent Administrations).

It should be required reading (and hopefully understood) by economically inclined journalists to study the magnificent little volume by Nobelist Tom Sargent (“Rational Expectations and Inflation”) published in 1986.

The dilemma of monetary policy when singly focused on interest rates or HPM, with no consideration for the excessive fiscal expansion of recent years comes out of the closet in this economically cogent gem!

You might be surprised to learn that in 1923/1925, five European countries stopped their inflations cold (even hyperinflation) by tight budget control and restraint of HPM. Plugging one hole is not enough. The public has to believe that policy has been changed in both domains. The Central Bank cannot do it by interest rates alone, and The Treasury has to control excess spending which means either raising more tax revenues or not funding every political whim.

When the public catches on, tighter HPM will and does work, but what is needed is strong evidence that the Treasury is not marching to a different drumbeat. Sadly, our Fed and the Treasury have been reading different musical scores!

Keynes knew that and said so in his 1924 book, MONETARY REFORM. The French knew it when trying to stop an inflation before it blossomed into a full hyperinflation in Post WWI.

In Sargent’s tour d’force are featured the abrupt stop of hyperinflation in Germany, Austria, Poland and Hungary; and, the prevention of inflation in Czechoslovakia.

Keynesian theory labored in the 1960’s thinking that Fiscal Economics was like Coach Lombardi’s “only thing.” Friedman’s 3% annual expansion of the Money Supply presumed a non-inflationary excess in the Federal Budget. But, current Fed policy labors because excessive spending is not a little “mouse that roared.” It is a rather big Lion that will eat our lunch and us too if not controlled.

Perhaps the saddest part of the lack of budgetary control is the continued bribery paid to Congress members in the form of Earmarks, even for legislators that in the end don’t vote for a “negotiated“ budget agreement. That kind of political payoff is emblematic of the true lack of a national interest in DC. Both sides of the aisle need a Civics lesson, a modern course in macro economics and some common sense about budget restraints.

The geopolitical world is much less friendly to the self-image of American democracy. We are troubled by Russian aggression in the Ukraine; by the increased likelihood of a Chinese military takeover of Taiwan; and, by Iranian proxies in Lebanon, Syria, Iraq and Yemen. Some of us worry that our open border in the South is a door through which terrorists with designs on US locations have now passed and through which they will likely attempt to open in the near future. The US needs a flexible Treasury, not an overspent one and immediately needed fiscal restraint The public will get the message if political leaders start playing the right music.

A few correspondents at Fed Chairman Powell’s news conferences have tried to question Powell directly with this issue. Powell is notably discrete about his luncheon partners, but this creates dubious expectations by the public. The public’s expectations about future tax and spending policies count significantly for ending inflation. Cautious ambiguity is not helpful.

Making Carbon Taxation Simple, Universal and Equitable in the USA

A recent Mid East seminar at Columbia featured a fascinating presentation by Jason Bordoff, the leader of the Columbia Global Energy Center. Unfortunately, due to technical and time constraints, there was little time to discuss the relative efficacy of carbon taxation or its current policy substitute, carbon trading.

Carbon taxation (or carbon trading) is now common but not uniform at all among many industrialized countries, but is likely to become more addressed as concerns about global warming become more amplified in democratic countries.

This script is based on a recent, rather extensive review of the subject by Professor Govinda R. Timilsina (also of the World Bank) that is published in the current edition of the Journal of Economic Literature 2022 60 (4) pp 1456-1502. The review is comprehensive both in terms of the author’s text but also for its extensive Bibliography on these issues. My purpose is to focus attention on the political economy side of Carbon Taxation rather than to elaborate the Timilsina survey.

  1. Carbon taxation makes sense even if one doesn’t subscribe to all the alleged “findings” in the growing literature in Climatology and the current public debates over the incidence and implications of global warming. One doesn’t have to accept the most extreme global warming “findings,” to be in favor of more rational taxation programs for hydrocarbons as there are other benefits to a rationally implemented, long term policy contour of a generalized carbon taxation format for both the United States and for other countries as well.
  2. Internationally, it is unlikely that all countries will implement an identical carbon tax profile and to some extent, this is not detrimental to the success of carbon taxation. It allows poorer, less industrialized nations a longer period of wealth growth as smaller contributors to the world’s emission of various hydrocarbon gasses and particulates. It will also allow them to raise the relative price of carbon emission as their national wealth grows.
  3. A striking benefit for carbon taxation as compared to the trading of carbon emission permits is that a uniform carbon tax rate that escalates over time is its automaticity and comparative lack of a centralized and growing bureaucracy to police the various aspects of carbon trading permits. In principle, one can achieve roughly the same result from either system, but trading the rights to emit carbon gasses involves substantial regulation and enforcement personnel—in short, an enlarged bureaucratic functions. All that is required is a clear statement of the rate of the carbon tax for each form of the many hydrocarbons in a mature, industrial economy. The carbon content of natural gas, or gasoline or diesel or fuel oil is a scientific datum, so the beginning tax rate can easily be determined for each type of fuel. What perhaps matters more is the gradient of the curve that describes the tax rate over time. Presumably, the tax rate should grow in concrete steps as the costs of hydrocarbon emission rise and as the desire to “clean up the environment” seems to grow apace. We see that program as extending over say a 30 year or longer horizon as we gain knowledge about the social costs of emitting hydrocarbons. A long contour also incentivizes private agents to modify production processes and the actual products that use hydrocarbons. How steep the time curve of taxation should be or the intervals at which the tax rate increases can be settled in a nationally held debate over costs and benefits.
  4. Tax universality—In our view, everyone should be subject to the tax because rising carbon taxes should motivate users to reduce their consumption of hydrocarbons in whatever form they arise: driving a car or truck, consuming electricity derived from a hydro carbon input, taking a plane or train or bus trip; going on tour ship, or simply buying products or services whose inputs require hydrocarbons. The main issue that we see arising in the United States is the old bugaboo, FAIRNESS, with respect to the income class of the consumer. That’s the essential political economy concern.
  5. Traditional Welfare Economics attempts to differentiate between welfare economic costs even if there is no “compensation” paid. However,compensation is a politically loaded topic, and, in my view, the easiest way to neutralize the compensation issue is to rebate ALL OF THE COLLECTED CARBON TAXES PAID back to the public. That is to say, carbon taxation should not be viewed or used by politicians as a disguised income tax. Rather, it seems to me that the equity considerations militate redistributing the tax revenues gained from carbon taxation on the base of the withholding taxes paid on wage and salary income only.
  6. Various countries have instituted carbon taxation, with different rates of tax per unit of carbon emission and with different time profiles of taxation. The fact that different countries with different political systems create different “cost-benefit” implications from different tax rates over time is an artifact of different political systems. So be it. The real issue is health and not every country will value the incremental benefit of restricting carbon emissions. For the United States, there is an issue that could be resolved within the understanding that it is a Federal not a State issue that should fall under the interstate prohibition of barriers to trade between separate States.
  7. A Federal Statute that levied the same tax rate and time profile would be highly desirable. It would achieve a badly needed uniformity for the penalty of emitting hydrocarbons as between states. Presumably, States that feel more strongly on ecological grounds could add their own additional time profile and we might hope they would remit proceeds similarly rather than use State carbon taxation as a State revenue device. They could refund by using their own State income tax structures. At the least, a Federal minimum would exist. A Federal Statute would also not require a vast bureaucratic undertaking, another benefit of universality.
  8. Ironically, I made this same proposal to Senator Al Gore at a non-partisan Economics and Environment event held in Golden Colorado in 2005 or 2006 before the release of his major social media contribution, An Inconvenient Truth. The Senator seemed to like it a lot at the time, but I am unaware of any subsequent speeches or advocacy publications by Senator Gore advocating this policy proposal.

A TIME FOR SENATE GOVERNANCE: the Powell Re-nomination

Not by whim or chance did our Founding Founders create a tripartite division of governance even though they gave significant power to the Presidency. It is time for our senior legislative body to step up to that responsibility and reject the confirmation of the Chairman of the Federal Reserve to another 4-year term.  Why?  Because he and his Board of Governors of the Federal Reserve have failed to carry out their dual mandate.

Any thoughtful observation of the recent inflation data shows that inflation is neither transitory—as the current Chairman has previously asserted it would be over the  past year—nor is it anywhere close to the self-proclaimed 2% boundary that the Fed had so often stipulated for inflation governance in the past. It is well past the time that the Senate carried out its mandated  (Constitutional) task of “advise and consent.”

Failure to reject a Powell second term would be a feckless concession to Executive power and another long step down the path of faulted political governance. Sadly, but likely, we should anticipate another failure by this present Senate.

The only reason that key Senators in the confirmation process could possibly evoke is that a failure to confirm Powell now might produce an even less qualified and “woke” nominee!  The evidence of that likelihood are this President’s other nominees’ to other important financial positions. Specifically, Ms. Raskin’s pending nomination and strong doubts concerning the orientation of Ms. Lisa Cook’s nomination to the Fed’s Board of Governors.1

If the Senate confirms the Powell reappointment it will have failed to assert the responsibility given it by our Constitution. If it denies the reappointment, it will have to face the likelihood of a rudderless Board of Governors at least until the November elections when its voice can be important in telling this President that he must act prudently in finding a more adequate leader of the Fed. A rejection now could accelerate a more reasonable appointment process to begin earlier!

  1. Professor Harald Uhlig has recently posted a strong letter on that nomination in a recent Wall Street Journal opinion column. “The Fed doesn’t need a Censor,”
    The Wall Street Journal 2/13/2022. []

The Fed on Trial

The Powell Fed deserves Talleyrand’s opprobrium of the Bourbons: “learned nothing and forgot nothing.”

Some sixty- odd years since Friedman and Schwartz published their monumental tract on the monetary history, this Fed believed and populated its belief of transitory inflation after the greatest monetary expansion in US history. All this while Powell’s renomination for another 4 year term as Fed Chair awaits Senate confirmation.

A Senate approval will be an unthoughtful victory for those who relish a triumph of politics over economics. But, is that a victory for good governance? What should we expect from a Fed that thinks that Global Warming and the pursuit of Diversity trump the already abused dual mandate of restrained inflation and maximum employment?

The only issues now are how big a jump in the Fed target rate we will get on March 16, if not before? How high will the target rate be pushed? Will balance sheet contraction get onto the Fed’s policy horizon?

The Fed has created far more market uncertainty by its laggard monetary policy actions and its attraction to being a significant agent of social change. As a Central Bank, this Fed has gone far beyond legendary Chairman William McChesney Martin Jr.’s obiter dictum that the Fed “is independent in Government.” Martin at least had the courage to defy LBJ and raise interest rates by 50 basis points in 1965 despite a trek to the President’s Texas-ranch as the Viet Nam war heated up spending.

The Fed’s actions should make Senators who will vote on Powell’s re-nomination think carefully. Do they really take Central Bank independence seriously? Or, are they happy that the Fed played a significant role in unleashing the cruelest “tax of all”— inflation?

If a Company underperformed its projections as badly as this Fed, an activist Board would find another CEO. That would be standard corporate governance. The Senate can’t fire the President, but it could give a vote of “no – confidence” on the President’s CFO! That is unlikely, but re-confirmation is a bad example of proper governance over America’s central bank.

Cosmetic Economics and Politics

Written March 3 after the close of the market yesterday before the Super Tuesday Primaries results but not posted until March 4 8:36 AM

The Fed’s Move: and the market’s reaction

Widely debated by the savants of economic forecasting at the end of last week, the Fed cut 50 basis points off its target rate. This came after a kind of coordinated mouthing of mutual support by various countries in the G-7, but no substantive policy change. Australia, hard hit by China’s massive slowdown had already cut their rate prior to the G-7 communique and the Fed’s announcement and press conference. Continue reading

Ostrich Policy: escalating the tariff war with China

The present Administration wants to talk and act tough with China and has deployed various tariff and other economic tools to induce China to change some of its most important trade policies. China currently requires the transfer of American technology as the price of a firm’s “admission” into China. We don’t think that our campaign for IP protection offers a good prediction on how the Chinese will ultimately respond to our charges. We think that “selling that story” to the U.S. voter will make it much harder to achieve the goals we have set for ourselves in this current commercial policy war. Continue reading

The Fairness Doctrine and Economic Change

Formal economics used to be almost entirely devoted to issues of the allocation of scarce resources.  A subset of inquires, usually called welfare economics, frequently explored how  different allocative schemes affected economic welfare.  Welfare, however, had a rather arcane meaning in formal economics because inter-personal comparisons were generally frowned upon in formal theory and applications.   To get around the “dryness,” of such studies, economists adopted a compensation principle where by if at least one person was made better off and none worse off, then welfare was improved.  This skirted the issue of “fairness,” or as some wrote about it, of “justice.”   What if compensation by the winners was not paid to the losers after an economic policy change?  A mere glance at today’s media tells us that issues of “fairness” rule the day, almost to the exclusion of discussions of efficiency.   Social change is often motivated by issues of fairness and politicians of every stripe place fairness at the top of their choice menu.   But, what is fair to one person, clearly could be unfair to another.  Moreover, the achievement of “fairness,” brings with it economic costs.   The latter are often ignored, but the consequences should not be.   To truly be fair, we need to evaluate the cost of achieving fairness, however it is defined.   This is the first of a series of notes that discuss aspects of the linkage between fairness and efficiency in political economy.

Continue reading

The Independent Fed is “a riddle wrapped up in a mystery inside an enigma”

At a time when many fed-up voters in the UK seem to want to get out of the EU, it seems appropriate to use a Churchill quote to describe the utterly dependent nature that our Federal Reserve has chosen to acquire.   Yes, we have a nominally independent Central Bank—that is to say that once the politicos have nominated and approved a member of the Board of Governors, they technically vow to keep their “hands off.”   Of course, neither really allow a Fed to be independent, and it is hard to say that the shrill voices from 1600 or the Hill have no affect on the voting behavior of Governors. Who really knows how the Board comes to its conclusions?   If you still think the FOMC is independent, ask the Regulatory wing of the Fed if it operates as a deaf mute!

That said, 50 years ago or so, the talk in US monetary policy debates among academicians and central bankers who seemingly agreed that a Central Bank had to be politically independent and should make its decisions based on the fulfillment of whatever chartering mandate it was given.   Is it not strange, therefore, that the current FOMC finds that “international considerations” have now paralyzed its rate-making decisions? After a feeble 25 basis point (“bp”) raise in December, the FOMC has staggered and stuttered, looking around the world at what other enfeebled CBs are doing and has paused and paused and paused.   Talk about ‘waiting for Godot.” Meanwhile, rate-starved fixed income holders now have the privilege of paying their respective governments in Germany and Japan for the privilege of making their savings available over the next decade. Nearly nothing for the insurance in Germany (3 bps) but 8 bps in Japan, a far cry from holding government bonds as a default-risk free investment with a nominal positive yield.   Surely, they would have been better this year to buy Gold and stick it in a bank vault!

Meanwhile, for a Fed now fully engaged in the regulation of bank balance sheets in order to root out (still undefined) “systemic risk,”  what has happened to independent monetary policies? The answer is quite simple.  They no longer exist—and returns to Americans who wish to invest in default-risk free 10 year Govies are shrinking as well.

Oh, well—why not throw out everything we ever learned about monetary theory and policy?   If such policies don’t work (according to the Fed), there’s no point holding on to them, is there? One might ask to be shown the theory that has replaced older thinking on monetary policy, but it is to be doubted that the question would  even be heard in the board room at the Fed.   It doesn’t seem like they have a theory that governs their policy making. Maybe they are too busy telling each other how they are preventing systematic risk via their new “stress tests.”

Well, why should central banking be any different from Health Care, Internet policing, Environment Protection, and Pharma Controls?   We have entered the Grand Regulatory State—no point studying Macro anymore…it is irrelevant because the Fed is a totally Dependent Creature—as are we all in this highly regulated political environment.   We must speak correctly, we must invest correctly, we must be correct on our identification of the soldiers of terror.   We are all now quite correct, are we not?  A riddle? Yes. A Mystery? Yes.


Mr. Prime Minister: we need an Enigma Machine to read the Fed’s Code.   Please re-open Bletchley Park and start cracking it for us.

The Economic Costs of the Regulatory State: ‘a little hole in the dike can be as damaging as a big one. Just give it time.’

The troubling antics of the remaining three contenders for each party’s Presidential nomination have forced me to detour from postings on far too long. Governance issues have been capturing my full attention. Let’s direct some comments to their economic policy recommendations.

Each candidate speaks of doing something for those who feel underserved or even left out of the economic benefits our economy creates. Their substantive proposals amount to two sorts of “cures.” One is to blame someone or a class of “someones” for poor economic outcomes and the other is a continuing advocacy of ‘once size fits all’ remedies—more government intervention. Actually, all three wish to use the government to “do something,” with little or no recognition that government interference is not costless to economic growth. On the contrary, increased regulation has undoubtedly contributed significantly to lower economic growth. A smaller pie, even if redistributed, is not a winning economic strategy.

The two Democrats, Clinton andSanders both argue for more government intervention, more regulation and heavier taxation (albeit more “progressive”).   Trump also argues for government intervention. He wants to punish the Chinese and other “foreigners” for American job losses. He even wants to punish American firms who relocate production overseas. Traditional Republican support for free trade has been eviscerated,  free traders have little to choose between the two parties. Restricting trade is a sure fire method to reduce growth.

One expects Democrats to try slicing up the economic pie and redistributing it to pay off the various political minorities and interest groups that Democrats depend upon to win public office. By assigning much of the blame for the 2007-2008 financial meltdown to greedy bankers, evil mortgage companies and mortgage brokers and other profit seeking financial intermediaries, Democrats don’t look deeply, if at all, into the role played by much faulted government housing policies. They continually advocate more regulation, not less. Meanwhile, instead of attacking the increased interference and regulation that deters the formation of new business enterprises, the Trump response is that voters need to pick a Winner instead of sticking with Democratic losers. Is that a policy prescription or a denial of how the economy actually works?

Neither side seems to understand that government intervention and regulation does not offer a free lunch.   They seem totally unaware that the already well-laden Regulatory State costs the US substantial economic growth. Obama always argued that the US needed to become more like Europe. He succeeded beyond all measure. The US has more regulation and lower growth. Welcome to Europe, voters!

Of course, if you think that the economic pie has been distributed “unfairly,” you probably don’t focus on how to bake a larger pie. You might not even think that regulation can affect how fast the economy grows. Former President Reagan’s remark that “Government is not the solution; Government is the problem,” has long since been forgotten, even by some claiming to be market- oriented Republicans.

In recent years, however, a number of economists have been focusing on the costs of regulation and how regulation can slow and undoubtedly has slowed U.S. economic growth. When the question is, How much does a reduction in annual growth of say 1% per year actually cost the US, when that reduction continues over say a thirty five year period, the cost is staggering. A bigger pie was available, but increased regulation destroyed a much better outcome.

A recent study published on the web site (“The Cumulative Cost of Regulations,” by economists Bentley Coffey, Patrick McLaughlin, and Pietro Peretto) provides some insight. They estimate US economic growth was lowered by 0.8% per annum as a result increased regulation. Putting it more graphically, they find our economy would be 25% larger today than it actually is —-even if the costs per annum were as small as 0.8% per year. We conjecture that the annual costs might well exceed 1%.

There are many studies that show that the current level of reporting now required under environmental, health care and labor regulations pose a heavy cost burden for new, small businesses. New business formation lags in spite of very low interest rates.  Yet, it is widely understood that real economic growth comes from precisely this segment of the economy. It is also well noted, but yet unexplained, that business investment in plant and equipment has been unpredictably sluggish.   Perhaps, our declining productivity trends are not just accidents due to “slower innovation.”

These are subtle arguments but none of the candidates care or perhaps are even aware of them. They have missed the truism that a little hole in the dike can be as bad as a large one, given sufficient time. Time makes water a very powerful cumulative force. Similarly, even small decreases in annual economic growth can cumulate to a very large reduction in actual output. Increasing regulation works the same way and the US economy is badly under achieving.

It will be hard to punish the “foreigner” for our own failings. Punishing our own business sector can only worsen the problem of inadequate growth. The first step in getting well must be a proper diagnosis of our growth disease.   We become our own worst enemy when we listen to the Siren calls  for more regulation by the current candidates.




The Market for Lemons: Peaches, Phools and Phishers

The other day, a non-economist friend asked me about Janet Yellen’s husband [George Akerlof] and I was dragooned into explaining what his famous “Lemons” paper was all about.1 Then Jason Zweig of the Wall Street Journal published his interview with Ackerlof and Shiller again raising the issue of asymmetric information.2 Here is a re-think of some of the fundamentals raised by the notion of poorly informed market participants: the Phools who are Phished by competitive markets.

I missed the first edition (1970) of the Lemons paper as I had already left organized economics for the business world. In thinking about Macro most of this summer at my fire-surrounded California home, I have been focusing on what is “left out” of conventional macroeconomics. I chanced this morning to see Zweig’s note in the WSJ about Akerlof and Shiller (my former student) telling us that competition produces thievery and questionable products offered by “tricksters.” The timing of the interview, coming after the incredible disclosure by Volkswagen that it had tampered with the results of EPA pollution tests on its diesel cars underscored the “trickster” nomenclature. Score one for Zweig’s timing. Still, the underlying critique of competitive markets is a long-standing thread among social reformers and also has its place within the economics profession. The Lemons paper is part of that thread. The issue is the relevance of that model for consumer well being.

I don’t remember Adam Smith or Milton Friedman or George Stigler telling us that competition abolished all the less desirable traits of humankind. I thought their message was that the social good was promoted in spite of the knavery of the butcher, the baker and the candlestick maker. I don’t believe that the Wealth of Nations pretends to be the description of the perfect society—perfect in the sense of the much-desired Kingdom of God. Nor has the constant rant against competitive capitalism produced a demonstrably clear alternative that has stood the test of time. The absence of a demonstrated alternative must then mean that we must evaluate the success of competitive markets not as an abstraction but as a comparison to other likely systems of organizing economic activity.

Moreover, I thought the central theme of many writers since Smith was that the motives of individual market participants are to a large extent not relevant in creating a plentiful supply of goods and services that are efficiently priced. Of course, it is the word “efficiency” in the last sentence that sets the roosters to crowing that something new is feeding in the barnyard. Did Smith leave out Phools and Phishers now current in behavioral models of human action? Must we now pay close attention to such individual behavior in order to evaluate competitive market outcomes? Let me back up a bit.

Having been asked to explain the Lemons concept, I did so, but I wanted to be sure I got the essence correct. This morning, I decided to check if I had rendered the Lemons story properly in lay terms, and went back to look up the famed Ackerlof paper. I didn’t have the time to read through the original piece. Instead I skimmed the Wikipedia summary for its central finding: using the Used Car Market as the example, the contention was that the “peaches” are driven from the market, meaning that the market only consists of lemons!

Admittedly, the asymmetric information model has always bothered me—e.g. the small businessman gets an “inferior” loan deal because the banker knows less about the potential borrowers’ true state. Why? I was a small businessman and I borrowed. Was I then a Phool? Did I get taken-in by my Phisher banker, or did I search for the best deal I could find considering my own idiosyncratic circumstances? Did my banker trick me into accepting an inferior loan? Back up to the Lemon’s truck. Presumably a rational businessman checks the credit opportunities open to him. He chooses from the alternatives open at the time. It could be a Lemon, a Peach or a Prune.

What happens to the peaches in the market for lemons? They must be piling up somewhere in the universe—like the third order of smalls we keep throwing away in most empirical studies. (I always feared that the Kingdom of the delta squares and the delta cubes would somehow bring the entire universe down on our heads. Conservation of matter must have mean something. Maybe it will be a squishy with peaches instead of raindrops falling on our heads?

What struck me this morning as I feared to look at the market smashing my paper wealth to smithereens was that Wikipedia never said anything about what happened to the peaches except they were driven from the market.

Where did they go? I mooted the possibility that there were so few Peaches on the used car lots of America that the intrepid used car salesmen themselves drove them home instead of selling them off to customers. But clearly, lemons to peaches is some sort of a quality continuum. However many cars are sold annually on the used car market, I have never seen a special lot where only Peaches are sold, nor do I assume that every used car lot consists only of Lemons waiting for a Phool. Am I wrong? Maybe all of the last two decades of specialized car lots that warrant everything but the VW diesel’s actual pollution emissions, are filled only with Lemons (that of course may now change)? How can that be? One answer is an undersupply of smart used car salesmen. Somehow, that is not a satisfying answer. Something is left out of the original characterization of how the used car market works.

Moreover, as I thought about the Lemons problem, I was reminded of the similarity of standard Chicago stock-flow problem that Milton Friedman used to ask us to solve. Think about it. The market in question is for used cars—and let us ignore the fact that a used car, even a Lemon, represents a household capital item. For now, just focus on the flow market for used cars.

The cars start off largely in an auction market where new car dealers are shedding the trade-ins that they deem unlikely to sell themselves. The Used Car Mavens at the auctions rip that market apart, pricing Peaches and Lemons appropriately. The New Car Sellers have some knowledge of the value of a vehicle (whether it is Peach, a Lemon or some other kind of fruit) and their objective is to clear their own lots. (I guess they hold back some of the Peaches themselves—but if that is true the entire structure of the Lemons theory kind of falls apart). So let’s just say, be it a Lemon, a dried up Prune or a fresh, firm juicy Peach, they all show up at the auction and the omnivorous Used Car tribe devours each of them at whatever price they can get away with.

For a trade to occur, there must be a willing seller and a willing buyer—both somewhat knowledgeable—although in this case the Used Car tribe must be at somewhat of a disadvantage themselves, since they have but a short time to inspect the available vehicles which represent only the ones the new car dealers don’t wish to carry on their own lots. Still, the market clears.

Now, the collage of fruit shows up on the Used Car Lots of America. Fearful buyers (the Phools) begin to shop, in terror that they will be stuck with a Lemon. According to the original version of the theory, the Peaches have disappeared. Competitive equilibrium thus leaves us with a highly inferior outcome. Only the Lemons survive!

That’s what still bothers me. We are purportedly measuring a flow demand curve and supply curve, but the observed supply curve is missing all the Peaches. How can that be a sustainable equilibrium? The theory says that the actual price paid is some sort of a combination of Peach and Lemon prices—but then the Peaches go somewhere—and all that is left are Lemons. This is clearly an incomplete characterization of how the used car market works today. I doubt it worked that way in 1970.

The Lemons theory without an adequate specification of true stock-flow equilibrium, throws a spanner into the works. The model is incomplete in a crucial way and welfare implications drawn from such a model are likely to be highly suspect in the best case, totally erroneous in the worst case.

The Lemons problem, structured as it was in those days, was a kind of incomplete game. Yet, a flow market is clearly a repetitive game in which learning must be taking place on both sides of the market. Suppliers gather information from yesterday’s outcome and buyers learn about faulty transmissions dropping out of their neighbor’s used cars. Thus, any inference drawn from the actual observed prices of used cars must somehow incorporate that prior learning which goes on day by day. Indeed, that explains the evolution of the Used Car Market today—a huge change from the mid 1960’s. Now reputational capital supplied by national used car dealers—public companies now as well—is involved in an efficient pricing game, with warranties and ‘take back’ policies available to a complaining Lemon buyer. And, as far as I can tell, the stock of Used Cars doesn’t have a special lot only for Peaches either.

Dynamic Stock Flow equilibrium seems to sharply weaken the asymmetry case. Learning behavior is absolutely critical to understanding the behavior of market participants. Yesterday’s Lemons are not just thrown away. Somehow, they get incorporated into the pricing of currently available used cars. Their values rise and fall upon much more comprehensive knowledge about the performance of various models and makes and vintages. Dealers who specialize in selling Lemons to Unwitting Buyers must achieve something of a reputational equilibrium as well. Why would we think the Buyers who talk among themselves over time, so to speak, don’t know which dealers have better fruit and what the price of damaged fruit ought to be?

Still, however, we get the assertions from very learned and honored economists who claim the competitive model leads to flourishing thieves who prosper while Phools suffer. No one seems to learn. Common sense tells us that the market is made up of both—and all the rest of us in between.

Yet, pricing for quality works itself out. Better quality goods get better prices over time than poorer quality goods, while one can always find both kinds of fruit in any market. Cheap imitations of first quality goods sell for significantly lower prices. How is that possible? And how is it possible that new suppliers of varied quality enter markets with questionable quality goods—only to be sorted out by repetitive buying and selling? Apparently, even Phoolish buyers get to taste the fruit from time to time. Learning is essential in all markets over time. Nothing surprising here.

Under most conditions, the second golfer on the green, who puts last, has more information than the first to put. Learning by doing and reputational capital are permanent fixtures of all efficient markets. Otherwise, we would never get anything like an approximation to stock-flow equilibrium. Confusing an individual action and long-term market equilibrium is excusable for non-economists. Should it be for Nobel Prize winners?

PT Barnum was right, partially. A sucker is born every minute and by definition Suckers lose money. Others learn, however from those unfortunate outcomes. Over time, some of those suckers learn from their earlier mistakes and other market participants learn as well. The story doesn’t end here. The issue of who’s the fish, the sucker in the game is relevant. Are there other ways to organize trade and production that would alleviate this problem?

We need to ask, what alternatives are there to providing adequate information to markets filled with Phools and Phishers? The Government? Regulations? Here comes the Saint of non-market solutions. As far as I can tell from many years dealing with many governments in many countries, government gets its share of Phools as well. Worse, the compelling power of Law and Regulation often enshrines faulty views that are hard to extract from the regulatory complex. Furthermore, any given set of new regulations will send signals to market participants to find a work-around. The “regs” themselves set up a system of rewards and punishments that create incentives for “bad” and “good” behavior. In a public market context, this means that complex public companies have a manifold set of departments whose employees will be given inherently conflicting goals: “keep the product priced so we can sell it,” “expand output so that we can maximize profits,” and “stay within the regulations.” These are very complex instructions involving lots of tradeoffs between the letter of the law and the compensation available for those who don’t get caught.

Since we now tend to pay employees who produce the best results, we create incentives to find a “work-around ” within any given regulatory structure. Markets also tend to create larger and larger enterprises because of supposed economies of scale and scope. This leads to a complex set of organizations whose activities fall into “silos.” We then expect our senior executives and the Boards that supposedly supervise those managers to maximize shareholder value and stay out of trouble, presumably by looking down each silo to see what is going on all the way down. That creates a never-ending scenario of risk and return within which the various activities of a corporation get organized under a common capital base. Unavoidably, “solutions” occur that appear to solve the problem yet bury the inherent risk. A shock occurs and the risk certainly appears and we ask, “How did that happen?” Even a scrupulous honest senior manager cannot just look down into the silos and spot all deviations from “best practices.” We then get a “London Whale” or the “VW Fraud”—not for every enterprise, but for enough to keep journalists well paid to investigate possible If the final outcome were only entertaining investigative journalism that discloses what is not clearly obvious to market participants, the outcome would be tolerable. Sadly, we get more. Some are so offended that they go to the Government to regulate and get rid of the apparent problem recently disclosed. Some regulations do improve market performance. But, if we expect the Government regulators and legislators to be totally observant of the advice given by Caesar when he divorced Pompeia, who are the Phools?

PT Barnum was right…but the real suckers are those that believe that by saying Government or more regulations will solve such problems efficiently or in a timely manner. The evidence is in. Even regulation doesn’t avoid Lemons, even if changes where they appear.



  1. Akerlof, George A. (1970). “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism”. Quarterly Journal of Economics 84 (3): 488–500 []
  2. Zweig, Jason “Phishing for Phools’: A Q&A With George Akerlof and Robert Shiller, WSJ Jason Zweig 9/215/2015 []