Convergences

State of Biotech

To the extent that the health care debate thinks about biotech, the focus is on how quickly generics can be introduced so as to cut immediate costs.

Back in the real world, investors seem dubious about the industry. Xconomy is running a series and concluded:  "Luke did a massive analysis of the financial health of all the public biotech companies we follow the Boston area and the news… Well, it wasn’t good." The situation:

Even though jobs have been cut, drug candidates have been shelved, and some last-ditch partnerships have been struck, all that frenzied activity didn’t really add up to a strengthened financial future for a majority of the region’s money-losing companies. The cash crunch has prompted a couple of Massachusetts companies to fold this year . . .  a couple more to sell out for a pittance . . .  and one company that actually improved its financial position to move to Wisconsin . . . .

Rather than worrying about sharing the wealth, the political system should be worrying more about how to produce the wealth in the first place. The Xconomy report is not exactly a harbinger of Spring.

Understanding the Financial Crisis

Econ professor Russell Roberts of George Mason advises:

The latest issue of Critical Review is must reading. It's devoted to the financial crisis. It is fantastic.

As a regular imbiber at Cafe Hayek, where Roberts and fellow GMU prof Don Boudreaux hang out, I have already ordered my copy.

Industrial Policy -- Health Care Investment

In the torrent of words over health care reform, insufficient attention is paid to the reality that whatever is enacted will constitute industrial policy toward a major economic sector, which by its effects on investment flows can determine whether that sector flourishes or stagnates:

Finance pro Tigerhawk makes this point in Innovation After Obamacare:

Will a "reform" plan reduce the rates of return on investment to pharmaceutical and medical technology companies and, even, physicians? If you cut costs to the "system" (which is different than to the economy taken as a whole) by reducing returns to drug and technology companies, then it follows ineluctably that it will be relatively more difficult to attract capital to develop new drugs and devices. Fewer projects will meet the requirements for expected returns, so fewer projects will get funded. Same thing for medical devices. As I wrote in my 2007 post "a few questions for health care reformers," reform advocates need to explain how much reduction in innovation ought to be acceptable. Some surely would be if the result were massively lower costs and universal coverage, but even those benefits would not be worth technological stagnation.

Tigerhawk also notes that the government is squeezing the providers, dumping costs on them in a way that must inevitably decrease the quality of future care by discouraging entry by competent professionals.

This is the world's oldest government ploy -- find some sunk capital that is not easily withdrawn, whether in the form of industrial facilities (such as grain elevators, in Munn v. Illinois) or medical professionals' education costs and time, and then take it by regulation or taxation. It works in the short term, at the expense of the long. (Of course, then the pol can complain about a "capital strike.")

I make a related point in Saving the Goose: Intellectual Property and Follow-On Biologics (FOB), CLI White Paper (Sept. 17, 2008), where I argue that third-party payers do not want expensive treatments to exist because they create political problems. Rationing by non-existence is the easiest course.

So far, the stars are not looking favorable for a good outcome here -- a deliberately chosen image, because astrology has more rational content than much of the health care debate.

Nationalization as an Irrelevancy

The debate de jour is whether the banks, primarily Citi, should be "nationalized," in the sense that the government should take over their operations.

But the question is distinctly secondary. Citi's market value is already at zero; its stock market cap of about $10B reflects a bet that the government will in the end pay some money.

The real question is, what to do about the bond holders. As of 3Q2008, John Hussman points out that Citi had $560B in debt, which provided a huge protection for its customers.

The Fed seems to be bobbing and weaving to avoid inflicting any losses on these creditors. But this is silly. People who want risk-free debt obligations buy government securities; purchasing any private instruments involves accepting some risk in exchange for a higher return. Now that risk of loss has come home, and the Feds have got to stop pretending that any private investor is going to put more equity into the bank so that it can promptly be gobbled by the claims of the bond holders. And the Feds themselves should stop doing so. Protecting customers, including depositors, makes sense. Protecting bond holders does not.

The Education Bubble

Infectious Greed links to a chart showing how college costs have far outstripped increases in income since 1981, and argues:

Can there be any doubt that this cannot continue? While higher education sits apart from much of the credit crisis, or at least has so far, it will have its turn. To the extent that its costs are predicated on income from loan-fuelled students, and its operations requires further cheap credit, that will steadily (and in some cases speedily) change in the coming years -- or at least that's what I try to convince myself.

A commenter addresses the bright side:

OTOH, college is a great place to warehouse adolescents for four years before they swell the unemployment rolls, it keeps otherwise low-value collectivist academics employed way above their open-market value, and it makes it much easier for the CDC to track outbreak vectors of new-variants of popular STDs by localizing the mating pools.

Now It's The Economists' Turn

Lawyers are used to being good sports (or at least trying) when they hear for the zillionth time a second for the Shakespearean suggestion: "The first thing we do, let's kill all the lawyers."

Now it's someone else's turn -- the economists. As a Times Online headline says:

"Economists are the forgotten guilty men: Academics - and their mad theories - are to blame for the financial crisis. They too deserve to be hauled into the dock."

Infectious Greed alludes directly to Shakespeare in "First, We Kill All the Economists":

My frustration isn't so much the schoolyard silliness, but the demonstrated inability of prominent economists to talk to one another in the same language with words meaning the same thing and not freighted with a metric ton (or ten) of political baggage. . . .  If nothing else, however, one benefit of the current depression is that whatever meager value macroeconomics was thought to have as a prescriptive discipline is thoroughly shot.

IG links on to "On the Failure of Macroeconomists" at the NYT:

For the past month or so, I’ve made it a habit to ask fellow economists how the response to the financial crisis has been improved by the past few decades of macroeconomic theorizing. Dozens of conversations later, I don’t have much to report.

It is a worthy debate, since the economists do indeed have much to answer for.

Besides, we lawyers need a rest. Yeah - go get'em. They went thataway!

Blaming the Market

A theme running throw much commentary on the financial crisis is that the free market has brought us to this pass, so therefore we need to unleash hordes of regulators.

Financial analyst and blogger David Merkel tosses a bucket of reality on this budding meme.

5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.  First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.  Our dear government had many lending programs pre-crisis, and even more post-crisis.  They further encouraged the increase in debt through the tax code.

Why is debt finance tax deductible, and equity finance not?  What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?  Leverage would have been a lot lower, and the system would be a lot more stable.

Market efficiency means many things.  In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.  They reveal problems that need to be solved.  Some might call those market failures but they aren’t.  In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.  The visible hand, the government, says: “Have some more of the hair of the dog that bit you.  We need lower mortgage rates.  We need more consumer lending.  We’re going to borrow more than ever before in an effort to create prosperity.”  Caroline Baum takes a similar view, and as usual, she expresses it well.

Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.  Some things become revealed as truly public goods that the government needs to regulate.  But that is not the majority of human actions.

This was point #5 of 7 -- the others are good, too.

Who Said It?

Excessive intervention in economic activity and blind faith in the state's omnipotence is another possible mistake.

True, the state's increased role in times of crisis is a natural reaction to market setbacks. Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent.

The concentration of surplus assets in the hands of the state is a negative aspect of anti-crisis measures in virtually every nation.

In the 20th century, the Soviet Union made the state's role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated.

Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors and shareholders for their decisions, is being eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state.

And one more point: anti-crisis measures should not escalate into financial populism and a refusal to implement responsible macroeconomic policies. The unjustified swelling of the budgetary deficit and the accumulation of public debts are just as destructive as adventurous stock-jobbing.

Sounds like Rush Limbaugh, or perhaps someone from AEI? Maybe even Cato?

Actually it was Russian Prime Minister Vladimir Putin, speaking at Davos. It seems a bit odd to look to Moscow for a counter to the dirigiste spirit of Washington these days.

Putin also noted:

In the last few months, virtually every speech on this subject started with criticism of the United States. But I will do nothing of the kind.

I just want to remind you that, just a year ago, American delegates speaking from this rostrum emphasised the US economy's fundamental stability and its cloudless prospects. Today, investment banks, the pride of Wall Street, have virtually ceased to exist. In just 12 months, they have posted losses exceeding the profits they made in the last 25 years. This example alone reflects the real situation better than any criticism.

Whew! It's certainly good that he wasn't feeling critical.

Don't Just Do Something . . .

The Group of Thirty (est. 1978) is:

a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. . . . It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.

It just issued Financial Reform: A Framework for Financial Stability, which "addresses flaws in the global financial system and provides 18 specific recommendations" for additional regulation.

AEI's indispensable Peter Wallison raises an emperor's clothes type question in Regulation without Reason: The Group of Thirty Report:

A good summary is that bank-like regulation would be spread beyond the banking industry. But there’s a problem: banks have been tightly regulated for years, both in the United States and Europe, and of all the institutions hurt by the financial crisis, they are in the most trouble. How do the bankers, academics, and financial policymakers who make up the G30 deal with this? They don’t. In the wake of this report, the principal question that Congress, the Obama administration, and the American people should ask is why regulation should be extended to most of the major players in the financial system when it has been a consistent failure for banks.

One should also ask what existing regulatory authorities went unused. For example, Warren Buffet issued his classic characterization of derivatives in 2003:

other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with  derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly
multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our
owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

So why didn't any of the regulatory agencies pick up this hint and try to introduce some transparency? Come to think of it, where was the Group of 30? Perhaps a little Maoist self-criticism is in order.

The Rich Get Richer

Or at least they get poorer more slowly. During 2008, "hedge funds were down, on average, 19% in 2008 (vs. 42% for the MSCI World Index)."  The full study is Credit Suisse/Tremont Hedge Fund Index, One for the History Books: Hedge Fund Performance in 2008 (Jan. 2009).

The hedge funds sort of promised to make money in all kinds of climates, so some of the clients are unhappy, but losing half as much as the basic market in the worst financial gale since 1930 is not bad.

Of course, it is possible that some illiquid positions have not been marked down far enough, so perhaps revisions will be made. But that could cut in either direction. The panicky flight to liquidity may have caused excessive markdowns in some assets.