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Milton J. Madison - An American Refugee Now Living in China, Where Liberty is Ascending

Federalism, Free Markets and the Liberty To Let One's Mind Wander. I Am Very Worried About the Fate of Liberty in the USA, Where Government is Taking people's Lives ____________________________________________________________________________________________ "Extremism in defense of liberty is no vice. Tolerance in the face of tyranny is no virtue." -Barry Goldwater-

Wednesday, January 23, 2008

Caveat Emptor, Moral Hazards And A long Diatribe On The Function Of Government In Transctions....

Caveat Emptor was the principle that the buyer of a piece of property is responsible for determining the fitfullness for use or habitation of that property. But it does not mean that the seller can try to 'hide' problems and not be responsible for conveying the property that has unknown defects that were purposefully hidden or unrevealed in the normal buyer review process. The principle of Caveat Emptor, was used in an 1817 Supreme Court decision in the US but has been largely replaced by the Implied Warranty of Fitness.

The value to Caveat Emptor is to compel the buyer to take a great care when entering into a contract, agreement or purchase. If in fact, Caveat Emptor was not supported, then buyers could seek to revise these after the fact through courts or coercion and this would impede the ability to enter into these contracts.

Implied Warranty of Fitness, creates the responsibility of the seller to the value of property being conveyed is useful of fit for the purpose that it is being conveyed for and that this implied warranty does not have to be supported by verbal or contractual commitments. In other words, if one goes out and purchases a bicycle, then one expects that when one hops on it, that it doesn't fall apart and actually works.

So, there is plenty of case law and one can expect that given both sellers and buyers meet their obligations, that transactions should be consummated and the aftermath enjoyed by both parties.

Moral Hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. This assumes that the costs of loss are borne by another party that may not have perfect information or may not be a witting participant in a transaction. An unwitting participant in a transaction, where warranty of performance is implied in transactions, are prevalent when governments intervene in protecting participants from losses.

For example, if a government intervenes, when markets fall, and socialize the cost of these falls, then markets have a tendency to behave by accepting more risk or volatility since some of the downside of losses is born by a third party. Banks are a great example for potential moral hazards since they are regulated by governments but are still subject to losses in time of stress. If governments always intervene to protect these institutions from losses, they will continue to behave with a riskier profile than if they had to bear the full brunt of the losses.

So therefore, if in the course of a normal transaction one still has all of the upside but some of the downside is borne by the third-party in the form of a government, then the expected return of this transaction increases. If the government was not expected to intervene, then the over the course of all the potential outcomes, heavier losses could be expected therefore lowering the expected return.

So, if one rewards certain behaviors, then one can expect more of it. So by governments protecting the downside of certain commercial transactions, they increase the chances of these things happening since market participants will be compelled to take the course that provides them with the highest potential return.

These moral hazards reach beyond just commercial transactions but also all kinds of behaviors. If one expects the government to step in during retirement years and provide cash and medical care, then there is less incentive to save today for the risk down the road that one does not have enough money in old age. If a government provides a portfolio of social services, then there is little compelling reason for a member of a community to compete by providing alternate assistance when it is already expected from the third party. This has destroyed the sense of community and self reliance and responsibility that was prevalent in the US for most of its history. Why not live as profligate as one can today and not worry about tomorrow since one expects that there needs will be taken care of tomorrow if they need it. And there is no reason to invest in community since one is no longer relying on community but on a faceless 3rd party.

So, why all the stuff before on Caveat Emptor and moral hazards? Because the US is entering a period of time where people and businesses are going to rely upon the socializing of risk. Let deal with each of these one-by-one:

1. The sub-prime mortgage and associated problems: Some people purchased houses that they could not afford to buy. But they did it anyway. Some people provided financing to these people that will prove to be a loss making transaction but they did it anyway. Additionally, prices of homes rose much higher, in general, then is actually affordable by the population of people living there and prices are dutifully declining so that people who could not afford before, now can afford to buy a home at a more reasonable price. This is how markets work. the price of an asset finds its equilibrium level. Now, if the government intervenes to support the buyers of these houses with subsidies, we are rewarding risky behavior. This kind of risky behavior is being encouraged and there will be further incidents of this kind of risky behaviors in the future. If the government support homeowners by coercing banks to subsidize these borrowers, this will mean that the banks will have less funds to lend to other customers. So they will tie up their funds in the bad lending instead of making new lending to good customers. Does not seem like a very smart thing to do.

2. Fiscal Stimulus: This is always the stupidest thing to do. Governments have very very little control over the ability to stimulate an economy even in the short-term. This is pure form over substance. I saw George bush and Nancy Pelosi sitting there with their smiles saying we are doing something for you. The thing that they are doing is like taking buckets of water out of the deep end of a pool pouring them in the shallow end and expecting the level of the shallow end of the pool to rise. It won't happen. The economy will rebound with-or-without fiscal stimulus. All that will be created is a set of winners, those getting the fiscal stimulus benefit vs. the losers, those that pay for it or have their capacity to benefit from a normal market economy reduced. In order for the government to give funds to certain individuals, funds will be borrowed to give them the money. This reduces the amount of money available to lend to other people that the market determines to worthy as customers. These people will be denied funds for their interests and will be the losers.

3. Monetary Easing: The central bank, The Federal Reserve, has the responsibility to manage the money supply in the US so that there are enough funds so that normal commerce can be conducted but not so much that there is excess money floating around causing inflation. We saw that when the Fed lowered interest rates to only 1% and kept them there, that the economy expanded and created price pressures in the housing market. However, the role of the Fed is not to support asset prices but to maintain stable prices and adequate supply of money. The risk that the Fed takes in lowering of the funds rate by 3/4% last night is to create moral hazards where asset deflation is averted through Fed action. Maybe asset values should go lower so that new buyers enter the market and take the benefit. The owners of stocks and other financial assets are not owed anything from the Fed and need to consider all the risks and not expect the Fed to support prices over the short-term at the risk of potential inflation later on.

4. Tax Policy: Not withstanding the infantile class-warfare argument by the Democrats on tax policy, taxes in the US are on balance fairly good. Most working people in the US have very little tax liability other than their wasted contributions into the social security and medicare systems. Working people, therefore largely consume all of their income and unlike people I have observed here in Asia, do not feel compelled to save for retirement or healthcare instead of consume immediately. This is not ideal since these people should also be paying for their government and it leads to shortfalls in capital formation and forces Americans to borrow from overseas. High income people, on the other hand, pay a disproportionate share of income taxes in a heavily progressive income tax code. Taxes on capital, though, in the US are too high, particularly compared with other countries. Corporate taxes in the US are among the highest in the world, forcing companies to move offshore and discouraging companies that may want to relocate here to go elsewhere. Tax policy in the US should encourage savings and investment over consumption and that is exactly what the Bush tax cuts sought to achieve. It did not go as far as it could have but was a step in the right direction. These taxes that are set to expire in 2010 have to be made permanent. Permanent cuts in taxes are a much more powerful tool to stimulate long-term investment than temporary cuts that stimulate consumption. Capital formation and saving should be rewarded not penalized since we do not create enough of it internally. Consumption is what should be penalized since we get more of it than is supported by the nation's income as indicated by the large current account deficit. Its actually quite simple. Save more and consume less. And that is what is going on right now. Its a natural market reaction to reality.

I am sure that i will write alot more on this in the very near future.


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