HodgBlog

I recently read an interesting book by James Tooley called The Beautiful Tree: A Personal Journey Into How the World’s Poorest People Are Educating Themselves, published by the Cato Institute.

This book describes how the governments of many countries in the developing world are failing to educate their children, because their government-run schools are basically worthless. The author described seeing many schools where only a small fraction of the teachers even arrived at the school on any given day, and an even smaller fraction were engaged in meaningful teaching activities (he also did careful studies that documented these problems, as well as poor educational outcomes); this system was made possible by wide-spread government corruption. Perhaps it is no surprise that everyone involved is apparently aware of the issues at the government schools, from the children and their parents, to government officials at all levels, to the international aid agencies and foreign governments that continue to give money for education to the government agencies that are running the schools. So of course, middle- and upper-class families living there send their children to for-profit private schools.

But the real surprise in this book was that Tooley found that many extremely poor people in these countries were also sending their children to for-profit private schools — low-cost schools run by entrepreneurs of similar backgrounds to the poor families, living in the same neighborhoods (rural areas or urban slums). And although these poor private schools tended to have dismal facilities by our standards (poor lighting, poor sanitation, etc.), this was more than balanced by much greater level of accountability than the government-run schools, as parents would immediately withdraw their children (and their tuition money) from poorly-performing schools. Tooley also documented, through careful study, that these low-cost private schools (so low in cost as to be affordable by workers at the very bottom of the social scale) had much better educational outcomes than the nearby government-run schools.

After reading this book, I was left wondering (as Tooley certainly intended) why international aid organizations and US and other governments would continue to pour money into corrupt and ineffective government-run educational programs in these countries. Tooley suggested instead that we direct our aid money in two directions that seemed worthwhile to me. First, he suggested setting up scholarship funds for poor children’s tuition in the low-cost private schools. The cost of such tuition per student is very low, in US dollars or European currencies, and the return in educational provision is high. Tooley has apparently already been involved in setting up one organization that provides such scholarships. Second, the major barrier for educational entrepreneurs in setting up or improving their schools is the lack of financing — banks will not or cannot lend to them, in spite of their financial soundness. So, the idea would be to set up micro-credit institutions dedicated to funding such educational ventures. I haven’t been able to find any projects of this nature that are in progress, but definitely the ideas of micro-credit are well developed in general, and maybe someone will start one up soon. We’ll have to wait and see.

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What is going on with California lately? Last year, they passed an initiative that banned gay marriage. This year, apparently there is going to be an initiative that would check immigration documents of the parents of any child born in the state when they try to get a birth certificate, report the parents to immigration officials if they can’t produce documents proving their legal immigration status, and then grant the child some kind of a second-class birth certificate in an attempt to deny the child citizenship (see this BBC Mundo article, in Spanish).

Our Constitution states that anyone born in the US is a citizen. Our country’s principles of civil rights are supposed to protect minority groups from laws that deny them equal protection. Why is California trying to circumvent these fundamental principles? What happened to the California that used to exist, where people stood up for the rights of others instead of trying to take them away?

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I recently read The Green Collar Economy, by Van Jones (with a forward by Robert F. Kennedy, Jr.). I think President Obama must have read it too, since the ideas he’s been talking about lately for fixing the economy are basically the same as what Jones sets out in his book. This is a good thing, in my opinion. Here are the main points from this book:

• The US is spending about $1,000,000,000,000 (1 trillion dollars by the US definition of “trillion”, or 1 billion by the British definition of “billion” — 1 million million either way) per year to subsidize the coal and oil industries. The book doesn’t give any documentation on how it got this number, but if it’s true, I can only ask: Why?
• Given that burning oil, natural gas, and coal contributes to global warming and other pollution problems, that the supplies of these resources is finite, and that dependence on foreign oil is a major security issue, we need to move towards not burning these fuels at all.
• We can replace the energy coming from coal and oil with geothermal, wind, and solar energy (see my previous post on energy for more on that idea), in conjunction with a move towards better efficiency and sustainable food production.
• The following public policy shifts are needed, in order to make this happen:
  • Stop subsidizing oil and coal
  • Introduce a “cap and trade” system that will cap carbon emissions in the US at current levels, decreasing the cap every year on a pre-determined schedule (so that industry can plan ahead), and set up a system for companies to trade their carbon cap credits.
  • Streamline electricity transmission rules, so that any electricity producer is guaranteed access to the local grid everywhere, while owners of transmission lines and local grids are compensated for their use (similar to the access to local telephone lines from the Telecommunications Act of 1996).
  • Modernize the electric grid, adding high-voltage long-distance trunk DC transmission lines, better control software, and battery storage facilities, so that solar and wind-generated electricity can be effectively generated when and where the sun and wind hit, and used when and where it is most needed. The estimated cost of this modernization is about the same as the 1-year oil and coal subsidy mentioned above, and as with the telecommunications modernization that led to our current Internet backbones, if access is guaranteed, private investment may pay for a significant portion of this cost.
  • Subsidize efficiency and sustainability, ranging from home and building lighting/heating/insulation improvements to mass transit to organic food production.
• Jones and Kennedy believe this will not only improve the environment, but also significantly improve the economy. They cite examples of Sweden and Iceland, which have both significantly reduced their use of oil and coal, and whose economies are booming as a result. Jones also points out that many of the “green collar” jobs generated by these programs would pay a decent wage, be attainable by people with a high-school education (with a little training), and be impossible to outsource (things like installing solar panels and weatherizing buildings have to be done here in the US).
• Jones also advocates for an approach that is based on principles of equal protection and equal opportunity: making sure that this environmental movement includes, protects, and creates jobs in lower-income areas as well as among the more affluent.

President Obama apparently wants something very much like this plan to be put into effect, and the economic stimulus plan being signed today contains at least some of these ideas. I’ll be interested to see what comes next.

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I took a trip to Asia this past August and September with my dad, for six weeks. We visited the Russian Far East, Siberia, Mongolia, and China, traveling independently; most of the traveling was via the legendary Trans-Siberian Railway. I plan to get some photos and thoughts posted here eventually, but as you probably know if you read this blog regularly, I don’t make time for writing very often, so I’m not sure when.

Great Wall of China

Anyway, one day of the trip we spent on the Great Wall of China. It’s impressive: 4000 miles (6400 km) long through some pretty difficult terrain. But it’s not very tall, and what I was thinking about as we hiked along the top of it was that it wouldn’t be very difficult for invaders to climb over, especially since there were plenty of trees near the section we visited (i.e. wood for building ladders — see first photo). I was thinking that the only way it could possibly work would be to station lots of people on it to watch and shoot the invaders. Indeed, the Wikipedia article (see link above) says a million people guarded it at its peak, and it was certainly built with plenty of holes to look and shoot through (see second photo).

The Mexican-U.S. border is something like 3000 miles (5000 km) long, and there are lots of people who think the way to solve our immigration issues is to build a wall along the entire length. Maybe they should go visit the Great Wall, and think about whether this border wall would really do any good, without the population of China to draw upon to guard it. At least some people are thinking this way… I’ve been reading David Sirota’s The Uprising, and I found this yesterday (it prompted me to create this blog article): “Aren’t efforts to build a twelve-foot fence just creating a market for thirteen-foot ladders? Shouldn’t [they] be lobbying Congress to support antipoverty initiatives in Mexico?”

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Because I used to work on Wall Street, some people I know are under the (incorrect) impression that I’m an expert in all things financial, and they have been asking me if I can explain how we got into our current state of financial collapse. So, I thought I would write a short summary of my understanding of how rampant greed around the practice of sub-prime lending led to a full-scale financial crisis.

First, let’s set the scene: the sub-prime lending market. Here’s a brief summary of how it worked:

• For at least the past ten years, many banks and mortgage companies in the U.S. have been aggressively seeking out people who were not financially ready to buy homes (bad credit history, no savings for down payments, insufficient income to afford a house, etc.), and giving them mortgages. These borrowers had to pay high interest rates for their “sub-prime” mortgages, to offset the increased risk that they would default on them.
• Many of the borrowers were not very knowledgeable about money, and they often did not understand the implications of their mortgages. Some borrowers had low payments for the first couple of years, which they didn’t realize would go up dramatically after that. Other borrowers weren’t able to calculate the full cost of owning a home (including fire insurance, real estate taxes, association dues, and water and sewer bills that a renter typically would not pay), and they couldn’t even afford the initial payments.
• Many mortgage agents and brokers did not educate the borrowers or fairly assess their ability to afford the mortgages — they either were under no legal obligation to do so, or the laws were not enforced.
• Most mortgage agents and brokers are paid commissions (at least to some extent), so they had a financial incentive to make as many deals as possible, and no penalty if the borrower eventually defaulted.
• The lending companies sold the mortgages rather than holding them. Once they had traded a mortgage contract for cash, they had no more risk, and could go out and lend the same money again to another borrower. Because they were able to transfer the risk away and lock in their profits, they also had a financial incentive to make as many deals as possible, and no penalty if the borrower eventually defaulted.
• The companies that purchased the mortgages re-packaged them into very complex “mortgage-backed securities“, and sold them to investors (mostly banks); the companies that originally bought the mortgages therefore also transferred away all risk of default and locked in profits, and again had an incentive to do as much of this as possible.
• Since the Reagan era, we have had less and less regulation of our financial market (under the philosophy that a capitalist market can regulate itself more efficiently). One of the ways in which the financial market is supposed to regulate itself is that we have two big investment rating agencies (Moody’s and Standard & Poor’s), which rate the risk of financial assets. In this case, they failed: the investment rating agencies gave the mortgage-backed securities “investment-grade” ratings. This allowed companies that bought them to count them fully as assets on their books, rather than having to discount them according to the actual level of risk they carried.
• The traders and strategists within the purchasing banks (often people like me: ex-physicists who went to work on Wall Street), who were in the best position to understand the long-term risks of mortgage-backed securities, also had a large personal incentive to do these deals. They were basically gambling using someone else’s money: they made huge bonuses in the short term because the deals they did looked great on paper, and the most drastic down-side risk they faced is the possibility that they could lose their job some years in the future if the value of the mortgage-backed securities they had bought went too far down.
• Because of all of the sub-prime borrowers entering the housing market, there was a strong demand for houses, which contributed to housing prices rising at a rate that far exceeded inflation. This led to additional demand from housing speculators, who could buy a house, hold it for a short time, and sell it again (”flipping”), which drove housing prices even higher.
• So, everything worked smoothly for many years, with many people making a lot of money off the sub-prime mortgage market: even if someone defaulted on a mortgage (and the market expected a certain fraction of these borrowers to default), the principal could be recovered by investors because the house had increased in value. At the same time, many analysts warned that when the time came that the economy wasn’t so strong, the sub-prime mortgage could easily collapse.
• But because they were making money in the short term, banks ignored the underlying problems, and mortgage-backed securities became large fractions of many large banks’ assets.

In order to understand our current crisis, you also need some background on the workings of other (non-financial) businesses in our current economy:

• Much of the world economy currently depends heavily on credit. Medium to large companies do not generally operate by using the proceeds of their current and prior operations to fund their current expenditures. Instead, they fund their current expenditures by borrowing against their future profits. The businesses borrow by issuing bonds for longer-term capital needs, and by obtaining bank loans for their short-term needs. The banks get money to loan by borrowing from larger banks.
• This whole system depends on trust. The banks lend money to companies based on their belief that the companies will be able to generate income in the short term and pay the money back. Banks lend money to other banks based on their trust in the borrowing bank’s assets and loan portfolios.
• The current economy is also focused on the short term. Nearly every publicly-traded company focuses on quarterly profits rather than long-term prospects — the reasons being that their stockholders (who hold stock on average for days rather than years) demand it, and their upper management’s compensation is based on it.
• The current economy is also based on an underlying assumption that the economy as a whole will always grow, that the world will always increase its consumption. But consumption cannot grow forever — it’s not environmentally sustainable.

Now that we have set the scene, we are ready to understand the crisis:

• A few months back, the delicate balance in the average sub-prime borrower’s finances tipped (due to rising interest rates, rising oil and food prices, layoffs, etc.), and more sub-prime borrowers started defaulting on their mortgages than had previously been the case.
• Once this started, the houses these borrowers had owned started flooding the market, and housing prices started dropping quickly. This meant that the holders of the mortgage-backed securities not only held more defaulted mortgages, but the houses that formed the loans’ collateral were worth significantly less than the principal of the mortgages.
• The defaults and housing price drops meant that suddenly no one trusted the value of sub-prime mortgage-backed securities, which had become a very large portion of the total holdings of many banks. This led to a problem where the banks wouldn’t loan each other money, even in the short term, since they didn’t trust the financial stability of the other banks.
• When the banks couldn’t borrow from other banks, they couldn’t make loans to businesses, and the businesses didn’t have the money to fund their current operations (payroll, raw materials, etc.), and went into a state of crisis.

So that’s the story: short-term profits and risk transfers fueled sub-prime lending, and it got so big that when it collapsed, it took the confidence in the banking industry with it; without trust, no loans were made and our credit-based economy entered a state of crisis. This is why the U.S. government bailout is aimed at getting capital back to banks, and buying their untrusted mortgage-backed securities: so that the banks can once again loan money to businesses, and the businesses can get back to normal operations.

But I am not convinced this will solve the problem, since the underlying issues will not be changing:

• Economy focused on the short term
• Economy based on the availability of short-term credit, provided by banks
• Little oversight on the operations of banks and the investment rating agencies
• Economic assumptions of continual growth, which is environmentally unsustainable
• Coming crises in food and energy (see my previous blog articles) that no one is planning for

It will be very interesting to see if our next President and Congress will do anything to address these issues. So far, I haven’t seen much evidence that they plan to…

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