During the past two months, I have helped three technology startups raise early stage growth capital and casually advised several others. Each business is in a completely different market: mobile, pharma, cloud computing, crowdsourcing, global communications, etc. Each has unique strengths and weaknesses. The entrepreneurs have wildly different backgrounds and personal qualities.

Not all have completed their funding, but in the process each team has learned similar lessons in how best to approach outside investors (investments from friends, family, and fools doesn’t count. They apply different criteria.) Although I managed to raise tens of millions of dollars for early stage businesses, mainly Alibris, I have personally made most of the mistakes listed here and I have made some of them more than once. Nor is this list particularly unique: investors and experienced entrepreneurs write about them all the time.

So here is my list of the top ten mistakes that entrepreneurs make when they try to raise money from outside investors:

1. No story.  Entrepreneurs try to convince investors that they have a winning business – but investors have no idea which businesses will really work. It’s just too complicated. So investors do what human brains are wired to do when confronted with bewildering complexity: they listen for a coherent story. They listen for a particular kind of story that nearly always has three parts: a strong team that achieves impressive traction solving a big problem. These may be called Team has Traction on Trouble or Management has Momentum in a big Market, but to sell your company, you need to tell your version of this story.

2. No pain. Gill Cogan is a savvy financier, a friend, and a former investor of mine. I once pitched a business to him and after ten minutes, he smiled and said, “that’s what we call a vitamin business.” He explained that people often skip their vitamins – but they never skip their painkillers. Investors prefer a painkiller business. Or as another VC put it “what I really like is a tourniquet business”. A solution to a problem that is acutely felt can grow rapidly. A solution to a minor problem may not be a market at all, even if the problem is widespread. VCs do not fund vitamin businesses.

The flip side of no pain is, of course, no gain. More than anything else, investors want to back companies in huge or potentially huge markets. This leads to herd investing: everyone piles into mobile, cloud computing, or gaming. This is why venture investing has always been a fashion business. This looks irrational, but it makes perfect sense even if it kills the Phoenix. To start with, the cost and risk of investing in any startup is high and approximately constant, so why not focus on companies with huge upside? Moreover, fast growing markets put a lot of wind at a startup’s back, which makes errors much less costly. Investors understand what Google’s Eric Schmidt means when he says “rising revenues solves all problems” — so they back companies where explosive revenue growth is most likely. These are markets that solve big problems or capture huge opportunities.

3. No hub. You live in the wrong place. Capital is highly mobile, but capitalists and startup infrastructure are not. They live in Silicon Valley, Boston, and New York and more importantly, so do the entrepreneurs, technologists, researchers, startup attorneys, talented marketing types, engineers, specialized commercial banks, vendors, mentors, and much else. You can raise venture money in Austin, Charlotte, Seattle, LA, Portland, Chicago and a few other places – although investor quality drops precipitously outside of the major hubs. (If you care why and how this occurs and where is it all going, Google AnnaLee Saxenian – a leading scholar on this topic and a fantastic wife to boot). You may be able to raise money if you are not in a place with active venture or angel investors (several companies have, of course) but it’s tougher. If you live outside a funding hub and are serious about building a technology company, it often helps to relocate.

4. No traction. Your company has an idea but no product or service. Or it has a product but no customers. As Babak Nivi and Naval Ravikant, two well known investors behind the indispensable site VentureHacks, like to say, “traction speaks louder than words”.

You believe that you have invented a revolutionary new dog food that will quickly disrupt the market. Investors cannot possibly figure out if it is really better, so they look for a metric that is rising rapidly up and to the right – often by 20%/month. Any metric that shows rapidly growing engagement will do. Profit is ideal (if profits are growing fast, you can always raise money — although you may not need to). Revenue growth is next best, even if it is from a tiny base. Next best after that is growth in accounts, beta customers, users, or page views. Worst case, show videos of dogs wagging their tails and survey data from dog owners excited about your products. If you don’t have any signs of traction, you don’t have something that people appear to want. You don’t yet have a business.

As important as traction, is an understanding of why you achieved it and why it will continue. Are users engaging other users? What are your viral metrics? Are large companies buying? Why are they trusting a startup? Are customers buying? What are you offering that others cannot and how do you know? Real data about traffic, conversion, average transaction size, repeat rates, defections, costs, margins, etc. begin to paint a clear picture to investors. Ideas about what you hope will happen are simply no substitute.

5. No team. You love your team, but it may not be financable. Most investors back teams with a combination of proven business and technical experience. Why? A VC who was ex Air Force used to say, “backing entrepreneurs is like picking a pilot for an F-15. I favor the guy who has already crashed one, because he or she really doesn’t want to see that happen again”.  Or more commonly: “we know that good judgment comes from experience – and that experience comes from bad judgment”.

This may seem like a Catch-22, but it is rational. Recent research concluded that a venture-capital-backed entrepreneur who succeeds in a venture has a 30% chance of succeeding in his next venture. By contrast, first-time entrepreneurs have only an 18% chance of succeeding and entrepreneurs who previously failed have a 20% chance of succeeding.” The solution? Recruit a co-founder with the skills your team lacks. It does not substitute for product/market traction – but many investors will recognize that your ability to attract talented people is a form of traction.

By the way, there is one glaring sign of a weak team and I see it a lot: relatives in the company, especially on the founding team. Husbands and wives, fathers and sons, brothers and sisters, and couples of all sorts. It is rare that the weaker of these individuals would have been hired in a dispassionate search. Having your relatives in the company, especially a spouse, is a great way to signal investors that you are not determined to hire the very best.

6. Lousy communications. A lot has been written about this. Usually what gets called a communication problem is really a business problem. Bad communication is frequently a sign of bad thinking. But there is one communication problem that is chronic to entrepreneurs: over-communicating. You know too much about your business and in early stage conversations, your knowledge is a liability.

The solution is to prepare three sharply focused business summaries: a 15 word “big idea”, a 15 second elevator pitch, and a 15 slide funding pitch. The big idea is the subject line of the email that your trusted intermediary sends the VC. If they were helping you pitch YouTube in 2005, it might have said “Flickr for videos”. If you were pitching Alibris in 1997, it might have said “find millions of out of print books in one online store”. It is not a consumer-facing tag line, it is the cocktail party handle that people will use to describe your business.

The elevator pitch is the most important and most overlooked. Intermediaries who introduce you to investors will use this in the body of their email. You will use it to describe in a few sentences what problem you solve and what traction you are achieving. Bonus points if you can also fluff the team. Marc Andreesen, were he someone who needed money, might have pitched Ning in 2007 by asserting, “Social networks are an amazing, powerful medium. Ning lets any group build it’s own private social network. We recruited a first rate team, we are hosting more than 100,000 user-created networks, and we are growing at 10% per week.” Boom. Hold the elevator – I want to hear more.

Attached to the introductory email is either the 15 page pitch or a one page summary. Either can work. Do not prepare the pitch from scratch — follow a proven recipe like the excellent ones outlined here, here, here, or here. 15 pages, 15 minutes, 30-point type. It  is hard to over communicate in 30-point type.

There are three things that you should not communicate to an investor. Do not show them secrets. Investors share ideas — that’s often how good ideas germinate. They will share yours. Don’t show them an NDA — they won’t sign it. And don’t show them a business plan. You may want a business plan to force yourself to think through your operations and to have something to use to build a founding team, to brief a board member, or to attract talented leaders. But a business plan will not help you raise money because investors won’t read it and they shouldn’t.

7.  High burn. You have ten employees working for cash, nice offices, no product, and no customers. There are PR and law firms on retainer. You are burning faster than you are learning. Remember this: investors are not looking for companies that need money. They look for companies that will succeed whether the investor commits or not. Raising equity is like borrowing: quite often, the more desperately you need money, the less likely you are to get it. If this is you, take heart: you are unlikely, no matter how hard you try, to violate this rule more than I have.

To state the obvious: any business without revenue has to run very lean, even if they start with a million dollars of 3F seed money. You are still trying to fit your product to the market. You are testing, tweaking, selling, and learning. For most web-based businesses, you don’t need titles; you need one or two people who can sell and small team that can build. Pay is low – everyone works long hours for a bunch of stock. As one investor memorably put it, “an early stage business runs like a one story whorehouse: no fucking overhead”.

8.  No cred. Experienced investors listen for a team that shares the details about what it has built. They listen for specific milestones that reflect customer needs met. Weak teams spend more time talking about future plans – their unproven ideas about where to go next. Talk about traction, engagement, measurable progress both in your current business and in past ones. If you worked at a brand name company or went to a brand name school, mention it – but focus on what members of your team have built. You are trying to build a business, so your record of what you have built gives your team credibility.

9.  No insight into sales or distribution. Early stage companies often don’t know what they don’t know about sales or distribution. This is understandable because early stage companies are obsessed with building a product or a service to fit a market. Achieving product/market fit, or traction, or engagement is hard, critically important work. When it finally happens, it is like a deep sea fish striking your baited line – customers start pulling the product from your hands. You know it instantly (recall the crazy moment in the Social Network where Facebook suddenly goes viral at Harvard).  Getting to this point is the obsession of every startup team. As a result, most are not yet obsessing about sales and distribution.

But they will. Sales and distribution challenges vary all over the map, but most in most companies there are large learning curves and scale effects. Your customer acquisition costs drop as you get bigger and smarter. But in the beginning, you don’t really know how much it costs to acquire customers. The number is likely to be much bigger than you imagined. Which means you can burn through a lot more cash in year one than you expected to.

Put another way, traction can be a trap because it leads entrepreneurs to try to get as much capital as possible out of their growth. This is completely backwards. The point of starting a company is to get as much growth as possible out of your capital.

10. No lawyers. Entrepreneurs, with rare exception, did not go to law school or if they did, they did not pass the bar and become lawyers. New entrepreneurs often dislike lawyers – but they quickly learn that good lawyers matter. A lot.

Once investors are shareholders, their interests are substantially aligned with yours. Until they are shareholders however, the economic interest of an entrepreneur and an investor are opposed. Investors want to buy low; entrepreneurs want to sell high. And the terms, which can be bewildering to a new entrepreneur, matter a lot (as many a VC has said, “you can set the price, if I can set the terms”. They mean it.) In this situation, an entrepreneur needs legal counsel at least as competent as that enjoyed by investors. Day to day, a low cost lawyer is fine. For a major financing however, get a good lawyer who does startup financings for a living.

That’s my list of ten common errors. It is not comprehensive: you could no doubt put together a list of ten others. Nor is it universally right: every generalization has exceptions, including this one. And avoiding these mistakes is no guarantee that you will attract an investor. In raising money, most entrepreneurs kiss a lot of frogs before they find a prince. Then again, so do investors.

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What’s up with Wisconsin? Is the American labor movement finally rising from the dead? Will progressives in the birthplace of the Progressive Party defeat Republicans in the birthplace of the Republican Party?

Wisconsin is a misleading event because Republican overreach masks the real, even desperate, problems facing public employees.

• Public unions in many locations face legislation intended to destroy them. The attacks will succeed in some states — perhaps even in Wisconsin. But unions are well-equipped to deal with political attacks. Plus, as Wisconsin illustrates, politicians habitually over-reach. These things backfire.
• Every public union is now under massive economic pressure thanks to the math of budget deficits. This is a separate problem that fuels the political attacks. It’s urgent because most unions lack the tools and the imagination to address structural deficits in state and local governments and their contribution to those deficits is both nontrivial and politically damaging.
• Finally, public unions lack a sustainable strategy. Public employees depend on public support. But they sold their soul in the 60s when they chose politics and collective bargaining over service innovation and professionalism. They will be obliterated if they don’t rethink the deal.This is the most daunting challenge of all because it requires unions to rethink their purpose and redefine the source of their power — something that very few organizations can do successfully.

The Cheeseheads Fumble

Wisconsin Republicans are behaving badly and increasingly, the public knows it. The newly elected governor, Scott Walker, is turning out to be the gift to organized labor that keeps on giving. He has made at least three unforced, rookie errors:

• He ruined the optics by championing a self-serving proposal. Instead of proposing to weaken all public unions, he wants to exempt the firefighter’s and police unions that supported him. Since the public fears strikes by cops and firefighters more than by teachers or janitors, this is hopelessly back asswards.
• His timing is off. Walker attacked after unions had granted substantial economic concessions not before. He denied himself the cloak of economic crisis. Weak.
• His tactics are ham-fisted. By confronting unions directly, Walker played to their strength. American labor unions are born of industrial combat — confrontation is a core competence. Walker forgot what every third grader knows: don’t pick a fight with the big mean kid. Instead, put him in a round room and bet him he can’t find the nickel in the corner. Major fail.

Walker has botched not only his tactics, but along with most Republicans, his fundamental strategy is also a mess. Walker wants to cut off the air supply of public unions by removing union security and dues check off provisions and requiring annual recertification votes. Union security agreements address the free-rider problem that plagues organizations designed for collective action. These provisions require anyone who enjoys the benefits of a union contract to contribute to the costs of obtaining and enforcing the contract. Dues check off requires an employer to collect the dues via payroll withholding.

Walker fails to appreciate that what makes unions happy also make them fat. Union security provisions are like donuts: they satisfy an immediate craving but leave unions soft in the middle. When union members pay dues in person to a shop steward or at the union hall, unions get valuable first-hand information about their member’s concerns. The union becomes tightly woven into the fabric of work life. Once management automates the process, loyalty to the union weakens. But hey, those are some nice donuts…

I began organizing and representing public health care workers in the mid 1970s, when California did not permit either agency shop or union shop agreements in public hospitals. As a union representative, I had to collect dues on the job, which required me to organize and train a cadre of shop stewards to get it done. It forced me to visit all three shifts 2-3 times each week for every public hospital I represented. I got to know every workplace leader. If someone had questions about the union or a problem with it, I met them in person. I learned about workplace problems early (in a hospital in Salinas, I never filed a single grievance in two years. I knew every supervisor and could worked out quick solutions when I needed to – often before an employee had been disciplined or fired. Of course the threat of formal grievances helped). The point is not that I was always convincing – it’s that I was never indifferent. Frankly, I couldn’t afford to be.

In the late seventies, California law changed and we negotiated union security and dues check off provisions. Soon, I knew the shop stewards but not the shop floor leaders. I cut back on late night and early morning visits. The union felt stronger because it was richer– but we had been weakened and we knew it. One sign: a backlog of grievances.

Employers, notably those affiliated with the National “Right to Work” Committee think that taking donuts away makes unions weaker. They look at states that prohibit union security arrangements and see weaker unions. They conclude that imitating these states, as Wisconsin is basically proposing to do, would weaken their unions. And in the short term, they are surely right. Sugar cravings are a bitch.

But in the long term, Republicans would be smart to remember that every truly powerful union in American history was built without union security or dues check-off. The railroad, steel, mining, auto, shipping, and textile unions that could and did paralyze national commerce were built by hand, without the help of friendly HR staff who signed up members as part of the employment paperwork. Republicans who want their unions unsweetened risk seeing them mutate like a zombie virus. Unions may die or they may go the gym and come back ten times stronger, especially any place they enjoy a steady diet of arbitrary management. Which is to say, everywhere.

During my health care days, there was one CEO we feared more than any other -- a guy who achieved astonishing clinical and cost results by applying management principles to hospital operations. He didn’t fight unions so much as he focused them on improving patient outcomes. His hospitals were very tough to organize because he fired arrogant managers and listened to his people. Unions were delighted when this guy got caught in the largest Medicare fraud scandal in US history.

That CEO, Rick Scott of Columbia HCA, is now the governor of Florida. He thinks he is CEO of Florida, but he knows better than to do things that strengthen his unions. He cannot put enough distance between his state and Wisconsin. What Rick Scott and other politicians much smarter than Scott Walker know is that if you hate unions, grant them security provisions and dues checkoff. Don’t take away the donuts — they are a proven sedative.

Indeed, if Republicans want to lower the cost of government, they should look as we will now, to those responsible for controlling costs: public sector managers.

Next: Management Malpractice and High Union Pay

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If the global financial collapse has a silver lining it’s the Vanity Fair accounts by Michael Lewis of how three different European countries responded to the meltdown. We can only hope that Lewis adds to these reports and turns them into another best-selling book.

Lewis (Liar’s Poker, Moneyball, The Blind Side, The Big Short) is a genius who is studied by every serious business writer. A local guy who finds drama and comedy in high finance and sports. Lewis is funny and astute. He exposes fools with a touch so deft that they become his friends. The man appears incapable of producing a dull paragraph. 

In his Euro DisasterLand trilogy, Vanity Fair serializes Lewis’ accounts of the financial collapse of Iceland, Greece, and Ireland. In each country, cheap and unregulated money created a very different disaster. In each case, Lewis notes, “An excessive faith in free financial markets led people to be allowed to do things with money they should have never been allowed to do.”

• <Wall Street on the Tundra> describes how a group of Nordic Alpha Males pretending to be investment bankers looted and wrecked the economy of Iceland, which is now run mainly by women. 
• <Beware of Greeks Bearing Bonds> tells of Lewis’ visit to a wealthy monastery to meet monks who exploit the uniquely Greek combination of extremely generous social services and rampant tax evasion.
• <When Irish Eyes are Crying> Lewis finds a housing bubble which is a parody of the US experience. Without a single derivative, the Irish bid their real estate to spectacular levels and dump the full cost of the resulting bank collapse onto taxpayers.

Lewis brings an innocent eye to these stories of nations seized by financial foolishness. It helps that he does not have a deep background in these countries. As he did in The Big Short, he meets people who saw the crisis coming (an in some cases profited from their insight).

Lewis is of course anything but innocent. Having documented the foibles of his reckless co-workers who traded bonds for Salomon Brothers, exposed the fact-averse pretenders who ran baseball teams, and shamed willfully blind US regulators, rating agencies, and derivatives investors, he knows that the story will end badly. You know it too, but you press on because, like any mystery novel, you want to see the bad guy go down. 

Unfortunately, in matters of global finance, the victims are not always the bad guys. Lewis asks who, when the dust finally settles, pays for all of this foolishness? Iceland seems determined to bootstrap its way back by rebuilding its banks. Greece, a nation that appears even less numerate than our own, looks to be in complete denial. Ireland, astonishingly, elected to impose the full cost of brain-dead banking on its taxpayers — for now. 

This will be a fine book — but it’s not worth the wait. If you have not followed the Euro DisasterLand trilogy, chase the links and treat yourself to some of earth’s finest business journalism.

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So what does the new stage look like? You can see a more interactive version here. You can see at a glance that the big ticket items are:

• 23% is health care for old people, poor people, and kids. This is the elephant in the room — the one that both parties know they must address and neither wants to go first. Obama doesn’t touch it.
• 22% is Defense, if you count veterans benefits, which are 3% of the budget. Republicans are especially prone to ignoring this one, although the Obama budget barely touches it.
• 20% is Social Security, which is actually fixable with some tweaks, mostly means testing. 
• 14% is Safety Net (“Income Security”). All of this is means tested and benefits our weakest citizens. Republicans view all of this as on the table. It should not be.
• 6% is interest on the debt. This is basically untouchable — trick is not to grow it.  
• The remaining 15% is smaller bits including Education and Transportation (both under 3%) and International Affairs, Technology investments, and Resource protection (each under 2%).  

At a glance, you can see that trying to balance the budget without touching Medicare, Social Security, Veterans Benefits, Interest, or Defense — as Republicans have proposed — takes about 2/3 of the budget off the table — very tough.

As Matt Miller and others have pointed out however, beneath the headlines lies political math:

• It’s more about taxes than spending.  Obama proposes to spend 22.7% of our economic output on government. Reagan’s idea of small government was 22% of GDP. The percent matters less than what you spend it on: investment that creates future wealth (freeways, education, research) compares poorly to spending to transfer current wealth (entitlements, safety net), which compares poorly with basic government functions (diplomacy, military, environmental stewardship, law enforcement, etc). Different modern countries devote different amounts of their economies to each. The US remains at the low end of the list of government spending as a share of GDP and at the very high end for military spending, but it is very hard to argue that we have a uniquely big governent. 
• Neither side cuts spending. What Obama calls “walking the walk” on fiscal discipline amounts to a 1% cut ($400 billion out of $450 trillion of federal spending over the next ten years). Indeed, Obama grows spending by 65% in just four years: from $2.2 trillion in 2011 to $3.6 trillion in 2016. The GOP is no better: the “fiscal conservative” Paul Ryan touts his ‘Roadmap’, which does not balance the budget for decades and adds $62 trillion in debt. The Washington Post shows that Obama plans to add 15,000 federal civilian employees.

• Goliath skips dessert. A prime example of phony spending cuts: Obama plans to cut 2% from the next $3.5 trilion in defense procurement. Republicans oppose even these cuts, even though the US spends much more on arms than the rest of the world combined — in part because we buy arms for much of the rest of the world.  
• Obama plans to borrow instead of tax. This is the guts of budget politics. Since nobody wants to cut spending or raise taxes, we borrow. Obama calls for $7.2 trillion of new borrowing, which would double our national debt in ten years without doubling the size of our economy. This is only defensible if the additional spending really is investment that creates new wealth. But it isn’t.
• Obama assumes strong economic growth to pay for his spending. This is a standard budget ruse that every President uses, which is why we would be better off using CBO growth rates for budgeting. Obama gets the federal deficit to 3% of GDP by forecasting spectacular growth. He assumes real growth (after inflation) of 3.6% in 2012, 4.4% in 2013, 4.3% in 2014 and 3.8% in 2015. Using average growth rates and no new taxes, we end up with chronic deficits in the 8% of GNP range for the many years — not smart and not sustainable.
• Interest expense will start to hurt. As a result, interest expense on the federal debt is scheduled to quadruple from $207 billion to $844 billion annually in ten years. Like any household or business with too much debt, this obviously further constrains productive public investment.

Obama’s case for running deficits is that fiscal stimulus is critical during this phase of recovery from recession. Two problems with this. First, the deficits are too small to spark a lot of employment growth, even if Congress would approve them, which they won’t, and when you factor in reductions of state spending, net federal stimulus is even smaller. Second, the idea of temporary spending increases has lost credibility because too many past increases have built constituencies that have made them permanent.  

Democracies are better at devising public programs than cutting them. This reflects gutless or innumerate politicians, less than it reflects a citizenry that wants it both ways. Polls say that we want cuts in spending without cuts in services. Everyone is willing to cut services that we don’t use and to raise taxes that we don’t pay.

The traditional solution to issues like this (think military base closures) is not a democratically accountable legislature but a commissions empowered to force up or down legislative votes, politicians not running for re-election (Jerry Brown in California), and less often, judges whose decisions withstand appeal. Obama of course, just received the results of such a commission and although it was hardly glorious, it was a mistake to walk away from their recommendations. 

What we have is Clinton redux, with the same players but higher stakes. Obama has set a cautious stage for the budget showdown:  irritating but not alienating Democrats while offering nothing for Republicans to embrace. He has set the stage not for compromise, but for a stalemate in which neither side takes the risk of new taxes or new cuts. in that respect, Obama may perfectly reflect the ambivalence of the American people, who want to cut taxes but not services. At the moment, our representative government is representing us a bit too well. 

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DeLong recently gave his students some well thought out advice: What Econ 1 Students Need to Remember Most from the Course” followed shortly by “What Econ 1 Students Need to Remember Second Most from the Course“. This is a brief, brilliant introduction to economic thinking (and the comments he received are worth a read as well). With the Jamkid home from Chicago and preparing to enroll in its fabled microeconomics course in the new year, it seems fitting to republish it (although the emphasis is mine). Savor the post like a fine glass of wine and perhaps with one.

“Economics”, writes DeLong, “deals with those things that we want but that are “scarce.” We economists care about commodities whenever there are not enough of them for all of us to be satisfied that we have all that we want. Under those circumstances societies then have to–we have to–figure out whether it is worth making more of these scarce commodities. And then, if we do make more of them, we then need to figure out who is going to get to use them.

Where things are not scarce (the air, for example), that is not economics. Where we do not care that is not economics either. Where things are both scarce and where we care, we have the economic problem.

How ought a society to go about dealing with the economic problem? How should we–collectively–decide whether it is worth our while to make more of any particular commodity? And if we do decide to make more of them, how ought we to decide who is going to get to use them?

At this point I need to pause and note two facts about the world. Most scarce things that we care about are “rival.” And most scarce things that we care about are “excludable.” By “rival” I mean the only one person can use it at a time. I am now using this iPad to read my lecture notes. Because I am now using it, you cannot be. By “excludable” I mean that it is relatively easy to keep someone from making use of a commodity. I can keep your cows from eating my grass by putting up a barbed-wire fence.

Because commodities are “rival,” somebody’s use of a particular good imposes an opportunity cost on the rest of society. Because I am using this iPad, there is one fewer iPad for the rest of you to use. My use restricts your opportunities. A good economic system would make me take account in my decision-making of any reduction in your opportunities and resources that might be caused by my actions.

This is where the market economy comes in.

Let us assign each newly-produced commodity a particular person. Call this person the “owner.” Let the owner decide who is going to get to use the commodity. Let the owner exclude all others who from using the commodity. And let the owner charge the designated user he or she has decided upon a “price” for the right to make use of this commodity.

This simple institutional arrangement has a huge number of advantages as societal mechanism for planning and coordinating the production and distribution of scarce, rival, excludable commodities.

It solves the problem of production–what commodities we should try to make more of. Individuals look forward into the future and recognize that others will be willing to pay them high prices for commodities they greatly desire. That gives individuals an incentive to figure out how to make more of those scarce, rival, excludable commodities that are scarcest.

It solves the problem of economizing--of how to get people to economize on their own consumption and not hog too great a share of society’s total resources for themselves. Because they have to pay the owners the prices the owners ask, their eyes may be bigger than their stomachs but their wallets generally will not be.

It solves the problem of distribution–of determining who is going to get to use newly-produced commodities. The owner has an incentive to choose the person willing to pay the highest price–and the person willing to pay the highest price is, in some sense, the person who values it the most, to whom it is scarcest.

Moreover, it solves the problem of coordination: As long as market prices are free to move to equalize quantities supplied and demanded, there does not need to be any huge centralized computer bureaucracy keeping track of everything and making sure that plans add up. The market will coordinate itself.

And it solves the problem of information: In a market economy with commodities with owners, decision-making is pushed out to the periphery of society where people already know what is going on. You don’t need any huge centralized computer bureaucracy collecting and processing information–and where people do discover that there are things that they don’t know but need to learn, why knowledge of something and that somebody else would like to learn it is also a commodity and those who know those two facts are its owners.

It is hard to imagine a simpler institutional framework–owners and prices–that could solve those five problems so very well.

At this point I need to pause and point out a lucky consonance between the requirements of a societal institution for producing and allocating rival, excludable, scarce commodities on the one hand and the psychological propensities of us East African Plains Apes on the other. That we believe that things are ours and that we own them is perhaps not so surprising–it appears deeply deeply engraved in mammalian psychology. Squirrels certainly act as though they believe that they “own” nut-foraging sites. Dogs believe that they “own” bones. We East African Plains Apes, however, not only believe that we own things–we like to give them away. We are animals that solidify our own societal bonds via relationships of gift-exchange. And it is this psychological propensity to engage in gift-exchange–what Adam Smith called our natural propensity to truck, barter, and exchange in such a way that both sides are happy because they feel that they have gained something from the deal–that serves as the underpinning of our market economy.

That is the first thing I want you to remember from this course: The market economy, based on deep human psychological propensities, is an extraordinarily effective societal instrumentality for planning and coordinating the production and distribution of scarce, rival, excludable commodities.

Remember this. Keep it as an active process running on your wetware always. Lay up this idea in your heart and in your soul. Bind it for a sign upon your hand, that they may be as frontlets between your eyes. Teach it to your children when thou sittest in thine house, when thou walkest by the way, when thou liest down, and when thou risest up. And write them upon the door posts of thine house, and upon thy gates: that thy days and the days of thy children–or at least the commodities they own–may be multiplied.

What is the second most important thing for an econ one student to remember? It is how stringent the requirements for any form of “market efficiency” are: how many ways a market economy can go wrong and go badly wrong. I count seven ways that market economies can and do go badly wrong:

First, the market will go wrong if the wealth distribution is wrong. The market judges value by willingness to pay, and the rich are much more willing to pay them the poor, and those without wealth or income have no willingness to pay at all. If your wealth and income are zero, then the market literally does not care whether you live or die–it is of no interest to it at all.

Second, the market will go wrong if commodities do not have the proper characteristics. Remember: rivalry, excludability, and also information–people have to know what they are buying. An absence of or imperfect rivalry–increasing returns to scale in production or consumption of any sort–and the market will go wrong. An absence of or imperfect excludability–free-rider problems of any sort, or any failure of property rights definition or enforcement–and the market will go wrong. An absence of good information about exactly what you are buying or selling–adverse selection or moral hazard problems of any sort–and the market will go wrong.

Third, the market will go wrong if market agents do not take the prices at which they buy and sell as given but rather have some control over the prices at which they transact. The belief that the market is efficient hinges on the absence of market power–as well as on the proper income distribution, and on the proper characteristics of commodities.

Fourth, the market will go wrong if prices do not equalize quantities supplied and quantities demanded at every moment. “Price stickiness” for any sociological or psychological reasons disrupts the market’s ability to function.

Fifth, the market will go wrong if Say’s Law breaks down (MM: I did not take the course, but Says Law says roughly that we will not have failures of either aggregate supply or demand. The market will always clear.) If there is substantial downward pressure on spending on currently-produced goods and services because of an excess demand for financial assets of a kind that the private sector cannot immediately and instantaneously generate on a large scale, then the market will go wrong and we will have a downturn and a depression. If there is substantial upward pressure on spending on currently-produced goods and services because of an excess supply of financial assets of a kind that the private sector cannot immediately and instantaneously shed, then the market will go wrong and we will have a burst of inflation that will disrupt the functioning of the price system.

Sixth, the market will go wrong whenever its prices function as forecasting mechanisms. A proper forecasting mechanism would weigh each individual’s opinion by the precision of his or her knowledge. A market tends on the contrary to weigh each individual’s opinion by his or her wealth. This means that whenever economic processes tend to revert to seem average level that the market is likely to get things wrong, for when prices rise above average those who are optimistic become richer and their opinions carry more weight and so prices tend to rise further above their likely long-run fundamental values. Bubbles and crashes, manias and panics, are thus built into the system.

Seventh, the market will go wrong whenever individuals are bad judges of their own long-term interests–note that I say when, not if. Humans are very bad at assessing and dealing with risk. Humans are not that great at appropriately weighting different conflicting pieces of information. And humans are absolutely horrible at dealing with substances or patterns of behavior that can be addictive.

Whenever the system falls into any one of these seven arenas of psychological, behavioral, or institutional myopia and market failure, the market will go wrong. A good government will put its thumb on the scale in order to offset all of these seven forms of market failure. A great government will have foresight and take care to structure political-economic institutions to make these seven arenas of myopia and market failure as small as possible.

Remember this too. Keep it as an active process running on your wetware always. Lay up this idea in your heart and in your soul. Bind it for a sign upon your hand, that they may be as frontlets between your eyes. Teach it to your children when thou sittest in thine house, when thou walkest by the way, when thou liest down, and when thou risest up. And write them upon the door posts of thine house, and upon thy gates: that thy days and the days of thy children–or at least the commodities they own–may be multiplied.

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Three years ago, I wrote a lengthy post describing Ferguson’s entry into filmmaking, a documentary on the Iraq war called No End in Sight. I disclosed that Charles is a friend and once invested in my company (it was not, I should add, a terrific investment for him). 

Charles became known in Silicon Valley as a difficult personality — a reputation sealed when he took up the pen and published a cri de coeur called High Stakes, No Prisoners.  Ferguson often describes himself as “pathologically direct” and the people he interviews on film soon learn first hand what that means (Charles can be heard off camera saying “forgive me, but that is simply not true” or “you cannot possibly believe that”). 

Although I had little sympathy for most of the people that Ferguson interviews, at some level I understand what they were going through. For a brief period of time a decade ago, I lunched weekly with Ferguson (I lunched; he grilled). A successful software entrepreneur, he at various times advised me to replace my entire board, my entire engineering team (“I would not have hired any of them”), and my VP of Engineering (“Marty, would it kill you to hire someone with a Computer Science degree?”). The problem was not that Charles was irritating — it’s that he was frequently right (or substantially right). Since an honest critic is tough to find, I sucked it up and kept meeting. In truth, I learned a lot.

As the title suggests, Ferguson wrote Inside Job as a heist flick. The movie begins calmly with reflections on a benign and happy Iceland. By the time the opening credits roll however, the pace of the whodunit is rocking, angry, and punitive. The laugh out loud interviews are supplemented by a great sound track, Matt Damon’s excellent narration, and crisp photography often shot at dizzying angles from helicopters. By the end you realize that this really is a movie about bank robbers — except that they paid off the cops and sent taxpayers the bill. At last night’s opening in Berkeley not far from Ferguson’s home, this lucid tale of unprosecuted criminality worked the crowd to a fever pitch. By the final credits, it was not just the local Baptists who were yelling back at the screen. 

Ferguson takes on some new ground by exposing the whores of the financial services industry — both those with PhDs in economics and those who offer high priced sex and cocaine to masters of the universe. In classic muckracking fashion, he interviews a Wall St. madame and a psychiatrist who in each their own way minister to Wall Street’s uncontrolled alpha males. He also skewers academic economists who serve on the boards of investment banks and publish “scholarly” research papers justifying their employer’s larcenous tendencies. Fredric Mishkin, a Federal Reserve governor and Columbia finance professor is revealed to be a complete imbecile. (His attempt at a rebuttal here confirms the verdict; Ferguson responds here). Democrats Laura Tyson and Larry Summers are exposed for making millions on Wall Street while advising policymakers. Harvard’s Glen Hubbard panics amidst his richly earned smackdown and tells Ferguson “you have three minutes left. Take your best shot”. Unfortunately for Hubbard, Ferguson does. 

Without ever becoming didactic, Ferguson uses the film to educate. He tells the comparative tale of Iceland and of EU reforms that resemble Obama’s campaign rhetoric more than our own financial reform bill. He tells the history of Wall Street, noting that Morgan Stanley used to be a small, thinly capitalized partnership consisting of moderately paid professionals who were famously conservative because they came to work each day and risked their own capital. He gets a great story out of financial author Charles Morris about a Wall St. trader in the sixties who had to hold down a second job as a train conductor because the pay was so low!

As often happens with films on a mission, Inside Job occasionally overshoots. It conflates the impact of repealing Glass-Stegall with the impact of broad financial deregulation. It paints mortgage securitization and the resulting derivatives with a very broad brush. (Simple derivatives like futures contracts and even collateralized mortgage obligations do exactly what academic economists say they do: reduce costs and risks. Unregulated derivatives built on uncollateralized securities into indecipherable collections of toxic waste that are misrepresented by banks and mislabled by rating agencies are rather a different story). Ferguson excoriates regulators, but generally ignores the government’s role in promoting subprime lending with easy housing credit, tax deductions, and lax monetary policy. And like most progressives, he treats every ill-considered loan as the result of a predatory lender, not a foolish or innumerate borrower. It’s the economic equivalent of blaming consensual sado-machoism on the sadist when in reality, it takes two to tangle. 

On balance however, Inside Job is highly informative, restrained, and entertaining. Its case against both Democratic and Republican regulators is devastating and infuriating. No End in Sight, Ferguson’s amazing debut film won on the war in Iraq him an Oscar nomination. I expect and strongly hope that Inside Job will earn him the statue. 

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Gawwande is a cancer surgeon in Boston. A Rhodes Scholar and the recipient of a MacArthur "genius grant", he trained at Harvard, and Stanford and grabbed a Masters in Public Health along the way. He has a sharp sense of public policy and worked for the
campaigns of Gary Hart and Al Gore, on
the staff of Congressman Jim Cooper (D-TN), and as Bill Clinton’s
health care lieutenant during the 1992 campaign.

More importantly, Atul Gawande writes. He writes so well that he has become a staff writer for The New Yorker — as unlikely for a full-time physician as for a full-time CEO or lawyer. His writing is stunning. Says fellow writer Malcom Gladwell: "Every subject Atul
Gawande touches is probed and dissected and turned inside out with such
deftness and feeling and counter intuitive insight that the reader is
left breathless.” 

Son of an immigrant pediatrician and a urologist, Gawand wanted to be a rock star in college (he still performs surgery with the Decemberists, Tom Petty, and Springsteen on his iPod). He soon gave up his guitar for a word processor however and did something few doctors would ever consider
doing: he published a collection of his medical mistakes in Slate, where Gawande
first emerged as a major writing talent. He has published three booksThe Checklist Manifesto (2009),Better: A Surgeon’s Notes on Performance (2007), and Complications: A Surgeon’s Notes on an Imperfect Science (2002).

But this year Gawande broke loose. He has become hugely influential because of three articles he published on health care reform in the New Yorker. Each has caused a national sensation. The first two were required reading in the Obama White House. Not suggested reading — Obama expected everyone working on health care to know these articles cold. I have no question that the third and in many ways most subtle article, just published, will enjoy the same status.

All three articles are brief and a delight to read.  I will summarize them here and comment on them briefly, and link to them. Read them — they are educational,  insightful, and important.

Gawande opened the year with Getting There From Here: how Obama should reform health care a mildly heretical essay on how to think about health care reform. The not obvious idea: health care systems evolve and are highly path dependent. Where you end up, depends hugely on where you have been. Gawande does a wonderful job of summarizing the impact of specific social reforms on the health care systems of Germany, France, and England. He argues that

"accepting the path-dependent nature of our health-care
system—recognizing that we had better build on what we’ve got—doesn’t
mean that we have to curtail our ambitions. The overarching goal of
health-care reform is to establish a system that has three basic
attributes. It should leave no one uncovered—medical debt must
disappear as a cause of personal bankruptcy in America. It should no
longer be an economic catastrophe for employers. And it should hold
doctors, nurses, hospitals, drug and device companies, and insurers
collectively responsible for making care better, safer, and less costly."

He spelled out the message to policymakers: you cannot remake a sixth of the US economy from scratch — you have to build on what has worked to date. Sound obvious? Tell it to Hillary Clinton or to the dozens of elected officials dreaming about legislating single payer health care in 2009.

In June, Gawande published The Cost Conundrum: what a Texas town can teach us about health care. He reports on McAllen, Texas, the town with the distinction of having the highest health care costs in America. Were they healthier for all the spending? No, they weren't. Were they spending because they were unhealthier — perhaps the Tex-Mex diet and nearly 40% obesity rate? Nope, El Paso is next door and just as fat, but spends a lot less. Did they have better technologies?

"there’s no evidence that the treatments and technologies
available at McAllen are better than those found elsewhere in the
country. The annual reports that hospitals file with Medicare show that
those in McAllen and El Paso offer comparable technologies—neonatal
intensive-care units, advanced cardiac services, PET
scans, and so on. Public statistics show no difference in the supply of
doctors. Hidalgo County actually has fewer specialists than the
national average.

Nor does the care given in McAllen stand out
for its quality. Medicare ranks hospitals on twenty-five metrics of
care. On all but two of these, McAllen’s five largest hospitals
performed worse, on average, than El Paso’s. McAllen costs Medicare
seven thousand dollars more per person each year than does the average
city in America. But not, so far as one can tell, because it’s
delivering better health care.

The article was smashing because it was so careful. It looked at the problem from the perspective of a physician, a patient, and a payer. Take this conversation:

"One afternoon in McAllen, I rode down McColl Road with Lester Dyke,
the cardiac surgeon, and we passed a series of office plazas that
seemed to be nothing but home-health agencies, imaging centers, and
medical-equipment stores.

“Medicine has become a pig trough here,” he muttered.

Dyke
is among the few vocal critics of what’s happened in McAllen. “We took
a wrong turn when doctors stopped being doctors and became
businessmen,” he said.

We began talking about the various
proposals being touted in Washington to fix the cost problem. I asked
him whether expanding public-insurance programs like Medicare and
shrinking the role of insurance companies would do the trick in McAllen.

“I
don’t have a problem with it,” he said. “But it won’t make a
difference.” In McAllen, government payers already predominate—not many
people have jobs with private insurance.

How about doing the opposite and increasing the role of big insurance companies?

“What good would that do?” Dyke asked.

The
third class of health-cost proposals, I explained, would push people to
use medical savings accounts and hold high-deductible insurance
policies: “They’d have more of their own money on the line, and that’d
drive them to bargain with you and other surgeons, right?”

He
gave me a quizzical look. We tried to imagine the scenario. A
cardiologist tells an elderly woman that she needs bypass surgery and
has Dr. Dyke see her. They discuss the blockages in her heart, the
operation, the risks. And now they’re supposed to haggle over the price
as if he were selling a rug in a souk? “I’ll do three vessels for
thirty thousand, but if you take four I’ll throw in an extra night in
the I.C.U.”—that sort of thing? Dyke shook his head. “Who comes up with
this stuff?” he asked. “Any plan that relies on the sheep to negotiate
with the wolves is doomed to failure.”

Gawande concludes

"Providing health care is like building a house. The task requires
experts, expensive equipment and materials, and a huge amount of
coördination. Imagine that, instead of paying a contractor to pull a
team together and keep them on track, you paid an electrician for every
outlet he recommends, a plumber for every faucet, and a carpenter for
every cabinet. Would you be surprised if you got a house with a
thousand outlets, faucets, and cabinets, at three times the cost you
expected, and the whole thing fell apart a couple of years later?
Getting the country’s best electrician on the job (he trained at
Harvard, somebody tells you) isn’t going to solve this problem. Nor
will changing the person who writes him the check."

This week, Gawande came out with what may be his finest piece yet: Testing, Testing: The health-care bill has no master plan for curbing costs. Is that a bad thing? He begins where my post this afternoon left off (I read his article an hour after the post on the current state of health care reform).

"Cost is the spectre haunting health reform. For many decades, the great
flaw in the American health-care system was its unconscionable gaps in
coverage. Those gaps have widened to become graves—resulting in an
estimated forty-five thousand premature deaths each year—and have
forced more than a million people into bankruptcy. The emerging
health-reform package has a master plan for this problem. By
establishing insurance exchanges, mandates, and tax credits, it would
guarantee that at least ninety-four per cent of Americans had decent
medical coverage. This is historic, and it is necessary. But the
legislation has no master plan for dealing with the problem of soaring
medical costs. And this is a source of deep unease."

Gawande summarizes the paralyzing effect of health care costs on our economy an then proceeds to tell an amazing story about how at

"the start of the twentieth century, another indispensable but
unmanageably costly sector was strangling the country: agriculture. In
1900, more than forty per cent of a family’s income went to paying for
food. At the same time, farming was hugely labor-intensive, tying up
almost half the American workforce. We were, partly as a result, still
a poor nation. Only by improving the productivity of farming could we
raise our standard of living and emerge as an industrial power. We had
to reduce food costs, so that families could spend money on other
goods, and resources could flow to other economic sectors. And we had
to make farming less labor-dependent, so that more of the population
could enter non-farming occupations and support economic growth and
development."

He then makes the case for a lot of testing and for a subtle role for government based on the experience of the Department of Agriculture's Extension Service. The last time I read a plea for a government agency based the experience of agricultural extension agents who tested, learned, and taught their way to high productivity, I was advocating to the Clinton Administration for what became the Department of Labor's Office of the American Workplace. I wish I had known as much as Gawande has learned on the topic however. He not only understands the subtleties of the government role, but of the role of the legislature as well. And he makes a compelling case for learning our way to reducing medical costs and for learning from the astonishing success of our Agricultural Extension agents as we do so.

These three articles, published during Gawande's annus mirabilas, may do more to shape the future of American health care than any others. Gawande has made such extraordinary contributions to our current debate that we should grant the man his life's wish: let's make him into a rock star. He has earned it, he always wanted to be one, and he has a message that will leave all of us much better off.

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This week Americans discovered that we are to pay multi-million dollar bonuses to the very AIG executives who bankrupted the company (a fairly small part of AIG called the Financial Products Group in London). Many of the recipients no longer even work at AIG. The claim that we had contractual obligations to pay them is silly – these guys would get zero but for the bailout. Any semi-conscious lender would bust these contracts as a condition of the loan.

What? Treasury Secretary Geithner removed limits on compensation in the bail-out bill? Oops.

Made-for-cable outrage. We are shocked to learn that federal bail out money ended up in the bank accounts of the bankers we are bailing out. Shocked.

This is where the problem of perspective comes in. Our city is ablaze, the firefighters are out in force, and although it is irritating to see looters pocketing the family jewels, it is a poor reason to stop fighting the fire.

Americans have lost $13 trillion worth of housing and stock market value since mid-2007. A $30 trillion global economy is actually melting. Employment riots are happening every week, China is starting to tremble and is suddenly a nervous lender (although it announced its case of the jitters the day after Hillary complained about Tibet). The EU, the world's biggest economy if you can call it that, is utterly paralyzed. There is precisely one person on the planet with the power to turn this thing around and he has spent the past week doing damage control because an economically trivial mistake was politically pitched for prime time. The ill-gotten AIG bonuses are less than one percent of the $200 billion we are lending AIG. It will cost us a lot more than that if the AIG bonuses become the legislative lever that lets the Senate tie up Barack Obama's recovery plan.

Did Geithner screw up? Yep. But his job, after all, was to keep the financial system from collapsing. Given that AIG was not remotely the only company being bailed out, it would be astonishing if Geithner HAD focused on small, ill-advised expenditures like this.

Now self-righteous populist indignation cascades from Washington like a mighty river. Republicans attempt to outdo Democrats in their disdain for unworthy rich bankers. Fingers point randomly at potential villains as Congress rushes through a bill to impose a 90% tax on any bonus from any company getting any bail-out money — a sure-fire approach to create very bad legislation. Remember this scene next time someone tells you that we should nationalize our banks.

Even the financial press has lost perspective. The Wall Street Journal leads with the AIG bonus story but tucks below the fold the news that Ben Bernanke's Federal Reserve is preparing for a bit of "quantitative easing", which means that the Fed will open wide the sluice gates and flood the land with liquidity. Specifically, the Fed's Open Market Committee will double its purchases of mortgage-backed securities from $600 billion to $1.25 trillion and buy another $300 billion of student and other loans or related securities.

Translation: grab your bucket Martha, the government is dumping a trillion dollars from helicopters. Since the fed cannot lower interest rates below zero, they have decided to crank up the printing presses. But since cash is only a tiny part of what we call money, they don't print money, they buy back government debt. Of course they have to be prepared to take the money out again when the time comes or we start looking uncomfortably like Zimbabwe.

Note that Congress did not approve this move. The Fed controls monetary policy without Congressional oversight (legislatures cannot sensibly rule central banks and almost nowhere have the power to do so). As a financial stimulus, this dwarfs anything that the Treasury Department could do on its own.

How will this help the economy? Well the Fed buying up every mortgage in sight means that mortgage rates are going even lower. This can represent real, permanent stimulus for homeowners who refinance. In 2008, the average rate on a 30 year fixed mortgage was about 6.50%. If the Fed lowers this by 200 basis points to 4.50% and all homeowners refinance, households would have roughly $200 billion per year to spend. It works out to about $2,000 per household that refinances (although at a time when home values are down and unemployment is up, not everyone will be able to refinance). It should push rates on auto and student loans lower as well.

Helicopter Ben did not make headlines, but compared to the $1.50 per household that Congress wants to seize from naughty bankers, he stands a much greater chance of actually defibrillating the economy.

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Ron is a bankrutpcy rock star who works out of a union office not a Wall Street highrise. He has jumped into some 50 bankruptcies in the past 20 years and he is very good at it. (And I take nothing from Diana Farrell who, with her McKinsey colleagues, has done some pathbreaking work on global productivity).

Ron and I worked together for almost a year to turn around Algoma Steel (McKinsey was on the other side of the table). Ron did an amazing job — he is a superb financial analyst, a strong and creative bargainer, and able to find deals in places where deals are very hard to find. He is smart, funny, and mildly profane — my kind of guy.

After Algoma, Ron went on the staff of the Steelworkers, where he has done more than anyone to help create a competitive US Steel industry. When Ron joined Leo Gerard, the tough and slightly crazy Canadian who had just been elected USWA President, the Autoworkers were twice as big as the Steelworkers. Today, the United Steelworkers are larger and a good bit of that that is due to Ron (and to Leo's courageous decision to put up with a Harvard trained investment banker on his staff).

 Can Bloom work his magic on the auto companies? As an economic matter, the patients require massive and painful surgery. This is why we have bankruptcy proceedings. In bankruptcy, the shareholders and most creditors are wiped out. Labor, dealer, and supplier contracts are restructured, assets liquidated, new lines of credit negotiated, new management brought in, etc. It is tough work that tests not just the patience but the values of the people who do it. Whether bankruptcy is the right tool for restructuring auto companies and if so, what flavor of bankruptcy works best has become a pundit's parlor game. The patients, meanwhile, are declining quickly.

Three challenges make Ron Bloom's task unusually tough.

First, Ron has the curse of the federal treasury behind him. Companies on public life support frequently conclude that federal money is really nice. Restructuring becomes a game of political chicken: the President will not let GM fail, so GM doesn't take the really painful steps it needs to succeed. 

Chrysler is not the problem — it looks utterly hopeless. Ford is not the problem, since at present anyway it prefers to sip its bailout funds, not gulp them. The big risk is that GM becomes like many banks — a federally subsidized zombie who cannot live and cannot die. A federal bail out may be perfectly good policy in a recession and bankruptcy may actually be as unworkable as some in the auto industry assert, but a credible death threat always helps a tough restructuring. Stern lectures from Congress just don't count.

Second, the car business is massive, slow, and complex. Cars are regulated fashion goods with integrated and sometimes fragile supply chains. They have highly politicized workforces and distribution channels. They are culturally and politically iconic. They are not a global commodity like steel or a fungible service like airlines.

Auto makers live and die with new products, which take years and billions to develop. If you managed to eliminate chronic legacy costs and operational inefficiencies, you still have a product development pipeline that is 2-3 years long with a tendency to produce Hummers (exciting, impractical, expensive), Saturns (dull, practical, cheap), and Volts (exciting in theory, impractical in practice, and expensive). To fix this industry is not simply a matter of quickly reengineering very complex balance
sheets. It requires a long-term product strategy against large, efficient global competitors. It is a very tall order and not one that the US Treasury Department is ideally equipped to handle.

Finally, in bankruptcy creditors compete with each other but in bailouts the healthy compete with the sick for public money. In other words, transplants want and arguably deserve a piece of whatever bailout money Congress puts up. The 19 transplants employ tens of thousands of Americans to produce cars that consumers often prefer to Big Three models. They will understandably resist the use of public funds to strengthen their half-witted competitors. This is a huge factor in the Senate already and will become an even bigger factor over the next 12 months.

Paradoxically, the Big Three will probably address this by doubling down — gambling that taxpayers will commit more money to a complete transformation of the car industry if it involved a transition to high mileage vehicles
and alternative fuels. This, of course, makes the restructuring climb even steeper and asks Americans to trust in managers who have spent decades fighting against change, not for it.

So on balance, I don't like Ron's odds and if the economy turns I am likely to question the mission. That all said, I would never bet against him.

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They are related economic diseases, but each requires different government medicine.

• We have a credit crisis. Banks won’t lend to people, they won’t lend to businesses, and they won’t lend to each other. Banks are on strike.

• We have a recession. This is a classic crisis of consumer spending. When consumers don’t spend, businesses don’t grow, since consumer spending is 70% of the economy. Consumers are on strike and frozen credit markets are turning a bad recession into a depression. 

• The normal medicines won't work as well or as fast because we have massive and unsustainable global financial imbalances.  High-saving Asian countries grow by exporting goods and savings to the US. They cannot recover from the current crisis by resuming this export-led growth and we cannot recover through borrowing more. China is not on strike – it has been laid off. This condition carries with it a very high risk of complication in the form of economic nationalism.

The Credit Crisis
The credit crisis is food poisoning. Banks consumed toxic assets and ended up sick and paralyzed. Some are actually dead but still walking around -– zombie banks.

At the time, the food looked healthy enough. Banks and other financial institutions took on portfolios of loans secured by homes or insurance on bundles of loans secured by homes. Yummy. But the assets were toxic for two reasons – both made worse by government inattentiveness.

First, lending standards fell apart. There were a lot of reasons for this, but a fundamental one is that banks no longer held the loans they originated. If I loan you money and quickly sell the loan, I care a lot less about your creditworthiness. That’s now the other guy’s problem.  My incentive is to loan to anybody. So-called Ninja loans (no income, no job, no assets), and loans with teaser rates that reset into unsustainable payments are the logical result. Whether this was flagrant lending abuse by mortgage originators, progressive policies that let farm workers buy $700,000 houses, or innumerate borrowers who did not read their loan documents is much debated but no longer matters. A lot of people took out loans that they cannot repay. As a result, housing prices dropped below the value of the loans, so mailing the house keys to the bank makes economic sense.

Thanks to easy credit, housing prices soared and many people borrowed money against their newly valuable homes. And why not? Rates were low and on paper, we were wealthy. Americans borrowed $700 billion against their homes in 2005 and 2006. (Last year the number was well under $100 billion). These borrowings sustained a much higher rate of economic growth than would otherwise have occurred – adding an astonishing 1-3% to GDP growth in 2000-2006. All good — so long as housing prices do not grow faster than incomes for a long period of time. But they did.

Banks made the problem worse by chopping the mortgages up into securities. Nothing wrong with this – it allows investors to purchase bundles of mortgages according to the underlying credit risk and lowers the cost of capital for banks and consumers. But it only works if you really understand the underlying credit risk – and nobody did. In a bond portfolios cited earlier, 15% of consumers reportedly never made even one house payment. In every portfolio, the market value of many of the homes is now less than the mortgage.

Worse, securitized loans are really hard to restructure. Normally, consumers and banks would rework these loans (banks don't want to own the house, which in any case is not worth as much as anybody thought). But with every mortgage smashed to pieces and traded in parts, most borrowers have nobody to negotiate with.

Having eaten a plate of bad fish, banks washed the meal down with paint thinner. Financial institutions that held portfolios of collateralized mortgage obligations understood that the underlying mortgages might default. So they took out insurance in the form of credit default swaps. Organizations like AIG wrote credit default swaps to banks. A CDS is an insurance contract. For a fee I agree to reimburse you in the statistically unlikely event that your mortgage bonds turn out to be worth less than some amount we agree on.The dirty secret however, was that neither of us had any real idea what the odds of default were.

The CDS market is an unregulated insurance market. The writer of a CDS are not subject to capital sufficiency or other underwriting requirements. CDS soon became a way to insure not only a security or a portfolio against credit default, but even an entire company. It became a parallel and unregulated stock market — meaning a way to bet on the rise or fall of any company.

The market for credit default swaps erupted. The value of US housing stock is about $10 trillion. The value of credit default swaps is estimated at $65 trillion. Many of these are offsetting bets (some banks hold both the asset and the insurance against the failure of the asset. Presumably they are hedged). When you hear about “toxic assets” held by banks, think credit default swaps for mortgage bonds built on poorly underwritten loans.

Today banks have no idea what most of this stuff is worth. Worse, they don’t really want to know because as banks sells these assets, other banks have to mark down their portfolio to the new market price.  Doing so will put many banks in violation of their capital requirements and force them to seek new capital or close shop. So they hold their breath, take some government money, and do nothing.

Paradoxically, the situation for regional banks is in many ways worse because they hold more "whole mortgages" — loans that were never securitized. Even though mortgage bonds are written down as their market price falls, whole mortgages are traditionally not written down so long as the loan payments are current. As a result, regional banks are much more exposed to government purchases of mortgages at deep discounts — likely to be a part of any Treasury or Fed-led restructuring or homeowner relief effort. Re-pricing mortgages and setting a market rate for mortgage bonds and CDS will drive hundreds of banks out of business.

The sooner, the better. Far better to have fewer, better capitalized banks than zombie banks. When Obama says "some banks won't make it" he is really saying "you are dead and starting to smell funny. Mind if we bury you?"

The Recession
A few years ago, economists wrote a lot about “the wealth effect”. Essentially it meant that if you felt wealthy, you spent more – often more than you earned. Wealth effects were widespread because asset values – especially homes – were at an all-time high. 

Now we have a “poverty effect”. Home prices have collapsed and will decline further. Consumers who feel impoverished, stop spending. Companies cut prices to spur demand, then lay off people when that doesn’t work. When they realize that they can hire people back for 25% less than their current employees make because prices are dropping, they lay off more people. This is a classic deflationary spiral and it is as bad for debasing an economy as inflation. Homeowners default in droves, which further reduces creditor’s willingness to lend. Reduced credit and hits to household wealth further depress economic growth. Pretty soon you are hoarding cash and growing your own food. 

Three-decades of family income stagnation lies at the root of the recession and the credit crisis. Starting in the seventies we financed economic growth by adding women to the workforce and by working longer hours. Combined weekly work hours for dual-earning couples with children rose 10 hours per week, from 81 hours in 1977 to 91 hours in 2002, according to the New York-based Families and Work Institute. Today women outnumber men in the workforce for the first time in US history.  

In the nineties, we financed growth not by earning more but by borrowing more– typically against houses, but also using credit cards and other forms of consumer debt. Today the economy has twice as much debt as our long term average and is higher than our previous peak during the Great Depression. Debt of all kinds (consumer, mortgage, business, government) is at record levels. Mortgage debt grew 60% from 1998-2008. Household income did not.

Of course income can grow only as fast as labor productivity. But the gains from labor productivity have gone overwhelmingly to top income earners. This has produced a set of economic arguments for stronger unions, including the so-called Employee Free Choice Act, about which more in a future post.

It is also true that labor productivity is unlikely to grow faster than the share of our workforce that is college educated. In the last century, the US led the world in the share of 25 year olds who were college educated. Today we are 31st — behind Bulgaria and just ahead of Costa Rica. As Obama economic adviser Austan Goolsbee notes, "The problem for countries with skill levels between Bulgaria and Costa
Rica is that 20 years from now they'll also have income levels between
those countries".

Global Imbalances
The massive increase in home mortgages, consumer credit, business, local government, and federal debt has not come from the savings of Americans. It has come from the savings of Chinese who were selling to Americans and not spending much of their paychecks (which many would argue were too small in dollar terms to start with). High Chinese savings required Americans to spend ever larger shares of our income to support China’s export-led growth.

Americans have now stopped spending and started saving – with a vengeance. The Chinese are being forced to stimulate local spending in a big way (every family got a bonus check from the state just before New Year's this month). But with so little social safety net, Chinese families save for medical emergencies and retirement. The global economic crisis will almost surely force the Chinese government to divert resources from capital projects to social ones in order to spur consumer spending in China.

Also as a result, China is unlikely to continue to loan the US trillions of dollars. In part this is because Chinese growth will increasingly be driven domestically, so they share of the state treasury consisting of dollars will decline. It is also true that with US savings rates rising, we may need less overseas capital (not necessarily a good thing). Also, Chinese direct investments in the US have frequently done poorly (Blackstone and Morgan Stanley come to mind).

Perhaps the most important consequence of trade and national income account imbalances however, is the common side effect. Major recessions always produce economic nationalism – which can quickly turn a recession into a depression. Whether in trade union rhetoric or the “Buy American” features of the stimulus package, economic nationalism is clearly on the rise. The urge to keep jobs and capital at home is politically powerful but economically misguided. Trade is the least of it. Trade enriches countries by enabling them to specialize, but it is global capital markets that are real engines of prosperity. Global financial institutions do a better job of allocating money than local ones and they promote economic integration and co-operation. 

Even without a political backlash, globalization is suffering a huge reverse. According to The Economist, world trade will probably decline this year for the first time since 1982 with net private-sector capital flows to emerging markets dropping to $165 billion, from a peak of $929 billion in 2007.

The Prescription
The standard remedy for recessions starts with the central bank reducing interest rates and increasing the money supply. Normally this is a recipe for a debauched currency and all manner of economic havoc, but any government will lower interest rates and fire up the printing presses to prevent an awful recession.

• Monetary policy hasn’t worked. The Fed has lowered interest rates to zero and the government is printing money overtime (actually buying back bonds with cash to get banks to lend). It has had at best a modest effect. Banks and investors are freaked and frozen. Free money is not an incentive to lend if you are not sure about your own balance sheet or that of your borrower.

• Next stop, fiscal policy. A lot of attention this week to the massive government stimulus package that is (sort of) designed to create jobs. The package is a dog’s breakfast – short term mixed with long term, permanent mixed with temporary, capital investment mixed with spending, and the entire thing at the small end of what would stimulate a $13 trillion economy.  Unless our plan is to shrink the economy to fit the stimulus, this is unlikely to make a massive difference. As a political matter, I wish Obama had written the bill and let Congress amend it. As an economic matter, I'm less sure that it matters. 

• Treasury initiatives. Next come efforts to restart bank lending. This is critical work and is likely to be a mix things short of outright nationalization. We will see direct investment in banks, the creation of so called “bad banks” to buy toxic assets like the Resolution Trust Corporation did during the Savings and Loan crisis, loan guarantees, and programs to help consumers refinance mortgages. As with the stimulus, the devil is in the details. For example: how will TARP price toxic assets (best answer: a reverse auction where banks bid to sell a portfolio of assets the only buyer in town – the government. Would probably require an accounting change however). We already have seen evidence that the Bush Treasury knowingly paid too much for bank stocks in Q4 of last year.

• Regulatory reform. This will take longer, but a mix of reporting requirements, capital requirements, registration requirements, and a clearing house for derivatives like credit default swaps makes a lot of sense. Some derivatives (basically the ones too difficult for investors and regulators to understand) should be banned because they meet the Warren Buffett definition of “financial WMD”. Mortgages need to be standardized and abusive practices prohibited. I’d be in favor of forcing banks to retain a share of the loans they originate, although there are sensible arguments against this. All of this amounts to closing the barn door after the horse got out, but some of it will help value current securities and in any case future horses ought to be properly restrained. And an SEC that is once again muscular and competent (as it was not so long ago) would also be a very good thing.  

• Global coordination. In his spare time, Geithner needs to coordinate US efforts with every other large economy and build in the multilateral arrangements to ensure philosophically consistent approaches with our trading partners. Stimulus plans should share principles, including a commitment to trade. Cross-border banking rules need to be reviewed and measures taken to address the crushing impact of the crisis on emerging markets. If he does nothing else, avoiding trade wars is an exceedingly good idea. It is tough to be an economic pacifist when other countries start talking trade war – but the US and Britain have done it in the past and need to do it again.

Will all of this work? In the long run it is likely to work. If we are lucky it will help in the short run. Because as the great economist pictured at the top of this post used to say, "In the long run, we are all dead."

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