Smart for one, dumb for all

Spurred by some links from Economist's View and some conversations with Yang about a highly progressive consumption tax, I have been reading some of economist Robert H. Frank's editorials. The theme seems to be that government, and policy makers in general, have the imperative to eliminate or mitigate "smart for one, dumb for all" incentives.

Some examples of "smart for one, dumb for all" situations: at a stadium, one can get a better view by standing up, but if everyone stands up, then everyone has the same view as before but without their comfy seats. In athletics, one can gain an edge by taking steroids that may have some small probability of health risk, but if everyone takes the steroids, then everyone has the same relative standing but now all have the health risk.

I find the metaphor of an arms race most compelling.

Capitalism is all about competition (relative gains are rewarded). But there is a hidden assumption that improvements in relative value result in improvements in absolute value. In many cases this is true; companies compete to produce a higher quality product, or the same product for a lower price, resulting in value for the society as a whole.

Frank's essays focus on situations where this assumption breaks down.

The relevant recent example is the rise and fall of the housing market in the US. There is growing competition between people to buy more expensive houses. Much of the motivation for this is as a display of social status (that is, consumerism in general). In addition, the best public schools are found in richer neighborhoods, and due to the growing importance of eduction, it's rational for a family to try to live in the most expensive house it can afford.

But what's good for one family is bad for society as a whole. Bidding wars result in home prices way above their value as shelter (this can be measured as the ratio of home prices to rental prices). One difference between the 1950s (the beginning of America's recent prosperity) and the early 2000s is that lending rules became laxer (no/low down payments, for example), which allows home buyers to stretch to the very limit of what they can afford.

There is a symmetric story on the side of the lenders, where competition incentivizes fund managers to make riskier and riskier investments. Due to the lifting of regulations, lenders likewise take this to the limit.

The pattern:

	Home Buyers	Fund Managers/Mortgage Lenders
A gamble with a high probability of small gain and a low probability of significant loss	Buying the more expensive house, risking not being able to afford the mortgage.	Buying mortgage-backed securities that offer higher rates of return but greater risk.
Exponential (feedback loop) rewards based on slight relative gains ("winner takes all")	Better schools which have an exponential effect on future generations' success	Better fund performance which attracts more investors, providing greater opportunities
The illusion of safety in numbers	Home prices will keep going up so the house can always be sold	Everyone else is buying mortgage backed securities/offering laxer loan terms

A really excellent, very human telling of this story from the perspective of all players can be found in the This American Life episode, The Big Pool of Money.

I have started a separate blog. Will be posting there from now on.