Bad Economics 101 From Radio Host Ed Schultz and Gov. Rendell

Heading into the campaign's final stretch, Pennsylvania Gov. Ed Rendell said to lefty radio host Ed Schultz that John McCain and Sarah Palin spent so much time in the Keystone State, "I'm thinking of charging them state income tax they've been here so often."

The quip drew hearty laughter from a union audience for Schultz's show on Oct. 29 from United Steelworkers' headquarters in Pittsburgh.

But then Rendell said this about what would result from imposing Pennsylvania income taxes on the GOP candidates -- "it would be good for our economy." And while Rendell was clearly kidding about levying taxes on McCain and Palin, Rendell wasn't kidding about what he believes would result if he did.

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Needless to say, the dutiful Schultz didn't correct Rendell of his flawed assumption, having thoroughly absorbed the same belief. 

The next day, for example, Schultz had this to say at a town hall meeting he moderated in Asheville, N.C. --

We have lived in the most selfish generation in the history of the country, undoubtedly. We have put all the favors at the top 2 percent. We've given all the breaks to the top 2 percent. The Bush economic plan has failed! It has failed! It has miserably failed, it has gutted this country's infrastructure. And you know what's gonna have to happen? Those who make more than 250 ($250,000), those who make more than a million, they're going to have to step up! Because they can! That's why!

Rendell must have meant this, because without much in the way of thought he would have concluded, if only in a moment of private candor, that imposing higher taxes for no other reason than an amorphous notion of it being "good for our economy" has the opposite effect.

For example, if wealthy individuals like McCain and Palin weren't paying higher taxes Rendell yearns for, how might they spend their money instead? John and Cindy McCain might use the money to pay for maintenance and upkeep of their seven residences, the ones liberals resented so much during the campaign. The carpenters and landscapers, caterers and other hired help thus employed would spend wages they earned, which -- dare I say it? -- would be good for our economy. Who knows, the McCains might even purchase another vehicle or two, helping an auto industry in desperate need of customers.

Higher tax money not extracted from the Palins could be spent on all manner of things -- baby clothes and toys, cell phones and electronic gizmos for the older kids, replacement parts for snowmobiles as another brisk Alaskan winter approaches.

In fact, not only is actual appropriation of higher taxes for vague or unstated reasons bad for the economy, the mere expectation of this has much the same effect.

Exhibit A: The stock market plunging nearly 500 points on the day after Obama won the election, a sobering decline in stark contrast to the unabashed giddiness of Obama disciples 'round the cosmos.

In fairness to Obama and friends, the stock market hit a rocky patch well before the election. But in fairness to McCain, Palin, et al., the speculation as to what was causing the market's ongoing decline through October fell along predictable partisan lines. To Democrats and liberals, it was due to the expectation of a McCain presidency. For Republicans and conservatives, it was the market's keen awareness of Obama's oft-stated intention to soak the rich.  

Well, as of Wednesday, after a blissfully undisputed election, John McCain was no longer a candidate for president, Barack Obama was president-elect -- and the stock market promptly tanked. 

Those inclined to dismiss the market's immediate reaction to the reality of Obama's looming presidency may wish to read James Surowiecki's insightful book, "The Wisdom of Crowds: Why the Many Are Smarter than the Few and How Collective Wisdom Shapes Businesses, Economies, Societies, and Nations."

One of the examples cited by Surowiecki stems from an earlier cataclysm, with an immediate -- and prescient -- market reaction that followed: the loss of the space shuttle Challenger and its crew on Jan. 28, 1986.

As described by Surowiecki --

At 11:38 am on January 28, 1986, the space shuttle Challenger lifted off from its launch pad at Cape Canaveral. Seventy-four seconds later, it was ten miles high and rising. Then it blew up. The launch was televised, so news of the accident spread quickly. Eight minutes after the explosion, the first story hit the Dow Jones News Wire.

The stock market did not pause to mourn. Within minutes, investors started dumping the stocks of the four major contractors who had participated in the Challenger launch: Rockwell International, which built the shuttle and its main engines; Lockheed, which managed ground support; Martin Marietta, which manufactured the ship's external fuel tank; and Morton Thiokol, which built the solid-fuel booster rocket. Twenty-one minutes after the explosion, Lockheed's stock was down 5 percent, Martin Marietta's was down 3 percent, and Rockwell was down 6 percent.

Morton Thiokol's stock was hit hardest of all. As the finance professors Michael T. Maloney and J. Harold Mulherin report in their fascinating study of the market's reaction to the Challenger disaster, so many investors were trying to sell Thiokol stock and so few people were interested in buying it that a trading halt was called almost immediately. When the stock started trading again, almost an hour after the explosion, it was down 6 percent. By the end of the day, its decline had almost doubled, so that at market close, Thiokol's stock was down nearly 12 percent. By contrast, the stocks of the three other firms started to creep back up, and by the end of the day their value had fallen only around 3 percent. (emphasis added and throughout)

What this means is that the stock market had, almost immediately, labeled Morton Thiokol as the company that was responsible for the Challenger disaster. The stock market is, at least in theory, a machine for calculating the present value of all the "free cash flow" a company will earn in the future. (Free cash flow is the money that's left over after a company has paid all its bills and its taxes, has accounted for depreciation, and has invested in the business. It's the money you'd get to take home and put in the bank if you were the sole owner of the company.) The steep decline in Thiokol's stock price--especially compared with the slight declines in the stock prices of its competitors--was an unmistakable sign that investors believed that Thiokol was responsible, and that the consequences for its bottom line would be severe.

As Maloney and Mulherin point out, though, on the day of the disaster there were no public comments singling out Thiokol as the guilty party. While the New York Times article on the disaster that appeared the next morning did mention two rumors that had been making the rounds, neither of the rumors implicated Thiokol, and the Times declared, "There are no clues to the cause of the accident."

Regardless, the market was right. Six months after the explosion, the Presidential Commission on the Challenger revealed that the O-ring seals on the booster rockets made by Thiokol--seals that were supposed to prevent hot exhaust gases from escaping--became less resilient in cold weather, creating gaps that allowed the gases to leak out. (The physicist Richard Feynman famously demonstrated this at a congressional hearing by dropping an O-ring in a glass of ice water. When he pulled it out, the drop in temperature had made it brittle.) In the case of the Challenger, the hot gases had escaped and burned into the main fuel tank, causing the cataclysmic explosion. Thiokol was held liable for the accident. The other companies were exonerated.

In other words, within a half hour of the shuttle blowing up, the stock market knew what company was responsible. To be sure, this was a single event, and it's possible that the market's singling out of Thiokol was just luck. Or perhaps the company's business seemed especially susceptible to a downturn in the space program. Possibly the trading halt had sent a signal to investors to be wary. These all are important cautions, but there is still something eerie about what the market did. That's especially true because in this case the stock market was working as a pure weighing machine, undistorted by the factors--media speculation, momentum trading, and Wall Street hype--that make it a peculiarly erratic mechanism for aggregating the collective wisdom of investors. That day, it was just buyers and sellers trying to figure out what happened and getting it right.

As Surowiecki points out, it took six months after the Challenger explosion for the market's initial suspicion to be confirmed by the presidential commission that investigated the disaster. Much as it may take an equivalent length of time for the market's initial wariness of Obama to be seen as prophetic.