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The Optimistic Case for the US Economy

April 11, 2010 Leave a comment

Daniel Gross waxes optimistic about the state of the American economy:

But the long-term decline of the U.S. economy has been greatly exaggerated. America is coming back stronger, better, and faster than nearly anyone expected—and faster than most of its international rivals. The Dow Jones industrial average, hovering near 11,000, is up 70 percent in the past year, and auto sales in the first quarter were up 16 percent from 2009. The economy added 162,000 jobs in March, including 17,000 in manufacturing. The dollar has gained strength, and the United States is back to its familiar position of lapping Europe and Japan in growth. Among large economies, only China, India, and Brazil are growing more rapidly than the United States—and they’re doing so off a much smaller base. If the U.S. economy grows at a 3.6 percent rate this year, as Macroeconomic Advisers projects, it’ll create $513 billion in new economic activity—equal to the GDP of Indonesia.

This is all well and good, and it would be nice if it comes to pass. But here’s the thing: Gross is essentially being a contrarian here. He looks good if the economy turns out to perform better than the consensus opinion suggests, and, well, if the economy crashes, none of us are exactly going to be looking to him for guidance anyway.

Bad Business Models and the Consequences of Union Labor

April 8, 2010 Leave a comment

Megan McArdle has an incisive post about the problems that have driven US Airways and United into each others’ arms:

The airline industry is not a particularly attractive market. You’re selling a perishable commodity–once the doors close, any unfilled seats are worthless–to an audience that stubbornly resists treating your product as much other than a commodity. Attempts by the airlines to resist this, with their byzantine pricing rules and frequent flier programs, have by and large not succeeded particularly well; business travelers tend to have multiple frequent flier accounts unless they live near a single airline’s home airport, and economy fliers don’t care. Meanwhile, software is steadily eroding their ability to thwart bargain-hunting consumers through pricing power.

Clearly, the airlines have plenty of reasons for their current parlous state. But it is interesting to consider that, given the blame intransigent labor unions have in this state of affairs, how few people make the connection between rigid labor rules and poorly managed companies. Companies with a history of rancor between labor and management–which describes most unionized workforces–spend a lot of time and energy managing that fractious relationship and so spend less time on operational goals such as product innovation and revenue growth. Compare and contrast Apple and Google with the airlines.

The Problem with Regulating Banks is the Regulators

April 8, 2010 Leave a comment

Lost among all the discussion about how to regulate banks and financial markets in order to avoid a repeat of recent events is this: in order to effectively regulate something the regulators have to be good at their jobs.

Tyler Cowen writes:

Bank regulation is a tough slog, it depends on the quality of the bureaucracy and the periodic attention of a somewhat responsible legislature, “toughness” can be counterproductive, the historic periodic of regulatory “easiness” relied on cartelization and near-automatic profits, and it is like a chess game whereby the private sector eventually finds a way around most of the binding regulations.

Arnold Kling writes:

I do not propose breaking up large banks as a solution for risk cycles in banking. I have a pessimistic view, in which I think that risk cycles are inevitable. I see breaking up large banks as making it easier to disentangle banks from government. That is a good thing by itself, even if it does nothing to change the amplitude of the risk cycle. However, it is quite possible that the amplitude of risk cycles would be reduced if government were less involved. The presumption among those on the left who favor regulation is always that regulators will somehow be smarter than banks over the course of the risk cycle, when the evidence strikes me as showing the reverse to be the case.

Finally, here is Gregory Mankiw:

Government regulators will always be outnumbered and underpaid compared with those whose interest it is to circumvent the regulations. Legislators will often be distracted by other priorities. To believe that the government will ever become a reliable watchdog would be a tragic mistake.

It seems to me that one way to avoid the problem of ineffective regulators, or at least to mitigate it, is to pay regulators market-clearing rates, in order to attract people who would have otherwise gone into banking or trading. In other words, if financial market regulators earned salaries on par with mid-level bankers and traders, financial regulatory bodies may very well prove adept at being able to regulate market participants because the regulators would be competing on equal cognitive footing with those participants. A more succinct way of saying this: staff regulatory agencies with the same exceptionally bright people who work on Wall St. and you may actually have people capable of understanding markets. Perhaps, though, I am attributing too much importance to intelligence and too little to something else. Nonetheless, I think Cowen, Kling, and Mankiw’s comments are all correct and not enough attention is paid to them.

Update: There’s an interesting discussion here of Brazil’s regulatory structure. Simply put bank executives have a lot more on the line if things go bad:

The recent proposals by Senator Dodd do not go far enough in reining in a financial system that still incentivizes excessive risk taking. The suggestions I’ve made above are no panacea, either, but if any of them seems even the least bit Draconian to those occupying the corner suites on Wall Street, they should be very thankful our Congress has not yet adopted the Brazilian approach to financial regulation. In the most recent cover story of “Grant’s Interest Rate Observer” (www.grantspub.com), Jim Grant casts an approving eye on the Brazilian practice of holding a bank’s officers and board members accountable when things go awry at the institution they are charged with guiding. He quotes two principals at Dynamo Capital, who relate that “the net worth of officers and board members is blocked in cases of litigation, losses arising from negligent management or filings for bankruptcy.”

Having one’s net worth on the line while in office is sobering enough for a bank manager or director, but the Brazilians have added a sharp claw-back provision as well. The rule is in effect not just when managers and directors are on the job but also for a full five years after they leave office — longer if legal proceedings are the unfortunate result. What a great concept; with the chances for reward come the full responsibilities for failure! It makes one wonder whether Chuck Prince would have still been dancing in 2006/2007 if every penny he owned was on the line, or if Dick Fuld would have thought twice before levering Lehman’s equity thirtyfold or more.

In the not too distant past, Wall Street firms were partnerships and bank shareholders were liable when the bank they owned hit the rocks. Since we can’t turn back the clock, and since the average Congressperson is unlikely to understand half of my above-listed suggestions (let alone enact them), I would reluctantly settle for the following reforms: Put CDS on proper exchanges; institute a hard cap on leverage of no more than 12 times tangible common equity; and put in place a Brazilian-inspired rule to hold managers and directors financially responsible for failure. As long as banks are run by human beings, we’ll never be able to prevent bankers from making dumb decisions. But with these simple and enforceable border mechanisms in place, we can at least lower the systemic costs of those poor decisions while requiring those who made them to shoulder as much of the financial burden as they can bear. Who knows? Maybe even our contentious Congress will grasp the benefits.

Real Estate and its Consequences

April 7, 2010 Leave a comment

One of the interesting things about thinking about finance in terms of cognitive bias is that you suddenly see how pervasive certain biases are. In real estate, confirmation bias seems pervasive. For young professionals in their 20s or 30s, the thinking goes something like this: My parents bought real estate in the late 1970s or early 1980s and have made a lot of money on paper (or have sold real estate multiple times); therefore, it’s a great investment over the long term. Or, real estate flippers reason: My friend acquired multiple pieces of property and put his kids through college with the proceeds; surely, I am smarter than him.

The problem with this kind of thinking is that it ignores the underlying economy. If the economy does not grow, then real estate prices don’t grow. Real estate prices, over the long term, are a good proxy for an economy’s trajectory. If real estate prices are increasing, the economy is growing because personal incomes are growing and capital is cheap.

The other problem with the real-estate-is-a-good-investment thesis is that bankrupt municipalities and state governments do not make for places where people want to live. Or, rather, owning real estate in states and municipalities that can’t pay their bills is a troublesome concept. Just think of what happened to New York City real estate prices during its fiscal crisis of the late 1970s.

So, there are a lot of problems with owning residential real estate. The most important of these problems, and the one least in control of the homeowner, is the fiscal stability of the local and state government.

But, beyond those factors, about which much more could be written, lie a number of other troubling aspects.

Felix Salmon writes eloquently:

Homeownership is, if anything, a drag on the economy, since it funnels resources into unproductive overconsumption, and helps to impede labor mobility. There is absolutely no reason to believe that countries with high levels of homeownership, like the U.S., have better economies than those with low levels of homeownership, like Germany.

The survey just gets more depressing from there. Americans think now is a good time to buy a house, largely because they think it’s always a good time to buy a house. And they reckon — even now — that house prices are going up, or will at least stay stable.

Of course, free marketers will argue that people ought to be free to spend money on whatever they please, and if real estate pleases people, so be it. This is true. But it’s also important to remember that the real estate market is neither a free market nor a liquid one. One’s real estate follies can’t as easily be reversed as one’s foolish investment in overpriced Apple stock. The real estate market is also manipulated by the government, firstly by allowing homeowners to deduct interest from their taxes, and secondly by serving as a backstop in the form of Freddie Mac. Indeed, it has been the explicit social policy of the United States government over several decades to encourage homeownership, especially among the poor. While its origins have a laudable goal–encourage access to responsible use of credit–the practical realities of expanding homeownership to ever-greater numbers of people has been that many people who are not able to parse the terms of a mortgage document, or build a loan amortization table, or earn enough money on a monthly basis to service the debt inherent in taking on a mortgage, have become homeowners. Not all of these people should own homes. We’ve moved from being a society where housing is seen as a civil right to where homeownership is seen as a civil right. The former makes sense; the latter does not.

Finally, a note on rentals. Megan McArdle notes that rental prices in many metro areas have been increasing recently. Arguably, this bodes well for the economy: if rental prices are picking up, it means that tenants feel that they can pay more because they are more secure in their jobs. However, she also notes that rental price increases may also be a consequence of the government’s intervention into the housing market, which intervention has kept housing prices artificially high. This of course raises the question: if the government’s explicit policy is to encourage homeownership, why does the government also intervene to keep market prices high? The answer to this is obvious: the government likes to have its cake and eat it, too.

Update: Matthew Yglesias makes some very perceptive comments about how Greenspan & Bernanke egged the housing bubble on.

Offshoring Jobs and the Myth of a Static Economy

April 6, 2010 1 comment

It has become a commonplace that American jobs have been eliminated in favor of cheaper labor overseas. To some extent, this is true, but it misses the real story. Most of the jobs that have moved overseas, and which are not coming back to the United States, are jobs for which educational requirements are minimal. The poorly trained and uneducated are the victims of structural changes in America’s economy.

(Other victims of structural changes in the American economy are the overeducated who pursue education in fields for which there is very little demand, such as humanities PhDs. But there is little sympathy for naive academics who find themselves unemployable.)

But, there’s nothing new about this. When elevators went from manual to automated, the people who lost out were elevator operators, who, of course, did not need much in the way of education to do their jobs. Likewise, when sock or textile manufacturers move their operations from, say, the Midwest, to China, it is the employees of American textile mills, who, by and large are relatively uneducated, who lose. Other Americans gain.

Now, to a very large extent, this is blaming the victim for economic forces beyond his control. That is true. However, it is also true that if the American economy wants to continue to grow over the coming decades, there will be winners and losers in it. Egalitarianism is a false ideal upon which Stalin murdered tens of millions of people. That is what social safety nets are supposed to account for (in part). It is also incumbent upon people to realize the precariousness of their current employment and pursue opportunities to develop skills that are transferable. The United States’ deplorable educational system does not help in this regard.

But we can’t conclude from any of this, as some do, that the overall number of jobs in the United States has decreased because a lot of those jobs have been moved overseas. Neither the economy nor the number of jobs is a static thing. Buggy whip manufacturers were driven out of business by the development of the internal combustion engine, but in the decades since the internal combustion engine was invented, many more jobs than were ever lost by buggy whip manufacturers have been created.

The Municipal Bond Problem

April 6, 2010 1 comment

All of the sudden, a lot of attention is being paid to the municipal bond market. Rick Bookstaber writes:

Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

The problem, as always, is goverments spending more money than they take in. Except, unlike the US government, the nation’s municipalities can’t print money because they’re not sovereign entities with their own currency, and their ability to sell more debt is constrained by people’s willingness to believe that they will pay their existing debts.

David Merkel notes the similarities between ineptly run municipal governments and corporate crooks:

Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform. (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)

The question I would pose to those who inveigh ceaselessly about corporations and capitalism is this: when do we, the citizens, become taxed enough by governments that can’t spend within their means? All the attention paid to fraud on Wall Street is for naught if it allows government to escape unscathed.

The Problem with Confirmation Bias

April 3, 2010 Leave a comment

Confirmation bias is endemic to financial markets because their participants have money on the line and those participants want to know that the bets they are making will be profitable. Therefore, investors, traders, financiers, and all other manner of market participant seek reassurance. This type of cognitive bias makes an appearance in other places, and it’s useful to consider how it harms those unaware of it.

The New York Times has an interesting article about Tiger Woods, his inner circle, and the loyalty he demands from the same:

Tiger Woods, a self-acknowledged control freak, insists on loyalty as a fundamental quality in employees, associates and friends. Just how much Woods values allegiance was summed up by his father, Earl, in an interview shortly before he died.

“Loyalty is No. 1 to Tiger,” Earl Woods said in a biography of his son. “You’re loyal or you’re history.”

The problem here is a lack of perspective. If all the people with whom you deal hew to the party line you have no way of understanding perspectives different from your own experience. (North Korea’s cult of personality is probably the most extreme demonstration of this cognitive bias.)

How does this type of bias manifest itself in finance? The always-invaluable Robin Hanson at Overcoming Bias writes:

We’d love for things to go well. So we’d love people to think that things are going well. So we want folks to hear news about how things are going well. But sometimes people hear bad news, about how things are going bad. Gee – why don’t we fix this by banning bad news? Then people will only hear good things, and so only good things will happen, right?

This argument is transparently stupid to most everyone, at least when they think of “bad news” as appearing in newspapers or TV shows. Sadly, that insight seems to disappear when it comes to financial bad news communicated via short sales.

Just as Tiger Woods seems to want to avoid any appearance of discord or disagreement within his empire, and so has suffered as a result, financial market players don’t want to contemplate news that doesn’t comport with their view of the world. It is likely true that most investors are a rather optimistic lot–else, why bet on the future outcome of an investment–and so don’t want to contemplate that maybe the future is not as rosy as the conventional wisdom.