Dr. Sherry Jarrell

Let's Introduce Obama's left hand to his right!

As I was perusing the business press this morning, an article caught my eye:  “That would make a great post!” I thought to myself.  I continued reading through the rest of the articles, intending to go back to the one that piqued my interest to compose a comment.  Of course, when I went back, I could not find it!

But in the process of looking for that particular paragraph, I noticed something troubling. Something that, should my students’ papers include the same, would bring their score down by a full letter grade, if not more.

That troubling observation can be summed up in two words:  internal inconsistency.  My students and I don’t agree on everything, and don’t have to.  They can take any point of view in their written assignments in my class, but their views must be well-articulated, free of factual error and, perhaps most important of all, internally consistent.

The internal inconsistency of the policies coming out of Washington discussed in the news gave me a bit of a headache. While one article stressed the problems with winding down the massive mortgage-related asset accumulation at the Federal Reserve, another discussed the Treasury Department’s efforts to push banks and other mortgage companies to provide more relief to troubled homeowners.  While one article concluded that all executive compensation bonuses should be outlawed, another discussed how President Obama was reaching out to those very chief executives for advice on how to save jobs.  The Federal Reserve strives to ease credit while paying banks to hold onto their excess reserves rather than lend them out. The business section contains a half a dozen articles on programs and legislation – from health care to cap and trade -- that will increase taxes, and one or two articles on how businesses are having to cut back, convert full-time employees to part-time contract workers with no benefits, just to survive.

We need leaders in Washington who can step back and survey the whole of the landscape, who can see that the policies being promoted by Obama’s left hand are slapping up against those being waved about by his right. 
   

We shouldn’t be spending money to rescue bad mortgages when the policies of the government created those bad mortgages in the first place.  We shouldn’t be punishing private business executives while pretending to ask them for advice that the White House had absolutely no intention of following in the first place.  We shouldn’t be raising taxes and the other costs of doing business when we need private industry to keep our labor force gainfully employed. 

In fact, full employment is the key.  Focusing all policy, all efforts, all spending, on allowing free enterprise to do what it does best – hire labor and capital to produce goods and services that private consumers want and need -- is the solution to the problem. 

For example, gainfully employed people who go to their local bank to get a mortgage will be assessed on their true credit-worthiness without some Treasury Department official breathing down the next of the lending officer and telling them they have to extend credit for the greater good.    With full employment, foreclosures fall to normal levels.  Mortgage-backed securities are priced correctly.  There are no toxic assets for the Federal Reserve, in cahoots with the creative-accounting-extraordinaires at the Treasury Department, to pile onto their balance sheet. And the Fed would not now be undergoing experimental reverse-repos (WSJ20091130) to try to unwind the massive increase in assets (from $800 billion to $2.5 trillion by the time it’s over) without further upsetting the credit markets, fueling fears of latent inflation, and undermining the strength of the dollar. 

Ah, the internal inconsistency— better yet, the ETERNAL inconsistency -- between business and politics. 

U.S. Growth Rate Revised Downward

As expected, the Commerce Department http://www.marketwatch.com/story/us-third-quarter-economic-growth-revised-to-28-2009-11-24 has revised downward its estimate of the U.S. growth rate from the third quarter of 2009. Citing weaker consumer spending than originally estimated, the annualized growth rate is now 2.8%, down from 3.5%, far too weak to make any progress on the employment front. 

Paul Krugman's Endless Ego

In a recent New York Times op-ed (http://tinyurl.com/NYTimes-Krugman-Nov2709), Paul Krugman continues his boundless quest to become the "it" guy in the world of economics.  I have taken issue with his command of basic economic facts in the past -- a gutsy, if not insane thing to do given the man was awarded a Nobel Prize in Economics.   In this post, however, the topic is more about ego than economics.

In this op-ed, Mr. Krugman says (and I kid you not), "...But after the debacle of the past two years, there’s broad agreement — I’m tempted to say, agreement on the part of almost everyone not on the financial industry’s payroll — with Mr. Turner’s assertion that a lot of what Wall Street and the City do is “socially useless.” And a transactions tax could generate substantial revenue, helping alleviate fears about government deficits. What’s not to like?"

Well, I disagree with the idea that what Wall Street does is socially useless.  And I am not on the financial industry's payroll.

Nope, I'm just a simple ole' economist, using my head, training, and experience to consider this idea, map out the pros and cons, and analyze the logical end-game of such a tax.  I conclude that it is a really bad idea.

Why?  There are lots of reasons, but I will mention only two. One, raising taxes reduces private economic activity, which will curtail growth, reduce tax revenues and increase the deficit.  Two, taxes distort the price signal between suppliers and demanders of goods and services, including financial capital, reducing economic efficiency.  

His reasons?  Other than citing one academic study (while ignoring the many others that reach a different conclusion), he gives no economic reasons for his views.  Instead, he make claims. He claims, for example, that “socially damaging behavior … caused our current crisis.”  He says that the financial services industry is “bloated” and needs to be cut down to size.   He says that the new tax is okay because it raises revenues for the government which, he claims, should make us all feel better about the deficit and, apparently, the size and nature of government spending under Obama. And, the lamest of all, for no other reason than to hide behind their skirt, he claims the existence of some phantom majority, apparently to create the impression that anyone with a different view is clearly in the minority.   A tactic that should be beneath a Noble Prize winner.

Mr. Krugman, I so disagree with you.  Even in an op-ed piece -- perhaps especially in an op-ed piece – I believe that one needs to reign in an ego that would parade claims as facts, especially when each of those claims is disputed by your fellow economists, none of whom stooped so low as to imply that you were paid for your views.

 

Commercial Real Estate and the U.S. Financial System

The U.S. banking system remains vulnerable to sizeable potential losses as the housing market struggles to recover.   Estimates of these losses range from $500 billion to $1 trillion. The Federal Reserve Board is especially concerned about the impact of commercial real estate on many regional and small banks across the country.  Occupancy and rental rates continue to decline dramatically as 2009 draws to a close, and the worst seems yet to come. 

Commercial real estate loans on banks’ balance sheets total almost $1.1 trillion dollars.  With near-term commercial real estate losses topping $100 billion, the Wall Street Journal estimates that as many as one-third of small and mid-size U.S. banks could experience financial distress. 

 
 

Troubled banks restrict lending until they can raise more capital.  In this illiquid market, expect banks to fight for survival by raising lending rates, shortening maturities, and lowering loan amounts.  Credit will continue to shrink in the U.S., which spells big trouble for any economic recovery. 

 

Housing and the Recovery

As an economist, I am frequently asked for my predictions on when the economy is going to turn around.  Have we reached the bottom?  Have we begun to recover?  Might we go into a second, perhaps more severe recession? 

Those are tough questions to answer.  Business cycles are notoriously difficult to predict.  In fact, about the only thing we know for sure is that no two business cycles are alike. Each is unique in some significant way. 

Changes in the housing market may be one of the most meaningful indicators of a recovery, because housing stability is such a fundamental indicator of how households are budgeting their income.  Notice that I did not say that the level of homeownership was a useful indicator; instead, I look to changes in the housing market, either away from or toward an apparently sustainable and affordable supply of homes, for evidence of where in the business cycle the economy may be.

Despite record low mortgage rates and first-time home buyer credits, the U.S. housing market remains anemic.  Rising foreclosures in several major metropolitan areas will keep housing prices low for some time to come.  The U.S. currently has about 1.7 million excess housing units available.  Typically, about 1.3 million new households are formed in the U.S. per year.  But with the unemployment rate topping 10%, new household formation will fall to about 1 million per year.  If new home construction remains at its current level of about 600,000 units per year, it will take over 4 years (1.7 million/400,000) for the excess supply of housing to be absorbed and housing prices to recover. 

Recovery rates will be much slower in some markets, such as in Florida, Nevada, and California, but I believe that the rest of the U.S. along with most other developed economies are looking at a three- to four-year period of time before housing and thus the overall levels of output return to their pre-recession levels. 

Why the Anger over Compensation?

It came up again in conversation today:  someone was offended and upset over the level of compensation of some senior executives in the U.S. economy.   I have to admit I just do not understand the anger. And I have a fundamental lack of respect for the arguments that have been served up thus far in support of the position. 

I have tried to resist drawing the conclusion that the anger is born of envy, but I am very close to throwing in the towel on that one.  Why should we begrudge anyone who earns a healthy salary, especially in an economy that provides each of us the opportunity to aspire to the same?

Even if there were reasonable ways around the practical issues and costs associated with legislative caps on salaries -- how to set them, who sets them, using what measures, what value judgments -- it simply makes no sense.  It is the antithesis of a competitive market economy where individuals have the incentive to learn, grow, work hard, and succeed.  It ignores the role played by capitalism in creating a strong and vibrant private economy that provides endless opportunities for all who want to put in the hours and the effort to succeed.  

U.S. corporate governance rules provide the framework for determining the compensation for senior executives, and it works remarkably well.  Each shareholder, or owner of the company, gets one vote on material issues such as reorganization. The Board of Directors is responsible for hiring and firing senior management on behalf of the shareholders.  If the shareholders do not like the decisions of the board, including those that set the level and form of compensation for senior management, they have at least two, very effective choices. They can either sell their shares in the company or they can vote to replace the board members.  The board can take several steps if, after negotiating the compensation package for senior management, the executive fails to perform. The board can withhold the bonus, renegotiate the terms of the contract, or fire the executive.  Then the long, mostly objective arm of the competitive labor market will determine the market-clearing value for the skills and experience of the recently fired executive.  

One thing I've never quite understood is why the market doesn't seem to exact more punishment on senior executives who run their companies into the ground.  Maybe there is an old boys network that looks out for ex-executives; maybe my observations are biased; maybe I notice only those cases where failed executives rise again.  But it's an empirical question, in any case; we can gather data on the issue and study it objectively.   

Regardless of the conclusions of such an analysis, however, decisions about executive compensation must remain in the labor market where your ability to produce economic value still reigns supreme over your ability to curry votes and political favor.  

Heads Up Marketers and City Planners: The US City of the Future (part 3 of 3)

Back to the future - a new way of seeing forward

The concluding part of a three-part paper previously published by Gary Shoesmith, Garst Reece and Sherry Jarrell in Marketing Research Spring 2006. Part One is here and Part Two is here.

What kinds of business establishments will thrive in the U.S. city of the future?  To answer this question, we examined the count of the number of establishments per business category listed on yellowpagecity.com, adjusted proportionately to represent a population of 500,000, and found the following results.

Death services. Although the strain on the healthcare system has received much attention in relation to ageing in the United States, the next logical step—death—is rarely mentioned, although it certainly represents many business and professional opportunities.  Our data suggest that the number of funeral facilities and cremations per 500,000 residents might double or even triple by 2025. The same applies to the number of cemeteries and companies listing monuments.

Healthcare. Along with roughly 30% more doctors, our data suggest that a range of medical services and products will be in greater demand by 2025. Nearly all of them relate to age. Consistent with the expectation that mental and self-care disabilities increase with age, listings also jump considerably for alcohol information and treatment, and counseling services. This trend doesn’t occur, however, for mental health services.

Real estate and living arrangements. Real estate listings significantly increase across the six MSAs, along with a substantial growth in listed land surveyors. The number of listings for nursing and convalescent homes moves from an average of 30 for the current MSAs to 50 for the 2020 and 2025 cities. There’s an even larger average rise in the number of retirement communities and homes.

Perhaps the most surprising pattern, at least initially, is the dramatic increase in the number of listings for mobile home dealers and mobile home parks and communities. Insurance studies have shown, however, that the percent of manufactured (mobile) home owners who are age 65 and older has risen from 26% in 1990 to 30% in 2002. Similar percentages are cited for owners who are retired. In addition, over the same period, the amount of owners age 80 and older has changed from 3% to 7%. Therefore, the future might be replete with mobile homes. The data might reflect the strategy of retirees selling larger homes to extract the equity, which is used to help fund retirement and buy a less-expensive manufactured home.

Activities. The data show a marked increase in the number of associations, clubs, churches, and fraternal organizations, which supports the description of mature adults as “joiners.” Bingo games are more popular in the 2020 and 2025 cities. Perhaps most noticeably, more golf is played in the 2020 and 2025 MSAs, requiring many more golf courses and golf-related products and services—not just in Florida, but also in Youngstown, Utica, and Scranton. Residents in the 2020 and 2025 cities also spend more time at the library, at recreation centers and parks, and reading newspapers.

Finance. Services that will be in higher demand as retirees seek assistance in managing their retirement assets include credit and debt counseling services, insurance, loans, mutual funds, and stock and bond brokers.

Products. The number of listings for new and used automobile dealers increases between the 2005 and 2025 cities, as do listings for new and used furniture dealers, health and diet foods, hardware, lawn and garden equipment and supplies, service stations, TV and radio equipment sales and service, and vitamins. But the data also reveal many other rising trends that are likely age-related, such as for antique dealers, arts and crafts, ceramic equipment and supplies, embroidery, gift shops, giftwares, jewelers, and security-related products. The substantial increase in florists is probably related to the number of hospitals, funeral facilities, and crematories in the cities.

Services. The Yellow Pages listings indicate many more business, employment, and investment opportunities in the future. Several categories relate to home improvement, such as contractors for remodeling, landscaping, and swimming pools. Home maintenance also is in greater demand in cities with older populations. Similarly, listings related to servicing and repairing automobiles, furniture, and jewelry rise across the three pairs of cities—along with beauty salons and massage. Pets apparently deserve no less, as pet washing and grooming services are in greater demand in cities with older populations.

Research Implications

This innovative methodology for studying various aspects of the future reveals that many of the detailed trends across the three pairs of cities have significant implications with respect to new product development and marketing. For example, marketers need to begin partnering with development and land use officials to anticipate future growth in demand for golfing facilities, churches, parks, libraries, cemeteries, and mobile home parks. And medical services providers must be prepared to meet the demands for home health services and many other healthcare preferences of older adults in an increasingly competitive environment.

Although it’s true that many factors other than age will shape future spending patterns, such as changing tastes among mature buyers, new technology, and various economic factors, many of these trends are almost entirely age-related. Therefore, it’s unlikely the future will look that different from Lakeland today, where the share of the population age 65 and older is identical to that projected for the nation in 2025.

The United States will not be a nation of Floridas in 2025; it will be a nation of Lakelands.

The Power of Words

I can hear it like it was yesterday, resonating in my head, crowding out the doubts and negative thoughts, filling my mind with possibilities:  yes, I CAN do it!

I was in my junior year of college and had no idea what I was going to do with my life.  It was becoming quite a burden.  Because I had always been good in school, i.e., the “smart one,” everyone had expected so much of me when I went to school.  I really envied my older sister; she had always been the pretty one, the popular one, the one who got invited to the prom by not one, but three young men.  And, it seemed to me at the time, she was so lucky because no one expected her to go out and concur the world after high school.   She didn't go to college; she went to secretarial school and studied to become an airline attendant instead.  I envied her in every way possible!  But at least I had something: I was “the smart one,” or so I thought!  Years later, my sister went back to school to study psychology.  She earned a 4.0 and was invited to continue on to earn her Ph.D.  I’ll be darned if she wasn’t the smart one, too! And she is a wonderful and thoughtful person to boot! But I digress.

Anyway, I was in my junior year of college at the University of Delaware.  I went to the University of Delaware largely because I had to pay for college myself and could only afford in-state tuition. Although it was a perfectly acceptable school, I had dreamt about going to an Ivy League school.   After all, my older brother had graduated from an elite private high school and had gone to college on a scholarship. But those things seemed out of my reach, especially for a girl.

My brother was now in graduate school in Chicago, and he and I were talking on the phone one night. Ours was an awkward relationship, particularly in person.  It was much easier to talk on the phone or write letters.  Less personal maybe.  More safe.

The fact that we didn’t speak often and weren’t warm and comfortable in person made his comment to me all the more unexpected and memorable and, as it turns out, life-altering. I was telling him about some academic articles I had studied in class. The articles were about economics and regulation, and were so intellectually challenging but accessible and clear.    They were written by Sam Peltzman and George Stigler.  My brother said to me, “Sherry, both of those men are professors here at the University of Chicago.  You should think about applying to the Ph.D. program.  I can see you going here. You can do it!”

Well, you could have knocked me over with the tip of your pinky finger.  My brother, a lifelong withholder of gratuitous compliments and small talk, had just told me, his pesky little sister, that I should pursue a Ph.D. in economics under the professors whose work I so admired, at the school he was currently attending.

After regrouping, I asked him what a Ph.D. was and what one did with a Ph.D.  I remember his saying something about research and teaching.  I also vaguely remember that by the end of the conversation, I had a plan for crammin in as much math and economics before taking the GMATs.  But what stood out to me then and, every time since when I've had doubts about my skills or career, were those words, those glorious, uplifting words:  “You can do it!”

So be careful what you say, especially to those who look up to you.  Words can cut you to shreds, but they can also fill you with pride and hope and the joy of what is possible.  My brother’s words changed my life; teaching fulfills me; it makes me feel like I am making a small, positive difference in this world.  And I often tell my students, with the tangible memory of how it made me feel all those years ago when I first heard it, “You can do it!”

Heads Up Marketers and City Planners: The US City of the Future (part 2 of 3)

Back to the future - a new way of seeing forward

Part Two of a three-part paper previously published by Gary Shoesmith, Garst Reece, and Sherry Jarrell. Part One is here.

In this post, we examine the current income and spending patterns from metropolitan statistical areas (MSAs) with age demographics similar to those projected for the U.S. economy in 2020 and 2025.  Two MSAs are selected for each year to verify that differences in buying patterns across cities are because of differing age distributions, not peculiarities in the cities.

We began with U.S. Bureau of Census data on the percent of total U.S. population expected within five age groups through 2025. The share of U.S. population attributed to people age 65 and older is expected to increase from 12.4% today to 16.3% in 2020 and 18.2% in 2025. By 2025, nearly one out of every four drivers will be age 65 or older, compared with 15.6% today.

Income and Spending Patterns

We find that, although many mature adults are highly mobile, most stay put; this results in the Northeast and Midwest remaining key mature markets.  Three of our four 2020 and 2025 MSAs are in Ohio, New York, and Pennsylvania. We also find that older consumers:

• spend more of their income: The spending per income ratio rises from .67 today, to .76 for the 2020 MSAs and .77 for the 2025 MSAs.

• continue to depend on their cars and prefer them to public transportation.

• spend increasingly larger shares of their income on healthcare.

• make TV a key element of their lifestyles.

• remain in their homes and avoid nursing homes.

• are politically conservative.

• are civically active and wield growing influence.

• are joiners.

• spend heavily on housekeeping supplies, household furnishings and equipment, new vehicles, entertainment, computers, healthcare products, vitamins, healthier foods, and reading materials.

• spend less on apparel, cosmetics, and fast food.

Retail spending data

We find that the percent of retail spending on necessities such as products at food and beverage stores and the subcategory of grocery stores is generally higher in all six of our MSAs, compared with the nation. The same is true for the general merchandise store category, which includes discount stores.  We also observe generally lower spending shares relative to the nation in the more discretionary categories of clothing and accessories stores, furniture and home furnishings stores, electronics and appliance stores, building materials stores, and garden equipment stores.

The more important observations relate to spending patterns across the three pairs of MSAs. Looking at food and beverage stores, spending as a share of total retail sales declines across the three pairs of MSAs with increasingly older populations. Beginning with an average of 17.2% in the 2005 MSAs, spending at food and beverage stores drops to 14.1% in the 2025 MSAs.

Similarly, the subcategory of grocery stores falls from 15.1% today to 12.2% in the 2025 MSAs. Note that the approximately 3 percentage point declines in these categories are in spending relative to total retail sales, and that within the categories, the decreases in spending are nearly 20%. For example, for every $1,000 in retail spending in the 2005 cities, approximately $151 is spent at grocery stores. That compares with $122 in the 2025 cities. Thus, although spending shares at food and beverage stores are higher than the national average in all six MSAs, the spending shares fall across the three pairs of MSAs as their populations become increasingly older.

The trend also is downward over time for food service and drinking places, from an average of 9.7% in the 2005 MSAs to 7.5% in the 2025 MSAs—with the trend again representing a roughly 20% absolute dollar spending decline per capita within the category. These results support the expectation that older consumers eat healthier and in less quantities (especially in the case of fast food), and also spend fewer dollars at drinking places.

Per capita spending at clothing and accessories stores decreases from an average of 4% of retail sales in the two 2005 cities to 3.2% in the 2025 cities. As before, although the 1% drop appears small, it represents an approximately 20% reduction in per capita spending.

What types of stores benefit from older populations?

Our results indicate increased spending on furniture, automobiles, and homes. Looking at the per capita shares of total retail spending for furniture, home furnishings, and electronics and appliances, spending shares rise from an average of 2% in the 2005 MSAs to 3.9% in the 2020 MSAs and 4.2% in the 2025 MSAs. This suggests a doubling of per capita spending at furniture and related stores. There are similar patterns for the subcategories of furniture and home furnishings stores, and electronics and appliance stores. Spending also generally rises at building materials and garden equipment stores. Upward trends across the six cities additionally are shown for motor vehicles and parts, and healthcare and personal care.

In the third and final installment of this research, we will discuss the specific types of business establishments that will thrive in the U.S. city of the future.

Government Spending: All Demand, no Supply

The headlines are full of claims about the number of jobs created or saved by the stimulus package, the impact of the Cash for Clunkers program on U.S. output and, the latest, the reduction in the deficit from the proposed U.S. health care reform legislation.

What total rubbish.

Government spending is just that -- SPENDING.  It does not, can not, never has, and never will CREATE any output, economic wealth, or job.  The only way -- and I mean the ONLY way -- that profits or wealth or a new job is created is through a business.  Businesses are the only entity that can hire labor and capital and combine them in such a way as to create a product or a service that society may decide is worth more than it costs. And that spread between the cost of production and what society is willing to pay is economic value; it is the generation of profits that then enables the taxes that the government collects to spend on the goods and services it thinks America ought to consume.

Private industry is the job creator.  Not the government.   And this is not wishful thinking, or a political point of view, or a theoretical model.  It is an unmitigated, irrefutable fact.

 

Heads Up Marketers and City Planners: The US City of the Future

Back to the future - a new way of seeing forward

Part One of a three-part paper previously published by Sherry Jarrell, Gary Shoesmith and Garst Reece

Market research on the ageing of the U.S. baby boomer generation has focused on the spending habits of these older consumers. A new approach enables marketing researchers to observe the future now: Examine income and spending patterns from metropolitan statistical areas (MSAs) with age demographics similar to those projected for the U.S. economy in 2020 and 2025. With knowledge of these trends, they can begin preparing to meet the demands for particular products and services.

“Find a comfortable couch, lie back, and close your eyes. … Let your mind wander toward the future. Move, slowly, to the year 2030. Now open your eyes. What do you see? You see a country whose collective population is older than that in Florida today. You see a country where walkers outnumber strollers.” Laurence J. Kotlikoff and Scott Burns in The Coming Generational Storm (The MIT Press, 2004).

Projected Age Distribution, U.S. Bureau of Census data

There has been much speculation regarding the effects of the aging population on the U.S. economy. By the year 2025, more than 18% of the U.S. population is projected to be age 65 or older, greater than the percentage in Florida today. This has led some to describe the future of the United States as “a nation of Floridas.” Furthermore, the aging of the United States is not expected to pass with the demographic bulge produced by baby boomers (those born between 1946 and 1964). The U.S. population also is aging because of increased life expectancy and decreased numbers of offspring. As a result, current research projects that the U.S. age profile soon will transform from the current pyramid shape, with older groups at the top, to more of a barrel shape, with roughly 40% of the population divided fairly evenly between the youngest (under age 15) and oldest (over age 65) groups. This new profile will persist for decades.

Although much has been said about aging baby boomers leading to potential crises in Social Security and Medicare, we are more interested in the economic prospects of their retirement as they relate to consumer spending: in particular, whether they have saved enough to maintain their standards of living in retirement. In this regard, the Congressional Budget Office (CBO) reviewed studies from the past decade on the retirement prospects of aging Americans, and found evidence that varied with the standard used to define “enough.” Some studies defined it as the level that maintained the retiree’s working-age standard of living, whereas others defined it as levels that made the retiree as well off as his or her parents at the same age.

The picture that emerges from the CBO study is that baby boomers, relative to their parents at the same age, have higher real incomes, are preparing for retirement at the same pace, and have accumulated more private wealth. Furthermore, the savings behavior of baby boomers and other future retirees is dependent on their views of the health and stability of government benefit programs. If they believe that they will receive all of the government benefits they have earned, then they will tend to work and save less. If they believe that these programs are in trouble, then they might increase savings and postpone retirement.

What impact will changing age demographics have on future spending patterns? We obtain a more complete picture of future spending by observing aggregate spending patterns in local economies that resemble the future now: those cities where “walkers outnumber strollers” today. This novel research approach is based on actual observed data, rather than on speculation and long-term statistical forecasts, both of which are notorious for inaccuracy.

In the next post, we discuss our sometimes surprising findings on the spending patterns in the U.S. city of the future.

It May be Time to Reassess the Insider Trading Rules

On the face of it, prohibiting insider trading seems to be fair and reasonable.  Insider trading laws, refined over time in court on a case-by-case basis, define “trading on the basis of inside information” as any time a person trades while aware of material nonpublic information (Securities and Exchange Commissions Rule 10b5-1, which also creates an affirmative defense for pre-planned trades.)  SEC regulation FD ("Fair Disclosure") also requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large; in an unintentional disclosure, the company must make a public disclosure "promptly."  Lastly, the Williams Act gives the SEC regulatory authority over insider trading in takeovers and tender offers.

The intent of the insider trading laws is to prohibit a person with inside information from profiting at the expense of the public by trading on that information. As I said earlier, this seems fair enough.  But there are at least two significant problems with a fair and reasonable application of the insider trading rules.

One issue with insider trading laws which has been well articulated by Donald J. Bourdeaux over the years is that insiders could react to the proprietary information by foregoing a planned purchase or sale of stocks. This “non-trading” reaction to inside information is inherently undetectable, rendering about half the distribution of all insider trading activity unobservable. Bourdeaux argues that the insider trading laws are applied so capriciously that the markets would be better off and stock prices would reveal more accurate information if all insider trading laws were repealed.   

I personally would not go that far.  I do feel that there are clear instances where an individual who controls the flow of private information about a company could unfairly profit from delaying its release and trading in the interim.  An unexpected earnings announcement comes to mind as a fairly clear example.  This seems to be the case in the most recent insider trading allegations involving individuals at Galleon Group and SAC Capital Advisors.

Just because someone has proprietary information about a company does not mean that that individual either knows or controls the public’s reaction to that information. Knowing the information is not the same as knowing the consensus market opinion about the company’s future stream of cash flows and risks!  For one thing, the public may react differently than expected to the release of the information. Or, new information may become available that counteracts the inside information.  Third, the inside information may be factually incorrect.  Or, finally, the market may have already put two and two together and essentially inferred the essence of the so-called private information on their own, from other sources and developments, so that when the inside tip is released to the public there is no price reaction.

Recall that the stock price is nothing more, and nothing less, than the market’s consensus opinion about the value of the company’s future stream of profits or earnings.  Investors and other market participants base their valuation of a stock on innumerable observations about the future prospects for a firm; when people trade on the basis of that information, their forecasts of profits and risks become incorporated into the new stock price.  For example, suppose an investor learns something about a company which leads him to believe that the stock is now worth $11 a share.  Another investor, who currently owns the stock, puts the stock valuation at $9 a share.  If these two trade, they will strike a deal at somewhere between $11 and $9, say $10; this then becomes the new publicly reported stock price.  When they trade on their forecasts, the information upon which those forecasts are based is now reflected in the stock price.  If they did not trade, the stock price would have remained at $9 per share.

Let’s couch this example in terms of insider trading. Say a company executive overhears a dinner conversation by a judge presiding over a case.  The judge, feeling good, observes that he thinks the jury will acquit company management in an on-going lawsuit.  One would think that this is clearly good news for the company, which should make the stock price rise when it becomes public.  The executive, acting on insider information, quickly buys up extra company stock in order to profit when the verdict is announced.  If it turns out that the judge was wrong, or the stock price had already incorporated the probability of acquittal, easily gleaned from other, publicly available news reports, then the insider would have earned no abnormal profits.  Is this a case of illegal insider trading?  I do not know and, to be blunt, neither do you; this issue is decided in court, literally on a case-by-case basis; the arguments are difficult and complex, hinging on the “quality” and “timeliness” of the information, whether the so-called information was available otherwise to the average investor, and whether the insider would have traded differently without the information.  In other words, the court tries to rerun history as if the judge hadn’t had one too many cocktails that night.

The fact of the matter is that we rarely learn about such cases. Almost without exception, the only insider trading that generates enough attention to ever get to court are those in which someone makes enough profits to make the public stockholder feel hoodwinked;  the many cases where the insider guessed wrong about the eventual impact of the information on the public stock price never see the light of day.  Public stockholders do not bother to sue in cases where the insider loses money! And because we never hear about such cases, we are led to believe that trading on proprietary information necessarily creates an unfair advantage to the insider, which is not always so.  

Latest U.S. GDP figures a mirage

The press recently celebrated the 3.5% annualized rise in the third quarter in reported U.S. GDP http://money.cnn.com/2009/10/29/news/economy/gdp/index.htm

I urge caution in interpreting these figures at face value.  After all, the current GDP of the U.S. economy is simply the intersection of aggregate demand with aggregate supply.  As the figure shows, GDP increases with increases in either the demand or supply curve, although increases in demand are accompanied by rising price levels while increases in supply push prices down and real incomes up.  

The quarterly figures make clear that the increase in demand was driven almost entirely by the expansion of government spending; the other three components of demand – consumption, business spending, and net exports, were either flat or falling.  Government spending is inherently short-term; it does not create wealth or enable sustainable growth.  In fact, neither consumption nor net exports create sustainable economic growth either.   Only business investment in new productive equipment (which includes business fixed investment, new residential housing and additions to inventory) has the potential to create sustainable growth in U.S. GDP, and then only when the investment leads to a permanent increase in the productivity of the business, namely a rightward (increased output per input) or downward (decreased cost) shift in the Aggregate Supply curve.  And there was little chance that the reported increase in GDP resulted from a long-term increase in the productive capacity or efficiency of the U.S. economy, as Business Investment was soundly negative in the 3^rd quarter of 2009.

  

Limit investment risk? The dialogue continues...

Continuing with yesterday's post, I received the following comments from three colleagues from around the world:

Thanks Sherry.

Your response confirms that I do not understand what the heck is being done in our name!

I have no idea how we have been so stupid as to allow politicians and bankers to make such a mess. In the UK, at the BBC, we have a brilliant young economics journalist (Stephanie Flanders) who, for me, described the situation superbly; to paraphrase, she said “before this crisis, bankers would often wonder whether, if they made a mess of everything, the taxpayer would bail them out … now they know!!”

These organisation are not too big to fail, they are too big to succeed. From my point of view, our reaction to this behaviour has been completely counterproductive. Perhaps we should outlaw people entering politics until they have brought up children!

John L., UK

“Well, for one, if a financial product “fails,” the consequence is purely financial – it is not injury or death.”

Hmmmm!! What does “purely financial” mean? In one sense, all life depends on what is “financial”; if one has no money, one is then either dependent on charity, turns to scavenging or dies.

Many innocent people have been totally devastated by this crisis (most likely indeed to the point of death), caused by NO FAULT of their own. Many have suffered who did NOT take excessive risks with their money (i.e. were not driven by excessive greed).

I appreciate Dr Lewis’ modesty about his financial knowledge; the problem there is that if “ordinary” people and laymen like – for example myself – do not comment and/or get involved in financial matters, then we are leaving them to “the experts”. and you can guess exactly how I am rating financial experts at the moment.

On a personal level, I honestly believe I am totally innocent of this financial shambles caused by the greed of “experts”, who were so clever that they took most of the risks with other people’s money! And then they got bailed out with MORE of the same people’s money. I am very cross indeed, and by golly I am not alone!

Chris S., Germany

By way of encouraging debate, I tend to agree with Chris and John. I’m not sure, genuinely unsure, if the consumers of financial products want ‘risk’. But I am sure that humans are very poor at assessing risk.

By way of example, I have this notion that riding a motorbike is ‘risky’ and that flying a light aircraft less so. But in the UK the accident statistics show that both activities carry the same risk of death – thus my intuition is faulty.

Also, in many cases in life, the degree of risk is under my control even with products that have some form of consumer protection.

But with financial products how does a consumer really calculate the risk that he or she is potentially exposed to and, more importantly, is there any method to allow that consumer to renegotiate the contract if the risk changes during the life of the financial product? I doubt so.

To my mind there is great asymmetry between the trumpet blowing headlines advertising a financial product and the reams of very small print at the foot of the advert that include ‘the value of investments may go down as well as up’ or words to that effect. It’s meaningless!

Paul H., from UK, now in Mexico, moving to Arizona

My necessarily detailed response as it appears on LearningfromDogs http://learningfromdogs.com/. 

Many ideas are more complex that we appreciate.

One of the great bonuses in being part of the author group of Learning from Dogs is that we are all having to dig in deeper on issues than we might otherwise do.  Part of the weakness of our modern busy lives is that we run the risk of forming or reinforcing opinions 'on the fly'.  The modern media tends towards this approach.  But on a Blog that strives to write about integrity it behoves us all to be more careful about what is correct if, indeed, there is a correct answer.

John Lewis first posed the idea of whether financial products should be regulated in terms of consumer safety, like your toaster!  Sherry Jarrell then replied to that as a comment which was worth being made a separate Post.  That Post then attracted comments and, again, in amongst them was another detailed reply from Sherry that has been made the subject of this Post.  As implied, many of today's issues are far too important to be left to the headline writers.  Here's Sherry:

My understanding of the original question was “should there be a minimum level of safety, guaranteed by the government, for financial products.” My answer was, basically, “no.” The comments that have followed seem to me to be responding to a different, unspoken, perhaps deeper issue, and that is what is the proper role of government in protecting its citizens. Even with the question recast in a broader context, however, my response is still no, but I should explain it a bit better.

First of all, I am absolutely opposed to a government bailout of any organization, whether it is financial or manufacturing, large or small. At the same time, I am equally opposed to the government trying to displace or distort what should be the voluntary consumption and investment decisions of its citizens and private industry.

Private businesses strive to create wealth. They do so by employing physical capital and labor to produce a good or service that creates profits, i.e., that sells for more than it costs. Typically, though, a company has to spend money to make money; its costs occur earlier in time than its revenues, so it must raise financial capital, either from internal sources (retained earnings or private equity), or from external sources, namely the debt or equity markets. Investors buy this company’s securities in exchange for a positive return on their money. If the investor buys debt from this company, there is a legal contract backed by the court governing the timing and circumstances for paying back the money. If the investor buys stock, then they, as residual claimants of excess cash flows, accept the uncertainty that they may or may not get their investment back. But the investor would not have bought the stock in the first place unless there was good reason to believe that the company would continue to pursue profits and create economic value. And, in deference to Chris, I do not equate the pursuit of profits with “greed.” It is the pursuit of profits that employs labor, enables financial capital, and enables investment in the future, whatever specific form of investment that may take for the individual. And individuals choose to invest, or “save,” disposable income not consumed; they choose to invest in order to earn a return which enables higher consumption later, for themselves or their children or their charity. Investors are not forced to invest, forced to buy a home, forced to take risks. They choose to do so; and they should be able to do so with full information on the true risks of generating a return.

No one can guarantee a stock’s value; no one can guarantee a stock’s return. But the capital market can set a fair price for a stock; this is the price that, in relation to the expected future dividends and capital gains driven by the earnings generated by management, provides an expected rate of return that compensates the investor for the level of uncertainty about the future profits. An example might help: if you are guaranteed $105 next period in exchange for $100 today, you have earned a 5% riskless rate of return. This return compensates you for delaying consumption and for any reduction in purchasing power caused by expected inflation. But if there is a 50% chance you will get $100 next period and a 50% chance you will get $110 then, even though you expect $105 on average (.5 x $100 + .5 x $110), you will not pay $100 for that deal, because you require a higher expected return to compensate you for the added risk that you may end up with the $100 payoff. You would pay a lower price, say $97, which would generate an 8.25% return (($105-$97)/$97). The extra expected return is generated by a wider spread between the price today and the expected level of payoffs tomorrow; the required return increases as the uncertainty about the payoffs increases. And, yes, Paul, these risks can be “renegotiated” at any time: if you don’t like the returns you are earning on your stock, sell it! An active capital market provides ease of entry and exit, and the liquidity that accompanies it.

It is a little more complicated with derivative securities like options, hedging, and insurance, but the same principle applies: the less certainty about future payoffs, the higher the expected return the market requires before it lends the money and buys the financial instrument in the first place. If the government steps in and somehow limits that risk by trying to guarantee future cash flows to stockholders and other investors, the entire capital market would cease to exist as we know it. Liquidity would dry up; firms would be limited in the size of their operations and their ability to redeploy assets and grow; output and employment would drop. The reason the U.S. economy is as strong and vibrant as it is is because of our labor market, our capital market, and free enterprise. These markets are supported by the legal and regulatory systems that define the rules of the game; they are damaged when the government steps in and tries to play the game or change the outcome of the game.

The financial crisis began when an excessive, untimely number of home mortgage foreclosures began to surface. It is my conclusion that government intervention in the mortgage market caused this spike in foreclosures, which ultimately snowballed into the financial crisis we’ve all observed. Before the government intervention, lenders and potential homeowners negotiated mortgages just fine for decades. Homeowners provided information to the banks and mortgage brokers about their financial status so that the lenders could assess the risk or uncertainty of getting their money back; the less certain the bank was about the homeowner’s ability to make the mortgage payments, the higher the rate of return required. The higher rate of return could take the form of a higher down payment and/or a higher interest rate on the mortgage loan. Notice the analogy to the risk-return relationship of stocks.

The mortgage market was operating smoothly. Yes there were foreclosures but this possibility was priced into the interest rates charged on the loans. Then the government stepped in with its “every citizen has the right to own a home” social engineering initiatives. No longer was it the face-to-face negotiation between the banker and the potential homeowner. Now the banker had to satisfy government mandates on the number of mortgage loans made to high-risk customers; because these customers would have failed to qualify otherwise, banks had to reduce the costs to the homeowner, either by waiving the down payment, accepting a lower credit score, or lowering the interest rate below that which would compensate the bank for the uncertainty of the borrower. All of these measures reduced the expected rate of return the bank could earn on these loans. Left to their own devices, without the mandates of Washington, these mortgages would have never been approved. From the homeowners’ and taxpayers’ perspectives, the initiatives from Washington basically reduced the price of the mortgage to them. And, as prices come down, demand goes up. People who would not have “bought” the mortgage at the higher price are now in the housing market because the government has basically used its power over the banking industry to limit the price banks can charge for their service; to limit the rate of return they can earn to below that required to compensate them for risk.

But Washington had another carrot to offer the banking industry; Fannie Mae would buy those underpriced subprime mortgages from the banks to get them off their books. (I know this from firsthand information; I teach MBA students, a number of them are former mortgage brokers who left the industry because they couldn’t justify making loans to people with low credit scores anymore just to satisfy government mandates.) Now the homeowner would make their mortgage and interest payments directly to Fannie Mae. Fannie Mae then pooled all the mortgage funds together, and resold the principal and interest payments as new distinct derivative securities. Buyers of the repackaged mortgage payments often sold commercial paper to fund their purchase, so now the commercial paper market was dependent on the timely receipt of mortgage loans payments by subprime borrowers. Notice that the risk of mortgage default was not reduced by the government mandate, but the return earned by the lender was. This is the distortion caused by a politically motivated mandate being inserted into what should be an objective business decision made by private industry.

Fannie Mae, as a government-sponsored entity motivated by fulfilling a political mandate and assessed by the number of low income families who now owned a home, certainly had no incentive to determine the true risk of the mortgages they purchased or the new securities they issued. The value of the mortgages and the rate of return on the new Fannie Mae securities were determined by government edict, not by a freely functioning capital market serving private businesses seeking to maximize their efficiency and their profits. The signal normally provided by the rate of return about the value of the investment was distorted.

The only real “greed” I see in this picture is of the political variety; the desire by politicians to hold on to their power and position by diverting tax dollars to segments of society they hope will return the favor by contributing to their campaign or voting for them and keeping them in office. The only people taking “risks with other people’s money” are the politicians. Investors purchase securities in order to benefit from business risk; their money is not “taken” by business or financial experts; it is invested. It is tax dollars that are taken by power-hungry politicians to buy votes and support; it is tax dollars that are spent on exorbitantly risky ventures, like bailouts, like Cash for Clunkers, like purchasing the very toxic assets that their mandates created.

That’s my view.

Should the Risk of Financial Products be Regulated?

A lively debate from LearningFromDogs blog about the wisdom of regulating the safety of financial products ....  http://learningfromdogs.com/2009/10/30/consumer-financial-product-quality/

Consumer ’safety’ for financial products

with one comment

Are we missing a lesson that has been applied for years?

I have resisted any temptation to comment on the economic situation on Learning from Dogs. The contributions from others are based on far more knowledge and understanding of the subject then I will ever have.

However, I feel obliged to ask humbly for some clarification about something that bothers me. Are we putting the cart before the horse? Are we ignoring the relationship between provider and consumer in finance?

The regulatory regime applied to the vast majority of products which are allowed to be sold to the public is such that there are probably more stringent safety standards for an electric toaster than for most, if not all, financial products!

Much of the talk of regulation and restraint, in the current climate, seems to relate to remuneration of people working for financial organisations. But, why does it matter what they receive? In other fields, success is rewarded and the shareholders, admittedly fairly indirectly, have some say on the policy in that area. Why should they not pay what they wish?

On the other hand (to coin an economic phrase!),  the minimum standards of the products are set by regulators.

In other fields, if a supplier cannot demonstrate, to the satisfaction of the regulators, that its product meets specified safety standards, then that product is not allowed to be offered.

It is very simple! I am not referring to contracts, customer service, compensation and so on; I am referring to a threshold level of safety below which the product is not allowed to be sold or operated. Think: “cars”, “aeroplanes”, “electrical appliances”, “children’s toys”, and … well anything else!

To be even clearer, this is not about “perfect safety” which is, of course, not available at any price. This is not about blame. This is not about guarantees. It IS about inspection, testing, certification, regulation … oh and policing!

Can anyone explain why this approach cannot be applied to financial products? (Sherry attempts to here.)

By John Lewis

p.s. as chance would have it the image of the toaster at the head of this Post was taken from an article talking about a recall of the Viking Toaster – point made rather well, don’t you think?

My first attempt at a reply apparently hit a nerve!  Those comments tomorrow.

Sherry’s reply.

A great question, John: why do we not have a threshold level of safety for financial products, as we do with cars and toys?

Well, for one, if a financial product “fails,” the consequence is purely financial – it is not injury or death.  A financial product simply represents a financial investment today in exchange for financial payoffs tomorrow.

The less certain those payoffs, the higher the minimum required return on that investment. If the returns were certified or regulated in some way, risk would be reduced, and the required return would also fall.  Limiting risk exposure throws out the baby with the bath water:  less risk means lower returns on the investment.  Look at the real returns to U.S. Treasury Bills – they are almost zero!

There is a role for regulation in financial products and that is for disclosure of relevant information.  When we invest in a financial product, we are putting our money at risk in exchange for future expected cash flows.  We forecast those cash flows on the basis of material information about the firm, its products or services, and its management and strategy.

Even here there is a fine line between the right to know and proprietary information that enables a firm to invest its own funds in the hope of generating a large return in exchange for taking risks.

The Securities and Exchange Commission’s requirement for a 20-day window between the time a bidder makes a tender offer for a target and the time the target shareholders must decide whether to accept the offer or not is an example of a regulation that crosses the line, in my view.

In a misguided attempt to protect shareholders from fly-by-night tender offers, the SEC has created an environment where multiple competing bids can arise, driving down the return to the original bidder and limiting the incentives for firms to productively redeploy assets through tender offers.

By Sherry Jarrell