Dr. Sherry Jarrell

Significant Reversal by Eric Holder

U.S. Attorney General Eric Holder, on behalf of President Obama, has reversed himself. The five alleged co-conspirators in the 9/11 bombings will be tried by military commission at the Guantanamo Naval Station in Cuba.

I refer you to my post on the subject from November: http://www.sherryjarrell.com/2010/11/terrorist-wins-we-lose.html

 It's about time for this particular about face.  

Corporate Executives, I need your input!

Hello All,

I need some backup from corporate executives! Please have a look at the sequence of comments and replies in the thread on "Anger over Executive Compensation" on www.learningfromdogs.com,

http://learningfromdogs.com/2009/11/28/anger-us-compensation/#comments

where I am one of five co-authors who are attempting to discuss important issues with integrity and thoughtfulness. The comments this post are receiving are decidedly one-sided.  Henry Mintzberg's recent piece in the Wall Street Journal calling for the end to all corporate bonuses didn't help much.

http://online.wsj.com/article/SB10001424052748703294004574511223494536570.html

So, I need for you to add your insight and input! Please comment!  Thanks.

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.

 

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

Update: Real cost of Cash for Clunkers Program

In an earlier post, I noted that I thought that the real cost of the cash for clunkers program went well beyond the $4500 rebate per car.  Edmunds.com just came out with an analysis that shows that the cost of the program, once purchases that would have occurred during that period without the rebate are taken into account, at $24,000 per car!  http://content.usatoday.com/communities/driveon/post/2009/10/620000657/1  

Clunker program a failure? Where's your proof?

 I was asked by a reader recently about my claim that the Cash for Clunkers program was a failure.  He said, and I quote, "And your proof is...?"  Here is my response:

Hello Ramon, Thanks for the comment. My conclusion that the Cash for Clunkers program was a failure was based on three factors. One, it did not have the intended consequences on the environment; for those folks who purchased a marginally more fuel efficient car now, rather than later, the added fuel efficiency was likely more than offset by the pollution generated by destroying the old car, and by the loss in additional fuel efficiency they would have enjoyed had they waited a year or two to replace their current vehicle with an even later, even more fuel efficient model year. Two, the costs of the program, which are much greater than the $4500 rebate, far exceed any benefits generated (Abrams and Parsons in the Economists' Voice (http://www.bepress.com/ev/vol6/iss8/art4/) estimate that the costs of the program exceeded the benefits by about $2000 per car, which I think is an underestimate.) The list of costs include but are not limited to the additional paperwork and private and public workers needed to administer the program, the interest costs to dealerships of financing the rebate program while awaiting the government checks (some less capitalized dealerships actually went out of business because of the program), the costs of destroying the old vehicles, and the cost of lives lost and injuries sustained in accidents in smaller, less safe but more fuel efficient cars, just to mention a few. Last, this "injection" into the economy -- which, in reality, is the blatant substitution of private consumption choices with public policy, and an affront to our economic freedom -- costs the economy untold sums by putting off the inevitable failure of automobile companies that fail to produce cars the population values sufficiently to keep the auto companies in business without being propped up by the government. Case in point: GM's plunge of 45% and Chrysler's fall of 43% in the months following the rebate program; Honda and Toyota also reported double-digit slides, while Kia and Hyundai had double-digit increases. New car sales fell in September as the predicted post-"cash for clunkers" slump dragged the U.S. market down to its lowest levels in seven months (http://www.allvoices.com/news/4286397-clunkers-letdown-slump-auto). I wish it weren't so, but I'm afraid that good business is not the strong suit of our policymakers. Thanks again for your question. I hope you find my comments useful. Sherry Jarrell

Careful: The Public Option Head Fake

Sebelius' comments today that, due to public pressure and in the interest of bipartisan progress, the public option for the proposed health care reform may be off the table, reminds me of an experience I had in the courtroom some years ago.  The opposing attorney, who knew how to play very dirty very successfully, asked the jury for damages that were totally beyond reason.  The jury, in its infinite wisdom, ruled against the inflated requests, but then proceeded to award damages that were still outrageous, but only in absolute terms. Compared to what the attorney had originally requested, the award didn't seem so crazy. 

The manner in which the White House has handled the public option reminds me a lot of those courtroom tactics.  I'm not convinced that Obama or his team really thought that health care reform would get through with the public option intact.  But it couldn't hurt to try, right?  What's the worst that could happen if they had to put that part of the plan aside? Why, now the public would see Obama, Selelius and others as "reasonable;" now the public expects the opposition to also "give something up," "compromise," "cooperate" in the interest of political give and take, or risk being labled obstructionist.  

Brilliant.  Sneaky, deceptive, harmful to our country....  but brilliant. 

The Truth about the Health Care Plan

What is the purported goal of the President’s Universal Health Care reform?  I’ve been doing a lot of reading and listening on this issue and have summarized the most common claims in the following short list.

To make sure that all currently uninsured U.S. citizens have medical insurance.
To make sure that all U.S. citizens receive basic medical care.
To limit national spending on health care. 

How does the bill propose to accomplish these goals?  Let’s take each in turn.

“To make sure that the uninsured have medical insurance.”  The only way to guarantee that everyone who currently doesn’t have insurance gets insurance is to require it.  And if the government requires it, they have to have a way of paying for it, which means either increased taxes or a mandate for individuals and businesses to buy insurance that they do not now choose to buy.  In addition, in order to meaningfully require that everyone abides by the new law, there has to be a mechanism for monitoring, enforcement, and fines for those who fail to comply.  Sure enough -- it’s all there in the bill (the bill that neither the President nor Congress has read).

“To make sure that all U.S. citizens receive basic medical care.”  Let’s see.  Fundamentally, “receiving medical care” means that a patient sees a doctor.  It means that services are provided by the doctor and consumed by the patient. These services are not free: they use resources; they are valuable; they take time.  We can place a dollar value on these resources, regardless of the specific currency – private income, public tax revenues, bartering, or waiting -- used to pay for them.  How would the legislation ensure that everyone received basic medical care?  It would first have to define what kinds of treatments are considered basic; then it would have to require some sort of monitoring system to document that those services were received, and some sort of penalty if a person failed to receive them.  It would have to require that the right number of doctors provided the right kinds of medical services in the right geographic areas (a nightmarish concept in and of itself) and it would have to compensate the doctor for providing the service.   Of course, in order to pay for all this, the plan would have to limit the compensation for the doctor, which leads us to ….

“To limit national spending on health care.”  Or, as President Obama puts it, to “curb rising health care costs.”  What does this mean exactly?  How is legislation that forces demanders and suppliers of a service to come together in ways they now choose not to do going to make the production of that service more efficient?  (efficient means that more outputs of the same quality are produced from the same inputs….this is the ONLY way that the cost of medical service is lowered….) What single piece of evidence do any of us have that the health care plan will lead to improved medical care for either the individual or the nation as a whole?  Medicaid?  Medicare?  No, these are the very programs Obama references when he laments skyrocketing U.S. health care costs, and the primary impetus for the push for reform. Canadian or UK health care? Hawaii’s failed Universal Health Care experiment? No; each of these programs serves as a warning about the sorry state of our future should the Health Care bill pass.

The fact is that, despite the feel-good sentiment linked with the idea of Universal Health Care, the reality would be a disaster.  None of us would benefit; all of us would suffer lower quality, rationed health care services.  There is simply no other way around it.

Finally, as an economist, I have to comment on the analyses I have seen on this issue by other economists.  I have been very surprised and disappointed by them, on the whole.  I have seen claims by other economists that health care reform will actually save states money, increase the number of high-quality jobs, lower the unemployment rate, and improve the growth rate of the U.S. economy.  I hate to be the bearer of bad news, but these claims are just plain false. I could quote excerpts and detail step-by-step where the reasoning fails, and I’m happy to do just that if asked, but I will spare you!  Basically, these analyses are bogus for one of two reasons:  one, they ignore that tax revenues are foregone private income and; two, that individual choice is always better than decision-by-committee.

Oh no, Not Health Care, too!

No! No! No! Everyone please just take a breath, and THINK. When Obama says he wants to reduce the cost of health care, he does not mean he is going to reduce the price we pay for prescription drugs, doctor's visits, or health insurance. He means that he wants to reduce the cost of health-related government programs, like Medicaid, Medicare,and CHIPs. The reason those costs are going up is because the Government is using someone else's money to decide what medical services we can and cannot have without any mechanism for providing those services efficiently or in ways that enable us to make our own choices about how to take care of ourselves, whether to self-insure, how much insurance to buy if any, and how often to see a doctor and about what. Obama's plan is "Health care by committee" - regulated, limited, delayed, depersonalized. Can you name five bureaucrats whom you would entrust with the medical decisions for you and your children? I certainly can't. 

Obama has it so wrong.  He constantly confuses sound bites for fact.  Consider his question from today's press conference on health care: "Why would it drive private insurers out of business?" asked Obama. "If they tell you they're offering a good deal, why is it that government, which they say can't run anything, can drive them out of business? There are gonna be some legitimate debates to be had about how this takes shape. But conceptually, if they can't compete against a public plan as one option, with consumers making the decision on the best plan, that defies logic."  Notice his assumption that private industry would be "competing" against a government sponsored medical plan?  How patently ridiculous. The government doesn't compete in ANY sense of the word. If it were that simple -- if the best provider wins -- then how did we get into this single-payer Medicare/Medicaid disaster that Obama is saying will bankrupt the government unless we do something about it?  No, the government makes up the rules! The government directs, orders, fines, and imprisons, and that's here in a free country!  Their presence as a provider in the health care services and insurance industry will shift that industry as far away from a competitive, efficient, desirable equilibrium as anything you can imagine.

It is an incontrovertible fact that competition improves quality and reduces costs.  You don't think that applies to health care?  Think again.  Consider elective cosmetic surgery.  We all know that it is not generally covered by medical insurance. What you may not have realized, however, is that, as a result, it is a competitively supplied service, with malpractice laws in place to limit abuse. The quality of facelifts and tummy tucks? Up. Their price tag? Down. Dramatically!  (not that I would know personally, of course.....!)  We could all enjoy the same developments if we could get the government out of the health care business. Unlikely, I know; once the government starts a program that takes from some to give to others, we are pretty much stuck with it (except defense spending, of course.)  But let's not make it worse by expanding the role of government provided health care. 

Shotgun Merger: Bank of America and Merrill Lynch

Almost without exception, the press would lead you to believe that the banks are the real culprits behind the financial crisis.   The media coverage implies, assumes, or outright states that it was the banks who first asked the government for a bailout.  And because the banks asked, the argument goes, the government has every right to tell them what to do.  But, to my knowledge, the banks did NOT "go to the government and ask for help," and I have been trying to make that very point to every local and national reporter who's talked to me on the topic for the last several months, without success.  

 

I have very reliable information (including the Fall 2008 memos from Hank Paulson to Bank of America, among others, revealing that the banks were required to take the TARP money whether they wanted it or not) that it was the bailout architects who first approached the strongest banks about taking bailout money to help ease the financial crisis.  Bank of America initially declined.  In very short order, however, the regulators' request became an outright order; Bank of America would take the bailout money, or else.  Or else what?  Read on.

Back in January of this year a reporter for a newswire service asked me if I thought Ken Lewis should be fired because of the negative stock price reaction to the Merrill Lynch deal.  My answer was no, because I thought that BAC had generated a healthy return for its stockholders over the years under Mr. Lewis' watch. I noted that Mr. Lewis now had a very difficult job in trying to both appease the Treasury Department and keep shareholders happy. It's like having two Gods -- which do you follow? The exact quote is:

 

"Ken Lewis is in a very difficult spot," said Sherry Jarrell, a business professor at Wake Forest University in Winston-Salem, North Carolina. "He cannot please the political interest that the government role entails and the market interest in maximizing value for
shareholders."

 

It was evident to me at the time that BAC had significant conflicts about revealing what it knew about Merrill Lynch's problems to the public in accordance with its fiduciary responsibilities, versus obeying "suggestions" from the Federal Reserve and the all-powerful Treasury Department about proceeding with the deal.  

 

Shortly after this story appeared, Ken Lewis' testimony in a New York AG investigation into the Merrill Lynch bonuses was released.  In it, he stated that Bank of America was told by the Treasury and the Fed to go forward with the Merrill Lynch deal, even though BAC sought to kill the merger bid when they discovered negative new material information about Merrill's performance.  I wondered, "or else what?"

 

Until today, it was just a guess on my part that the "or else" meant that the CEO or board member(s) would be fired.  Today, my suspicion was confirmed.  In testimony in Washington, Ken Lewis, ex CEO of  Bank of America, stated that the regulators essentially told him in December of 2008 that if Bank of America did not proceed with the Merrill Lynch takeover that he and certain board members would be replaced.  (Turns out that this was reported in a February 5th Wall Street Journal article but I have to admit that I missed it then! Apparently I wasn't alone.)

 

I have to say I'm relieved that the "or else" didn't involve more explicit corruption on the part of government officials, like drumming up fake criminal charges with the threat of jail time.  Sad to say, but at this point, I wouldn't be surprised. 

Government Motors

So the “government” now owns a large chunk of General Motors, Inc.  Is this a big deal, or a non-event in the life of the average US citizen?  What real difference does it make who owns a company? 

Typically, this is how a company is “governed” (no pun intended!).   A person or group of people purchase equipment and hire labor to produce a product or service to sell.  The intent is to sell the product for more than it cost to make it.  The difference between the revenue and the costs is profit, and private industry is the ONLY entity in the United States that can create – i.e., give birth to – economic wealth. Consumers can’t do it, and certainly the government can’t do it!  More on that in a separate posting. 

So far in this example the company is private.  Its assets are privately owned and its equity is private equity.  The owners of the company make all the decisions and absorb all the risks, profits, and losses.  Only private wealth is at stake. 

Let’s say the company wants to expand beyond the ability of its private owners to generate funds.  So the owners have to approach the external financing markets for financial capital.  They have to go public.  They approach the market to raise funds by selling debt or equity, or some hybrid combination of the two.  Debt is a fixed income instrument, a legally-binding contract to repay lenders a set of cash flows over a specified period of time.  If the company misses a payment, it is in default, and the parties go to court.  Equity is a residual income instrument; if, after paying for physical capital, labor, taxes, and debt payments, there are profits remaining, it is management who decides how much of those profits will be paid out as dividends, and how much will be reinvested in the company each period in an attempt to grow the firm, to increase the level of future profits (i.e., to generate capital gains or to increase the stock price of the company). 

What governs how management decides how to invest or distribute its profits?  For a typical public corporation, it’s the Board of Directors that hires, fires, compensates, and otherwise manages the management on behalf of the shareholders.  These are the  shareholders who chose to lend the company financial capital by buying its stock (directly in the primary market through an IPO or stock offering; indirectly through the secondary market by buying and selling shares of outstanding stock from and to other shareholders – more in a separate posting) in order to make a decent rate of return.  These shareholders, under U.S. Corporate Governance rules, typically have one vote per share. Depending on the corporate bylaws, the shareholders vote on such important corporate matters as takeovers, seats on the board, and executive compensation.  And they own the ultimate voting right of selling their share if they don’t like the direction the company is taking or aren’t getting the rate of return they expected. 

This principal – agent relationship between owners and managers – i.e., between shareholders via their vote and the Board of Directors, and executives – has worked very well for our economy for a very long time.  It’s the private economy at its best. The government and the courts have a role, too.  They enforce the “rules of the game.”  If laws are broken – e.g., fraud, theft, or insider trading – individuals or corporations are prosecuted and punished and replaced. Businesses operate within a set of laws and regulations intended to create a fair environment. 

What happens to a company when the government becomes a majority stockholder in the company?   What happens when a voting stockholder also has the power to change the rules of the game, has the power to replace management’s decisions with its own view of the “correct” product and business strategy?  How does this actually play out?  Not well, that much we know. 

When “the government” owns a block of GM shares, who in fact is “the shareholder?”  Who gets to decide how to cast the one vote per share (or whatever the ratio is that someone dictates in some unknown negotiation with some mystery authority)?  And what decision criteria are they going to use to cast their vote?  Are they going to vote in favor of value-maximizing strategies, those that maximize the shareholders’ rate of return?  Or, are they going to vote for strategies that maximize their power, that make them most attractive to the voting public at large, or that enable them to implement their political or macroeconomic policies?  The government as shareholder is necessarily schizophrenic – it is both residual claimant whose only real exit strategy is to sell the share, and dictators who can force the company to build a certain car.  Management is no longer in charge of GM – they can not make their own decisions about what cars to build.   If management does not please the policymaker shareholders, Obama via the Auto Czar can literally obliterate the company with the stroke of a pen, or through taxation, regulations, or executive order.   And Obama has said as much, and in those very words.  “We will allow GM to set its own policies, follow its own strategies, unless of course we don’t like the direction they are taking…”  

And therein lies another dirty little secret of public ownership of private industry.  Not only does the amorphous, unidentified “government” get to decide how the company operates, the government also substitutes its preferences for that of the consumers.  GM no longer is incented to build the kinds of cars that consumers prefer.  They are going to have to build the kinds of cars that the government dictates will help the White House to reach their policy objectives.  What if people don’t want to buy the cars that GM builds under Obama’s rule?  GM will (continue to) lose money.  Under normal circumstances, GM would go out of business, and other companies who build cars that we want to purchase will prosper. That is the way a free economy is supposed to work.  But what happens to an unprofitable government and union-owned GM?  I can think of only two scenarios:  the government continues to pour our tax dollars into a failing business, or the government requires us to buy the car that GM is making, whether we like it or not.  And have no doubt, the government can and, in the current insanity that is the Obama White House, will do that. 

The Coming Inflation...

My guess is that within the next year or two, we will experience significant levels of price inflation in the US.  Let me explain why. 

Inflation is the percentage increase in the price level of goods and services sold in a geographic region.   There are several different measures of inflation: the consumer price index, producer price index, the chain-weighted deflator, and so on.  Each has issues: it is estimated on a limited basket of goods and services which may or may not represent what each of us buys; it is a biased measure of our quality of life; and, it is frequently reported only to be significantly revised later.  But as long as our measure of inflation is equally crappy through time, it will give us a reasonably reliable measure of the changes in the rate of inflation. 

Inflation occurs when the rate of growth of the money supply exceeds the level of real growth in the economy.  It doesn’t occur in the short run.  In the short run, in fact, an increase in the money supply actually lowers the interest rate, or the “price” of money. For us to see a pervasive and wide-spread increase in prices, the growth in money has to exceed the real growth rate for an extended period of time.  

What causes the growth rate in the money supply to increase?  It’s complicated, but there are basically three things the Federal Reserve can do to increase the money supply:  decrease the discount rate (which is basically as low as it can go right now); reduce the reserve requirements of banks (which isn’t likely to happen); or buy a lot of newly issued treasury bonds (or any asset for that matter – more on the creative acquisition of “special purpose” assets by Geithner and gang in a separate post) and pay for them with newly created deposits that it injects into the commercial banking system.   This last one is called Open Market Operations (OMO).  OMO give the Federal Reserve enormous power and responsibility: it basically gives the Fed the ability to create money out of thin air, and it is the only entity in the US economy that can do that.  Banks can’t; businesses can’t; consumers can’t. Just the Fed. 

And the Fed is doing a whole lot of that lately.  It is hard to surmise from the press reports exactly what fraction of the $300 billion in additional purchases of long-term treasury bonds and the $750 billion purchases of mortgage assets announced on March 18, 2009 were financed with deposit creation, but to the extent they were, the money supply is skyrocketing.  Given the subdued growth in real productivity in the US economy, this increase in money supply will translate into period of inflation, the likes of which we’ve not seen in this country for decades.  We see evidence of it already in the bond markets. 

True Cost of Government Spending

I think we all know on some level that every dollar of government spending is a dollar of income created by a business.  But this fact seems to be lost in the rhetoric of the press and the politicians.  Congress, the White House, and your local press would have you believe that the new government spending associated with the so-called “stimulus” program is going to help increase US output and create jobs.   This is just fundamentally not true.   Let me explain why.

Let’s begin with the current value of US output, whatever it is.  How can we increase the level of that economic wealth? Through government spending, consumption, or investment?   No.  None of these increase the level of wealth.  The ONLY activity in the US economy, actually in any economy, that creates wealth is what happens inside of a business.  When a business – any business, from a small private family business to a large international public corporation – hires labor, buys materials, and purchases or leases machines and equipment, and combines them to produce a good or service to sell, there is the potential for value creation.  If, for example, the business pays $100 for all the inputs, taxes, and fees to produce the good or service, and sells it for $120, then $20 of wealth has been created.  And I mean “created” in the true sense of that word:  through the “magical” inputs-to-output transformation process of business, what was worth $100 yesterday is worth $120 today. 

These profits are used to pay dividends, if any, to stockholders, and to reinvest in the company in the hopes of creating additional profits next period.   If the profit level remains the same, there is zero growth.  If the profit level goes up, we have positive growth.

Notice that all tax revenues collected by the government, from either individuals or companies, originate in business.  Employees use the income they earn from businesses to pay income, sales, and other taxes to the government.  Businesses use the revenue they earn to pay income taxes, licenses and fees to the government.   These taxes and fees are the government’s revenue.  The government sells bonds to generate revenues as well but these funds must be paid back later, so I distinguish borrowing from tax revenues.  (I discuss the impact of government borrowing and debt on the US economy in a separate posting.)

So what happens to that dollar of business earnings if it gets siphoned away from retained earnings and the promise of future growth they represent and becomes a part of government tax revenues instead?  Let’s follow the dollar: It begins life as a dollar of business profit.  Then it gets collected by the government and begins to wind its way through the layers of bureaucracy, each of which chips away pennies, nickels, and dimes of each dollar collected. The government then uses what is left of these tax revenues to pay the wages of government employees, and to support all government programs, including welfare, Medicare, roads, defense, bailouts, grants, and foreign aid.   

This relationship between the original dollar of business profit, and the impact on US output or income generation is known as “the government spending multiplier.”  Despite what Dr. Christina Romer says today, which contradicts the findings of her very own research when in academia, the government multiplier is less than one; MUCH less than one.  My belief is that every dollar of tax revenue results in about 50 cents of US wealth; in other words, government spending destroys US wealth. 

Claims to the contrary are just plain silly.  If it were true that government spending increased output, and increased job creation and wealth, then all we would need to do to do to pay for the bailout and TARP and all the government programs we want and to get out of the recession is to spend!  If, as some in the White House have recently claimed, the government spending multiplier is equal to 3, and we need $9 trillion dollars to recover, then all we need is for the government to spend $3 trillion!  Magic! 

Of course that is patently ridiculous.  In fact, had that dollar remained in the private sector, and the business that earned it did exactly the same thing it did to generate it in the first place, the income multiplier would be equal to one.  In other words, that dollar of income would generate, at a minimum, another dollar of income.  That is already double the wealth generation of government spending.   

Without the profit-motivated activities of business, there would be no increase in economic wealth, no increase in employment, no growth.   Taxes reduce economic wealth.  Government spending wastes economic wealth.   Government spending is inherently inefficient.  It may support programs that we as a society deem important and necessary, but don't confuse that with an increase in economic wealth and jobs.  It’s just not possible.