Dr. Sherry Jarrell

S&P Ratings - They either mean something or they don't

You cannot have it both ways. Either the bond credit ratings mean something, or they don't.  Public officials cannot point to the AAA ratings as evidence of good policy, then lambast them as "inaccurate" and "flawed" when they drop to AA+....or below.  

It is a fact that the ratings agency does not originate information; it simply gathers and interprets data that are publicly available to all of us.   The rating itself, however, is unique in that it summarizes a particular agency's forecast of how likely the US government is to repay its debt and sustain its borrowing needs.  

Don't get me wrong -- there is a LOT of information out there about the risk-adjusted rate of return on US debt to be digested.  But we don't have to re-examine it from the ground up -- we need only look at the marginal changes, the most recent developments, the direction of change, to update our expectations, and -- in my view -- to understand easily why S&P downgraded the debt.  

I think most of us realize that all government spending is financed by the private economy but I'm not as sure that everyone realizes that the return on government debt is also enabled by the productivity of the private economy.   The more productive the private economy, the higher rate of real return we can afford to pay on U.S. debt, and the more willing others are to buy our debt.  Being able to generate a return on debt is a good thing -- it's a sign of a healthy economy.   

Then there is the other side of the equation: the required return on debt from the point of view of the lender. The lender assesses the risk (or likelihood or uncertainty) that they will get their money back (and that the "money" is worth the same per dollar....so we are ignoring inflation just to simplify things).   The less certain they are, the higher the return they are going to demand before they buy the debt.  This required rate of return is a cost to the economy -- a higher cost eats away at profits, and makes the economy less productive, less able to reinvest, employ capital and labor, and grow.  

In the simplest terms, government spending is supported first by taxes and then, when those run out, by borrowing.  The debt ceiling debate made it clear that Washington was unwilling or unable to reduce or curtail government spending, which was on its way to starving the private economy of the sufficient earnings, liquidity and financing to continue to be productive.  The wealth creation capacity of the private economy is vast and impressive and has somehow miraculously employed labor and capital and supported AAA rating returns on government debt for a very long time, but it's not limitless.  

No, the ratings do not originate information. They simply publicly confirmed what many of us who understand and respect what private enterprise does day in and day out saw coming:  the current level of government spending is unsustainable. The private economy cannot take much more of the oppression and costs imposed by government policy, taxes, fees, regulations and -- perhaps the most troubling and insidous of all -- the public denigration and disparagement of the private economy, Wall Street and capitalism by our President.

 

It will be very interesting to see if this was a surprise to the markets.  

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.  

Fannie Mae and Freddie Mac: Scary

Fannie Mae and Freddie Mac are at the very core of the most recent financial crisis. Without them, the crisis would not have occurred.  Fannie Mae and Freddie Mac get between lenders and borrowers and distort the pricing of their transactions.   Fannie Mae and Freddie Mac have, as their mandate, social engineering, not arms-length business negotiations conducted for mutual benefit.  They have no business worming their way around our economy.  

Fannie Mae and Freddie Mac continue to operate because they make politicians better off, not business people or consumers. Someone is getting their pockets lined.  I believe that when the real operations of Fannie Mae and Freddie Mac see the light of day, that you will be stunned by the sheer magnitude of the fraud, corruption, and destruction of wealth.

You heard it here first.  

For fabulous reporting on all things housing, including Fannie and Freddie, I follow Nick Timiraos on twitter (http://twitter.com/nicktimiraos).

We have it Exactly Backwards!

The next time you hear about the deficit, the level of government spending, or a new bailout program, please consider the following.   We have it backwards:  government spending should never justify collecting taxes.  Instead, collecting taxes should first be fully justified by the specific government spending.   If we cannot justify the government spending as absolutely necessary for the public good, then the dollar of taxes should never be collected.

Instead, today, taxes are routinely collected and THEN the politicians fight over how the taxes are going to be spent. In fact, government spends future tax revenues!

We have it backwards. The press has it backwards.  The pundits have it backwards. Congress has it backwards. The White House has it backwards.    The only debate out there seems to be about WHAT we spend the tax revenues on, instead of whether the tax revenues should be collected in the first place.  

I think if we put government spending to such a test, we would decide against most of it, and our taxes would fall to a level that supported a vibrant economy with low unemployment and stable prices. 

 

A Government Motors IPO?

Does anyone else see how perverted this story is?  A company which is 60% owned by the U.S. Treasury, in other words, 60% owned by taxpayers -- not voluntary shareholders, but TAXPAYERS, has hired a private investment banking company to take the company public. That is, to be sold to public stockholders.  For a profit.  Which is going to be distributed to whom?  The government.  Who took the company over by edict, essentially by force, ignoring lawfully binding financial contracts in the process.  Oh, yes, technically G.M. went through a "banktuptcy," but when one of the two involved parties is the federal government -- the one who makes up the rules of the game -- then it isn't a game anymore.  It's "do it, or else!"

GM Headquarters

Absolutely unbelievable.  This IPO should not be happening.  The bailout should not have happened. None of this should have happened.  If the company cannot generate a profit in the marketplace, then it should go bankrupt and its resources freed up to be used where they are most valued by the marketplace.

SEIU Thugs Are at it Again

Thugs from the Service Employees International Union (SEIU) and Chicago's National Political Action trespassed on a Bank of America Executive's front lawn in a so-called "protest" over mortgage defaults.

SEIU Protests on private citizen's front lawn

This same group went after AIG executives in March of last year (see video).  I commented on local television and to anyone who would listen then how misdirected their anger was, and I repeat that sentiment now.

Where is the President's outrage at these mob tactics against a private U.S. citizen?  I can only assume his silence is tacit approval. The recently-resigned President of SEIU, Andy Stern, is reportedly Obama's most frequent visitor at the White House, after all. And Obama has made it abundantly clear that he has no respect for private industry and free enterprise.

Where did U.S. Incomes Go?

I've taken the liberty of reprinting in its entirety a recent piece by Karl Denninger of Market Ticker on the state of U.S. incomes.  This piece helps underscore the inescapable reality that private industry drives our economy.

"It appears that the Federal Tit Pump is running out of power...

Personal income increased $1.2 billion, or less than 0.1 percent, and disposable personal income (DPI) increased $1.6 billion, or less than 0.1 percent, in February, according to the Bureau of Economic Analysis.  Personal consumption expenditures (PCE) increased $34.7 billion, or 0.3 percent.

Oh boy, now the $1.3 trillion in additional deficit spending is no longer contributing to personal income!  That's not so positive - indeed, it's not positive at all.

Private wage and salary disbursements increased $2.0 billion in February, compared with an increase of $16.6 billion in January.  Goods-producing industries' payrolls decreased $3.5 billion, in contrast to an increase of $5.2 billion; manufacturing payrolls decreased $1.4 billion, in contrast to an increase of $5.0 billion.  Services-producing industries' payrolls increased $5.5 billion, compared with an increase of $11.4 billion.

Goods down.... uh, where's our so-called economic recovery? 

Proprietors' income decreased $6.1 billion in February, the same decrease as in January. Farm proprietors' income decreased $7.1 billion, the same decrease as in January.  Nonfarm proprietors' income increased $1.0 billion, the same increase as in January.

Very little change in proprietor's income ex farming, but farmer income is down significantly.

Rental income of persons increased $2.2 billion in February, compared with an increase of $1.9 billion in January.  Personal income receipts on assets (personal interest income plus personal dividend income) decreased $16.5 billion, the same decrease as in January.

Rents up a bit, but dividends are down huge, continuing a trend.  This is not positive at all, and implies that assets are being sold to continue lifestyle choices.  This leads to a question that has begun to gnaw at me: Have we begun to cross into where boomers start pulling funds out of asset classes to live on?

Personal current transfer receipts increased $16.6 billion in February, compared with an increase of $29.8 billion in January.  The January change reflected the Making Work Pay Credit provision of the American Recovery and Reinvestment Act of 2009, which boosted January receipts by $19.8 billion. The Act provides for a refundable tax credit of up to $400 for working individuals and up to $800 for married taxpayers.  When an individual’s tax credit exceeds the taxes owed, the refundable tax credit payment is classified as “other” government social benefits to persons.

Government to the rescue!  $45 billion worth in the last two months, to be specific.  That's a direct $270 billion in handouts, or 2% of GDP - and that's only the direct handouts!  So subtract that off GDP and..... (oh, and don't forget the rest of the $1.3 trillion too.)

Nothing to see here folks, as in "no evidence of sustainability in the recovery."  We have a government that continues to "prime the pump" but there's no water at the bottom of the well to generate self-sustaining economic growth. 

by Karl Denninger

Lessons learned as a Government Intern

When lending is motivated by politics, losses are not far behind.

Years ago, in the summer of 1980, I worked as an intern in the Federal Home Loan Bank Board at the Department of Agriculture.  I was a senior in college majoring in business and had been accepted to the University of Chicago doctoral program.  I didn’t want to take the internship because I wanted to take more courses over the summer to help prepare me for the rigors of grad school, but my college advisor had openly worried that I was far too serious for a young person.  He strongly encouraged me to accept the internship and take a break from academics before I immersed myself in graduate school, and buried myself once again in all things economics!

The U.S. Department of Agriculture was a major lender

I agreed, but only after I had arranged to take 6 credits of independent study in D.C.  I chose to examine the Negative Income Tax program, one of the largest social experiments in U.S. history. More on that at another time. Today, I want to talk about what I learned from being an employee of the U.S. federal government.

The first thing I learned was that the “problem” with government work is not the people; well, not all the people.  There was one man who spent his entire day going back and forth to feed quarters to the parking meter rather than pay for public transportation or do his work.  He represented the worst in government employees.  Most all of the others I met were hard-working and honest people, trying to do a good job and make a difference.

President George H. W. Bush

No, I learned that the real problem was with the way the "work" is done in government. I worked for the Federal Home Loan Bank Board (FHLBB) that summer, which was one of the largest lenders in the world.  The FHLBB was responsible for small business, rural, agricultural, and economic development lending. My job was to review loan applications from community groups, fairs, farmers’ markets, and various municipal organizations to make sure that they were complete.  We did not analyze the applicants for creditworthiness.  Instead, if the application was correct and complete, and satisfied the application process, it was approved.  The FHLBB, which was publicly trashed by the first President Bush as being largely responsible for the savings and loan crisis, was abolished and replaced by the Office of Thrift Supervision (OTS) under the Department of the Treasury in 1989.  The OTS eventually expanded its oversight to companies that were not banks, including Washington Mutual, American International Group (AIG),  and IndyMac,  all implicated in the current U.S. financial crisis.

AIG

Little did I know back in 1980 that I was witnessing, from the inside, a government lending process that would lead to the most significant financial crisis since the Great Depression. Looking back, the outcome was perfectly predictable: when politics replaces profits as the motivation of the lender, it should be no surprise that losses result.

The Hypocrisy of Finding Medicare Waste

I honestly cannot understand how President Obama can look the American people in the eye and tell them that Health Care reform will be paid for, in part, by finding savings and reducing fraud in Medicare over the next several years.

President Obama on Health Care Reform

If it is possible to operate Medicare more efficiently, why have we not done it already?  Why must doing it right wait for new programs and new legislation?  Why doesn't Congress first prove to the American people that it can operate a program efficiently and then come back and ask for more?

Because it can't, that's why not.   The plain and simple truth is that it cannot do so now, and will not do so in the future.  So why are we letting our elected officials get away with such a charade?

I just don't understand it.

Healthcare Summit: leadership or grandstanding?

Political leadership or grandstanding?

What has become very clear to me, after watching the U.S. Health Care Summit between Democrats and Republicans as objectively as possible, is that the President's goal was not to craft a thoughtful approach to shoring up and improving the U.S. health care system.

Pres. Obama making one of many points at Healthcare Summit

No, the reason for the President and the Democratic leadership to convene the so-called summit was to grandstand; to make a show; to create a photo opportunity; and, most importantly, to try to garner enough support from the Democrats in Congress to ram through the Reconciliation option on the behemoth, disastrous 2000-plus page version of the bill, filled with incomprehensible, internally conflicting doublespeak.

A sad day for American politics.  A very sad day for American citizens.  We deserve better.

Does Fed Rate Influence Consumer/Business Interest Rate?

Does the Fed Funds Rate, the rate charged by the Federal Reserve to make short-term loans to banks, directly influence the interest rate consumers and businesses pay on credit cards, mortgages, and consumer and business loans?  If you took the word of the average business news commentator, you would think not.  But the answer, of course, is yes.   

One way to view the market rate of interest, although certainly not the only correct or useful way, is to think of it as a base rate that represents the risk-free rate, a rate that compensates the population for its impatience to consume the goods it would have consumed had it not lent the funds out in the first place. This risk-free rate is also influenced by the efficiency and functioning of the capital markets that bring borrowers and lenders together.

A risk premium is then added to this base rate of risk-free interest, one that varies depending on the degree of uncertainty of the lender getting repaid.  The risk of default, the risk of prepayment, the risk of political uprising, exchange rate risk, and many other sources of uncertainty -- including the risk of inflation -- raise the level of the risk premium commanded by lenders in the market.  As an example, over the last 100 years or so, the average annual risk-free rate in the U.S. has been about 4%, and the average annual risk premium for equity securities has been about 8%, bringing the average annual observed interest rate or rate of return to about 12% on these securities.

So what happens to the interest rate charged to consumers and businesses when the Fed raises the fed funds rate?  Basically, the level of the risk-free rate in the economy rises and, as debt contracts expire or new lending takes place, this higher base rate gets factored into the market rate of interest charged.  

Overall, the demand for loanable funds falls, the aggregate demand curve for the economy falls, and equilibrium output and employment fall, RELATIVE to where they would have been without the rate increase.  The bright side is that a reduction in the money supply that accompanies an increase in the fed funds rate is absolutely essential to curtailing inflation, which drives the risk premium, and represents a much greater cost to the economy.

Oh, the Irony: The Market Speaks, and Obama Has to Listen!

In a recent article, Moody’s announced that because of the U.S. federal government’s excessive spending and historic debt levels, it might have to reduce the Aaa rating of U.S bonds (http://thecitysquare.blogspot.com/2010/02/us-aaa-bond-rating-threatened-by-obama.html and http://risingpowers.foreignpolicyblogs.com/category/multipolarity/)
 

What this means in practical terms is that the cost of borrowing by the U.S. government will rise, which will increase spending via more borrowing or higher taxes or more money creation to pay for the higher interest costs.  Sound like a vicious cycle to you?  

Has anyone noticed the absolute irony of the world capital market having a seat at the table that assesses the viability of Obama’s policies? Obama has spent the last year denigrating free markets, and has laid the blame for the credit crisis squarely at the feet of those "greedy capitalists." Now he has to deal with a rating agency, which plays a pivotal role in the functioning of those very capital markets, evaluating the creditworthiness of the policies of the White House and its Budget Director, Peter Orszag.  

How wonderfully ironic! 

 

The Farcical Freeze

President Obama's proposal to freeze parts of federal government spending over the next three years is a lot like a smoker buying a truckload of cigarettes today, then promising to "freeze spending" on cigarettes tomorrow.  He can keep smoking for years to come without spending another dime.

Federal government spending has increased so much over the last year -- by some estimates at a rate of 34% (http://www.usgovernmentspending.com/year2009_0.html#usgs302 -- that in December of 2009 the debt limit had to be raised to $12.4 trillion to help absorb a record-shattering $1.4 trillion deficit (http://www.washingtontimes.com/news/2009/dec/25/senate-oks-rise-in-debt-limit-to-124-trillion/).

The promise to freeze spending is actually a guarantee that spending will remain at record high levels for the next three years.  It effectively prevents a reduction in federal spending. 

How disingenuous of our President.  

 

Engine of Economic Growth is Sputtering

The engine of world economic growth is sputtering.  The most clearevidence of this is the lack of new business formation in developed nations across the globe.  Over the last year, the number of entrepreneurs starting new businesses in the wealthiest of nations dropped 10% from the 2006-07 level; in the U.S., that number fell by 24%. http://www3.babson.edu/Newsroom/Releases/globalgem2009.cfm

The contaminants in the fuel line are oppressive government policies that increase the cost of doing business, increase unemployment, and raise the risks to the current labor force of quitting their jobs to try to start new businesses.  

At a time when government should be encouraging venture capitalists and the formation of new business, it is instead putting on the brakes to this source of economic growth in the form of cap and trade, compensation regulations, fees on banks, and myriad other explicit and implicit new taxes.  In 2009, nearly half of U.S. employment was generated by small businesses; U.S. companies started through venture capital employed more than 12 million people, or 11 percent of private sector employment, and generated $2.9 trillion in revenues, or 21 percent of U.S. GDP.  

Fully 100% of economic growth is created in private industry.  Government simply redistributes that wealth, destroying some portion of it in the process.  Never have we needed non-interventionist government policies more.

Senate Version of Health Care Reform IS a Tax increase!

The latest from Washington on Health Care Reform is the Senate's version which taxes insurance companies on plans valued at over $8,500 for individuals and $23,000 for couples.

President Obama has defended the tax as a way to drive down health costs.  "I'm on record as saying that taxing Cadillac plans that don't make people healthier but just take more money out of their pockets because they're paying more for insurance than they need to, that's actually a good idea, and that helps bend the cost curve," the president said in an interview with National Public Radio just before Christmas. "That helps to reduce the cost of health care over the long term. I think that's a smart thing to do."   http://www.cbsnews.com/stories/2010/01/07/politics/main6066223.shtml  

Huh?  Mr. President, you need an Econ 101 primer. Let's begin now, with supply and demand: s

Supply is an upward-sloping marginal cost curve, and includes the taxes and fees a business must pay to the government.  By imposing this tax, the supply curve of insurance companies will shift up and to the left, as shown in the graph, representing a higher cost per unit of insurance coverage.  The demand curve slopes down, so when intersected by a more costly supply curve, the final price to consumers rises and the amount of insurance coverage falls. Period. End of story. Indisputable fact.  And nothing Obama or the Senate says will change this fact, though they will try. 

More Political Shenanigans on Health Care Reform

This topic may seem to be more about politics than economics, but anything related to health care reform is squarely rooted in the most important of economic issues:  the costs of doing business, the size of the government, and the potentially oppressive role of government in private industry. 

To that end, the following is a must-read, and should make you angry, no matter what your political persuasion.  http://bostonherald.com/business/healthcare/view.bg?articleid=1224249&format=text

In this article, we see how the Senate Democrats are going to do whatever it takes to get their version of health care reform through, even if it comes down to essentially stealing votes.  Could the timing of this Massachusetts special election, to replace the temporary replacement put in for the late Senator Edward Kennedy, be one of the reasons that the Senate wants to rush this reform through before the President's State of the Union Address, typically set for mid-January, though the White House is curiously reluctant to commit to a date....  ?

Troubling U.S. Unemployment Figures

The U.S. unemployment rate remains at a 26-year high.  This is troubling for two reasons. One, the struggle and suffering of the unemployed (and underemployed) and the impact on the world economy. 

Two, the mixed signals it gives policymakers.  I worry that the White House will think that it needs to do "more" of what it's been doing, and will dismiss any negative comments about its economic policies as a knee-jerk reaction to the unemployment figure when I, in fact, would be saying the same things if the unemployment figures had improved.  It would be a harder sell, true, but that doesn't change the facts.

The reason?  Because I believe we would be in a better position today, with lower unemployment -- no matter what the current unemployment rate -- and higher growth, had the stimulus program never been initiated.  I base this on my understanding of the fundamentals of how the economy works, how businesses create value, and how labor makes itself indispensable to industry.  

And none of these areas were helped or improved by the economic policies of this President. 

Q3 GDP Revised Downward - Again

What a shock.  U.S. GDP is not growing at 3.5% per year, as originally reported, and celebrated with much fanfare from President Obama about how the stimulus program was working.   It is not even growing at the revised 2.8% annualized rate reported a couple of weeks later.  The latest re-revised figure is 2.2%.

Nearly the entire 2.2% annualized growth, or 3rd quarter growth of 0.55%, is driven by the cash for clunkers program, the government spending program (also called the stimulus program, but I have a big problem with that particular name), and the extended tax credit for first time home buyers. Which means that this increase in GDP is not only entirely temporary and fleeting, but will cause lower GDP later.  The cash for clunkers program did not create more overall demand for cars; it simply pulled some of the future demand for a new car into today, all the while wasting millions of tax dollars on administering the program, and putting some dealerships out of business in the process.   The spending program simply shifted profits from businesses to support other segments of society, all of which is temporary and destroys the productive capacity of the economy for many periods to come.  The extended tax credit to first-time home buyers is a real head-scratcher.  A curious time to redistribute funds from the producers in the economy to finance a program which lowers the cost to those home buyers who would not have the funds to buy a home in the first place....second wave of home mortgage foreclosures, anyone? 

The Poor Pay Czar: Comment and Reply

Patrice Ayme posted the following comment on my earlier post titled "The Poor Pay Czar:"

1) Self referential loops have proven a problem in logic. Should not they be a problem in the market, or is it that the market has nothing to do with logic? The CEO class, in the USA, is self referential. 2) Europe has now more big companies than the USA. Still, big European executives are paid at least ten times less than their USA equivalents. How come the market is so different in Europe? Is the fact that more compensation in Europe goes to talent located on lower rungs of companies, related to the higher performance of European companies in the last decade? After all, the total compensation being finite, paying more for talent at the CEO level means paying less for talent just below. An interesting aside is that CEO in the USA are much taller than average. Are size and compensation the only way they can dominate their subjects? A few years ago, Renault was all set to buy General Motors. At the last minute, though, Renault executives learned that GM executives intended to pay themselves more than ten times what Renault-Nissan executives were paid. So Renault scuttled the deal. US taxpayers are left with the bill: more than 60 billion dollars, no? (And GM will fail within a year or two.) It is true there are markets, and they can deal. But they are more or less free. There are not just markets. There are also classes too, and they can dominate, with extra market mechanisms. The CEO class in the USA sits on each others’ boards, determining each others’ compensations. In some other countries, this sort of incest is more limited (in others, it’s worse: China). In Germany, union representatives sit on boards. Generally those who really love their jobs will do them for free. Too much compensation is actually a distraction. And bad markets, thus exists. They are not just bear markets, they can lead to captive markets, and oligarchies… 

My reply to Patrice: 

Patrice —

Your view of markets is flawed, perhaps fatally so.

The U.S. labor market, for example, provides just the right incentives for individuals to work hard in order to improve the quality of their lives in ways that free people see fit.

There are some issues with that market in its current form, like minimum wage legislation and unions, but overall the U.S. labor market works quite well, particularly when viewed dynamically, through time, instead of as a snapshot at a point in time, as you seem to do.

Your comments ignore the fact that most CEOs work their way up through their companies, or in other companies, for many years, putting in long hours, sacrificing time at home and with family, in order to rise to the top, to take on the huge responsibility of guiding an organization to sustainable profits.

Right this moment, people are toiling away in industry at lower salaries, or in school at no salary, honing their skills, building relationships, learning about their industry, coming up with better ideas. A select few of these people will one day rise to become the CEO of a company, many of which do not even exist today. CEOs earn whatever the labor market, in its objective, efficient way, as disciplined by laws preventing fraud and by the instantaneous referendum on value creation represented by an active capital market, deems is justified.

Yes, there are temporary glitches in the functioning of the labor market, like Enron. Yes, there are unethical executives, like Maddoff.

But the fate of Enron, its executives, and Madoff is glaring proof that the markets in the U.S. work to ferret out the thieves and reward hard-working entrepreneurs and business people.

Parenting the Government: More Q and A

Patrice Ayme continues:

Hi Sherry:
I made several points. Indeed by “public utility” I allude to public as in res-publica.
Funny you said that a “national interstate roadway system” should be paid by taxes. As I said, in France, it’s private, and paid by the proverbial ‘end user’. So much for France being socialist and USA private profitist. Please forgive the neologism.

I gave the example of waterworks. Private French companies lead worldwide in that domain. That means French (local) government use taxes to pay them. But recently some government realized they could get more services by doing the work themselves. So, in this case, they start as before: taxes. But then, instead of paying some giant private French water company, they pay municipal workers and engineers to do the work. Cost less (less taxes), better service.

Call that an anti-Jarrell universe. A mystery, like anti-matter. How could that happen? Very simple: think about it: the municipal government does not have shareholders (just stakeholders) and does not have to pay dividends, and does not have to increase the value of the shares by showing profits. It actually has no profits to make. So the end user (the denizen of said city under his city government) saves money (i.e., taxes), improves services.

This example, of course carries to health care. France has also a competition of public and private health care systems, large pharmaceutical companies, etc… And has done more face grafts (in public hospitals) than the rest of the world combined… and the first successful gene therapies (also in public hospital), etc. Was is it not to like? If profitist ideologues in the USA were not so greedy, they would see the necessity of having a strong public sector, be it only to keep the private sector honest.

By the way, French politicians are regularly condemned for corruption, and it’s not because they are richer than their colleagues in the USA, by a long shot…

My reply:

Ah Patrice….here we go again! For one, I did not say that government “should” pay for a national highway system, I said that we do pay for a national highway system. A positive statement, not a normative one.

I guarantee you that in any universe – not just the Jarrell one – the true cost of anything paid for by the government with tax dollars is understated by several orders of magnitude. And, possibly, overstates benefits. It is simply factually incorrect to say that the cost (the true economic cost as measured by the use of resources) of providing the service is less when provided by the government. The one-period ACCOUNTING cost put on paper by some government office, as reported to the press, and swallowed whole as fact by readers, may be less. But it is literally, factually impossible for the true costs to be reduced by inserting a redistributive middleman between consumers and business.

You also fail to understand the relationship between stock prices and economic value. You should step back, slow down, and consider the following. Let’s get dollars and stock prices and dividends and profits out of the equation entirely and just think about the amount of goods and services provided versus the amount of resources used up in the production of those services. Measure it however you want — quality of life, health of the citizenry, happiness, kumquats. Now ask yourself which is the most “efficient”method of providing final goods and services, where efficiency is measured, as it should be, as the number of units of output of the good and service provided per unit of resources used up in production process. The “dividends” and “capital gains” in this analogy are the EXTRA value created from a capitalist system; take one input, create 2.5 outputs, added value is 1.5. The government as provider creates zero extra value, if we are lucky, and negative value, if we are realists: take that same input, chew up half its value in bureaucracy, buying votes, and redistributing the consumption decisions of a free people toward something they would not choose to purchase in the first place (otherwise, why the government program in the first place?), and produce 0.5 total outputs, a loss of 0.5. The social loss from moving from capitalism to collective command and control is 2: from plus 1.5 to negative 0.5.

Yes I am including spending on defense and clean air and roads. When we spend on collective goods, we use resources less efficiently. This spending infringes on our economic freedom, but some goods and services are necessary to protect and preserve the system that enables that economic freedom.

You and I can and most certainly do disagree on where to draw the line on what goods and services the government should provide over the objections of a free people, but we cannot disagree on facts. Your claim that government provision of goods and services is less costly than private industry is factually incorrect.

Parenting the Government: Comment and Reply

From Patrice Ayme on www.Learningfromdogs.com:

Agreed about too much taxes without adult supervision…

Now something related to think about. Why not make American freeways private? The US government could sell the Interstate system, making lots of profits (are not profits the best thing?), then the private owners would make even more profits. No more taxes to pay for the roads, etc… One could extend that to the army. Make the army completely private, headed by the operators of the ex-Blackwater, I mean “Xe”. Army guys would be encouraged to make profits, as their predecessors in France around 1200 CE (interestingly called “Les Grandes Compagnies” = The Great Companies”).

And so on.
In France, freeways are actually private, and toll. But of course they were built and paid for by private capital (protected by law recognizing them as of “public utility”). It works well, nobody is complaining: superior surfacing, no holes, no debris, and advanced freeway architecture, differently from American freeways.
The high speed train network is according to similar lines.

Superior economic organization is all within that concept of PUBLIC UTILITY.

Profit is not the superior economic organizing principle. Public utility is.

Pirates made profits, so did Roman governors and Persian Satraps, or Carthage.

The USA can learn a lot from its sister republic, France. Another example is waterworks. Starting around 1850, private water companies grew in France. They soon became extremely profitable, and several private French water companies are now the largest water companies in the world.

This worldwide success did not escape the attention of typically suspicious French citizens. Some city engineers noticed that they could do the same cheaper. So, paradoxically, a rebellion against the French water giants has started in France, and some city governments are now running, cheaper and better their own waterworks, after wrestling back control from the private water giants.

It is not whether it is private for profit or government for public which matters. what matters is the maximization of public utility. At least in a democracy. In a banana republic, it’s different, true.

My reply:

Patrice: Just to clarify before I comment, by “public utility” you mean the benefit of the whole of the public? And your focus is on what is being delivered or consumed and how much good that does for the citizen?

I assume your point is the superiority of government supplied goods and services — specifically as it is done in France — over the profit motive of private companies. Again, you miss the point that the government would have no resources to spend without private industry. All the government does is to shift profits around in the economy. Now some of that shifting, like from private profits to public goods (and by public good I mean one where the consumption of the good by one individual does not reduce availability of the good for consumption by others; and that no one can be effectively excluded from using the good, like clean air, national defense or, effectively, a national interstate roadway system), is necessary and desirable. We, as a country, defined the need for public goods in our Constitution, but we have strayed very far away from that ideal over time, to our detriment.

Government Spending is like a McDonald's Burger

At times when money is tight and our resources are stretched to the limit, it pays to spend our money wisely.  That is why it makes so much more sense to reduce the costs imposed on private industry instead of increasing spending by government.  Industry takes their earnings and reinvests them to create sustainable wealth creation: they hire and train workers, conduct research, build and perfect machinery and robotics, and develop brand equity and a reputation for quality. All of these endeavors represent lasting value creation. What is spent on these things this year will continue to create revenues, wages, and profits for years to come.

Government spending is pure consumption.  It is temporary and fleeting.  It keeps the beast alive for one period, and then the process has to start all over again next period. When we approve a massive spending bill, it covers government purchases of goods and services for the next year, maybe less.  In one end; out the other, with nothing left to show for it, except a hungry program that needs to be fed again next year, and the next and the next.  Government programs in and of themselves never produce lasting value; only in conjunction with private industry is any wealth or value created. And even then the government purchases have pushed aside, prevented, crowded out, or priced out purchases that would have been made by the private economy.

So, please, keep this in mind whenever you think of any type of government spending or tax increase: it is here today, gone tomorrow. 

Yes, President Obama! Cut taxes!

President Obama said a good thing yesterday.  He proposed cutting taxes to small business to help spur job creation and economic growth.  This is good. Very good. Here's why:

Beyond the theoretical justifications for cutting the capital gains tax, how much wealth would actually be added to the economy if we cut the current capital gains tax rate of (an average of) 15%? I estimate that every dollar of capital gains collected by the government costs the US economy approximately $6.80 in economic wealth.   This is how I came up with this estimate.  

For every $100 in corporate earnings, a 15% capital gains tax represents $15 that the firm could have either distributed as dividends (for a 0% net growth rate in next period’s earnings), or reinvest in the company to generate future growth (with a growth rate of 20% per year considered healthy).  Most experts agree that a reasonable estimate of a sustainable annual growth rate in earnings is somewhere between these two extremes, say 5%. 

I combine this 5% growth rate with a ten-year investment horizon and a discount rate of 12% per year (using the 80-year average rate of return on the S&P 500) and find that the Present Value of the annual savings of $15 in capital gains taxes is $102. So every dollar of Capital Gains protected from taxes produces approximately $6.80 ($102/$15) in new economic wealth for our economy.

This increase in economic value enables economic growth in America, while also creating more jobs for Americans as companies create more revenues to allocate to new hires and higher salaries.  Every dollar that is collected by the government in capital gains taxes could have supported an additional job instead. In an economic time when the unemployment rate nears 10%, cutting the capital gains tax and increasing the production value of our economy is critically important. 

Parenting the Government

Okay. If you tried this ploy on your parents, you wouldn't get away with it.  If your kids tried it you, you wouldn't fall for it either.  So why are the American people letting the Government get away with this ploy?  I don't know. And I don't get it.  Maybe there is just so much going on that it gets lost in the mix. Maybe it's because of the deceptive and disingenuous way it's being presented by Pelosi, Reid, and Obama.  

Here's the ruse:  "Give us more of your money today, and we will reduce tomorrow's health care costs. We will increase efficiency.  And we will do all of this without increasing the budget deficit!"  

Yeah, right.

What exactly is stopping them from reducing health care costs and improving the efficiency of health care delivery now? Why do they need more money today to accomplish these things tomorrow? What magical powers does the next dollar of tax collections have that the current ones don't? 

Exactly.  None.  So when Congress asks to increase taxes and the deficit in order to fix health care tomorrow, let's respond to them as we would our clever but errant children: Ask to see some proof today first. 
 

You know how that will turn out. And so does Congress. That's why they just keep promising the moon.  What I don't get is why we continue to let them get away with it.  

The Insanity of Medicare 2.0

We've all heard this definition of insanity: doing the same thing over and over again but expecting a different result.  

Here, in a nutshell, is the insanity of the current U.S. health care debate:

1. Medicare, the government's single-payer wealth redistribution health care program, is quickly going bankrupt.  No one disputes this fact.  

2. When President Obama refers to "cutting costs of healthcare," he is referring to cutting the Medicare budget. Period.  No increased efficiencies, no improved services, no reduced market-clearing prices. No, cutting costs refers to reducing the fraction of the U.S. government's tax collections devoted to Medicare.

3. The new Health Care Plan is fundamentally a new Medicare program. Let's call is Medicare 2.0.

4. Medicare 2.0 is being funded in large part by cutting the current Medicare budget item. We are supposed to ignore the fact that the funds cut from the current Medicare program will be spent on Medicare 2.0.  

5. The Medicare 2.0 plan shifts as much as 25% of its (under)estimated costs (e.g. payments to physicians) to other accounts.  The costs are still there; these obligations would still need to be paid by the government under the proposed legislation, but Congress is hoping the public won't "count" the shifted costs if they slap another name on them, further fostering the illusion of "lowering costs of health care."

5. Medicare 2.0 will also go bankrupt but, as a larger, more far-reaching entitlement program, the impact on the U.S. budget will be larger and more far-reaching.

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. 

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.

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

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

Zombie Stocks: Not for the Faint of Heart

[http://in.sys-con.com/node/1157066#. By Eric Frazier, Advancement: University Relations, Wake Forest University.]

Two weeks before Halloween, the Securities and Exchange Commission again warned investors against buying shares of bankrupt companies, but like those creatures in horror films that rise from the dead, so-called "zombie" stocks--shares of companies that failed during the financial crisis--are still on the march.

Take, for example, Washington Mutual and Lehman Brothers. At the end of last year, their stocks traded at 2 cents and 3 cents per share, respectively. With no future earnings in sight, shares of Washington Mutual recently traded around 20 cents, and Lehman Brothers shares have hovered around 15 cents--spectacular gains fueled by what many consider nothing more than gambling.

Critics have called on the SEC to halt the trading of such stocks to protect unsophisticated investors who might be lured into unwise trades. But Lecturer of Finance Sherry Jarrell, who teaches a graduate-level class on investments and portfolio management in the Wake Forest University Schools of Business, disagrees.

While Jarrell doesn't think investing in zombie stocks is a sure-fire profitable strategy, she doesn't consider it gambling either, because there is an expectation of gain. Jarrell also doesn't believe those who are trading zombie stocks are ignorant or unsophisticated. "To outlaw these stocks means that you've truncated an avenue for people to express their different risk preferences," Jarrell says. "If someone wants to go on that haunted trail, let them. It's not like they're taking advantage of people on the other side of the trade."

Washington Mutual and Lehman Brothers lost their standing to be listed on stock exchanges, so traders have to keep up with prices through a quotation service known as the Over the Counter Bulletin Board, which unsophisticated investors are unlikely to access. Other troubled companies, such as Fannie Mae, Freddie Mac and AIG, whose shares are widely considered to be zombie stocks, are still listed on major exchanges. The federal government's own backing of those companies weakens any argument against allowing individuals to invest in them, if they dare.

One project Jarrell assigns her students is to identify a publicly traded stock they believe the market has significantly mispriced. By definition, she says, the exercise requires the same calculation made by traders of zombie stocks--reaching a different conclusion about a stock's future cash flows and risks than that of the market.

Jarrell points out that all investments carry a degree of risk proportional to potential returns, and investors have varying tolerances for risk. Some hide from risk; others seek it out. She recalls a study some years ago that found striking similarities in the blood chemistry of day traders on Wall Street and jet fighter pilots. "It turns out they need a certain amount of danger to feel normal," Jarrell says. "They seek risk in order to feel comfortable."

Let's Limit TARP Legislator Pay!

Seems that Congress is hell bent on replacing the best-functioning labor market in the world with their own unique brand of wisdom.  Well, I have a better idea.  Why don't we slash in half the pay of all those Congressional leaders who came up with the TARP idea in the first place, since they are spending our money, and I think it is clear that they are spending our money unwisely, which is precisely the logic they use to confiscate the salaries and bonuses of the bail-out executives.

Moral of the story?  Government should not be in the business of trying to run a business. The TARP bailout should have never seen the light of day.  With no TARP bailout, Congress would not have had it's latest excuse for grabbing up yet more of the private economy's resources for trying to put this country back on track toward improved productivity, output, jobs, income, and security.

A tax is a tax is a .... COST !!!

We've talked a lot about taxes as revenue to the Government and the inefficiency of government spending on this blog, but a far more important issue is the impact of taxes on the costs and output of businesses.

Any imposed cost to business is a "tax," whether it's called that or not.  And any tax is an additional cost to that business, which lowers its output, reduces employment, and raises prices of goods and services to you and me.  

How does a manager or business owner decide on the optimal level of production?  How does a manager decide whether to hire one more person, expand operations to a third shift, ship its product to a distant market, or to outsource?  By comparing the additional costs of that decision to the additional revenues it generates.  If the revenues cover the costs, then the manager forges ahead.  If they don't, the company can't expand without incurring losses and eventually going out of business.   Our desire or need for goods and services, along with our ability to pay, creates demand.  A company's costs of production (labor + capital equipment) along with any taxes or fees imposed by local, state, and the federal government, create the supply.  The two sides -- supply and demand -- are totally independent of each other; they come from two entirely different places in the economy.  But where they meet is where prices are determined:  prices determine the revenue of business, and thus the level of costs that can be covered, and thus the level of production and employment and consumption that can be sustained by private industry.   Taxes are a REAL cost of doing business; they are a REAL drain on productivity, innovation, and entrepreneurship.

The press is spilling over with reports of new taxes being considered by Congress and the White House: Cap and Trade, Value Added taxes, increases in capital gains taxes, higher minimum wages, sin taxes, additional costs of health care....  each and every one of these taxes pushes the costs of doing business higher, reduces the output of the economy, reduces employment, and raises the prices of goods and services.  It squeezes the private economy, it suffocates entrepreneurship, kills commerce, and it idles people and factories and local businesses.  It hurts everyone.   New taxes should be challenged and fought like our economic lives depended on it.....because they DO!

No actual gains from Clunker program

It should come as no surprise to anyone that the U.S. car companies are slumping once again.  The Cash for Clunkers program was a wasteful, inefficient publicity stunt or, worse, an actual attempt by the Federal Government to stimulate the economy.  The worse part is that the program cost the economy jobs: many healthy, profitable dealerships had their company taken away from them by government edict under this program, never to return.  It's almost criminal.

A Lesson from former East Germans and more

Have you ever noticed how the most ardent supporters of capitalism and free markets are those who've experienced a world without them?  How those who speak out most poignantly against health care reform in the U.S. are those who've experienced nationalized health care?  No?  If you can, then, take a moment and think back to the coverage, the news, the sound bites.  Take a look, perhaps a second look, behind the headlines and I venture that you will find endless examples of this phenomenon.    It is those who have done without freedom of choice, free markets, and self-determination who treasure it most, who most understand its value, who've lived with the consequences of its absence.   

We need look no further than Chancellor Angela Merkel and her recent victory in Germany's national election. http://online.wsj.com/article/SB125403307571043923.html   Chancellor Merkel grew up in communist East Germany and is now leading Germany out of recession with tax cuts and reduced government spending. 

   We should be listening to what the world is telling us.  Very hard, and very quickly.  We don't want to have to lose it before we appreciate what we have.  

 

Comment on WSJ: Fed and inflationary expectations

Fed Acknowledges Inflation Hawk Concerns

By Jon Hilsenrath

Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.

Fed Chairman Ben Bernanke. (Reuters)

Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.http://blogs.wsj.com/economics/2009/09/23/fed-acknowledges-inflation-hawk-concerns/

My comment:  Price levels result from the intersection of demand and supply. Aggregate demand in the U.S. increases with an increase in purchases by consumers, businesses, or government, and with an increase in the money supply (yes, money SUPPLY). The aggregate supply curve is basically the marginal cost curve of the economy, or the sum of the cost curves of all firms in the economy. It is driven by productivity and wage rates; more productivity, lower costs, and a downward shift in supply, pushing GDP up and the price index down. Lower efficiency and/or higher wage rates result in higher costs, a shift up in the supply curve, and a higher price level. Slack refers to "unused capacity," generally unused plant or physical capacity. But slack also results from "unused labor capacity," i.e., unemployment. There is no question that the U.S. economy currently has significant slack in both areas. This basically means that the short run supply curve is relatively flat; that a given increase in demand can be met by an increase in quantity supplied with minimal increase in prices. But that is not the end of the story. There are two additional factors that must be considered. One, the fed reserve is in unchartered territory right now, underwriting record increases in the money supply, which translate into unknown but potentially monstrous increases in aggregate demand. Unless the long run supply curve is flat, which it certainly is not, this is inflationary. Two, there is some evidence, though not entirely convincing, that expectations of inflation lead to increases in wages, but this is generally only after the economy experiences repeated bouts of unanticipated inflation. So, the bottom line is that supply and demand drive equilibrium output and price, as always, and that inflation will in fact result if the increase in demand continues to outstrip the increase in supply in the economy.

The smallest hint of oil surplus leads to a real fall in oil prices!

Today, the mere hint of a fairly insignificant surplus in U,S. oil reserves pushed down current oil prices and energy-related futures and other speculative plays.   Can you imagine the reaction to an announcement of a new source of U.S. oil reserves?  Of renewed off-shore drilling capacity?  Relaxed EPA standards? Additional refinery capacityA?  Our energy prices would be cut in half and we'd be so much less likely to war with oil-rich nations on whom we now depend for the functioning of our economy and who, indirectly or not, limit our economic and personal freedoms. 

How much is "too much" Unemployment?

How much unemployment "should" our economy have?  How much unemployment is too much, and how much is just right?  How high does the unemployment rate have to go before significant changes are made in government policy and approaches?

The question of the optimal level of unemployment has generally been answered by reference to the so-called "natural rate" of unemployment.  The natural rate of unemployment is measured as the long-run average rate of actual unemployment in an economy over time; it is a "trend line," as seen in this graph below:

This graph is from the Congressional Budget Office and taken from a paper, "The Effect of Changes in Labor Markets on the Natural Rate of Unemployment." [See Figure 2]. 

So, generally, when you hear policymakers say that the unemployment rate is "too high," they are generally comparing the current rate to the natural rate of unemployment.  

I have two very big issues with using the natural rate of unemployment to inform or critque policy.  One, the natural rate of unemployment is based on the long-run average of "where we have been," and should not limit where we think we can go.  Why not set a policy goal of halving the natural rate of unemployment?  Why should the experiences of the past limit what we as an economy aspire to do?

My second issue with using the natural rate of unemployment to inform policy is its inability to distinguish between long-term structural sources of unemployment, which are costly and detrimental to our economy and should be the focus of government policy, and unemployment that results from the search activities of employees and employers alike, which tends to short-term in nature and often leads to better matches between labor and business.  By focusing our national resources on retraining our labor force to fill the needs of emerging industries, we could eradicate much of the most harmful type of unemployment:  structural, long-term, chronic unemployment that leads workers to simply give up and leave the labor force, which actually reduces the reported unemployment rate, yet masks a significant cost to our economy in terms of wasted human resources.

The Unemployment Rate hides Dramatic Labor Market Activity

In an earlier post, I explained how the reported U.S. unemployment rate, which was 9.6% in August of 2009, is measured. This post will explore the reported unemployment rate in more depth, distinguishing between the short-term, temporary sources of unemployment and the long-term, more structural, and troubling aspects of the unemployment rate.  

The 9.6% U.S. unemployment rate remains the same next month if no one changes their employment status.  But the rate also remains unchanged if the same number of people hired get fired.  In truth, the U.S. unemployment rate nets out enormous flows of people into and out of the labor force and, for those in the labor force, between being employed and unemployed.   

A representative month in the unemployment statistic tells the story.  In May of 1993, there was no change in the reported U.S. unemployment rate.  And yet, fully 5 million people got jobs that month; 3 million were just entering the labor force; the other 2 million were in the labor force but had been unemployed.  In the same month, 5 million other people left employment:  3.2 million left the labor force, some for good reasons and some for bad, and 1.8 became unemployed.  

The net reported U.S. unemployment rate also hides another very important phenomenon, and that is that there are two distinct types of unemployment:  short-term and long-term unemployment.   The fact is that some short-run unemployment is desirable.  In general, it is better for people to take some time in finding the ideal job, one in which they are productive, happy, and satisfied.  If individuals always take the first job offer that comes along, rather than searching for a good fit, the odds of a bad match and future job separation increase. 

Chronic unemployment is a bad thing, however.  The economic, social, and psychological costs of the chronically unemployed are enormous.  

Policymakers must carefully weigh the costs and benefits to society of the type of unemployment insurance they support:  a little unemployment insurance for a short period helps people to find the right job, which is a good thing.  Too much unemployment insurance over too long a period encourages slack and enables more structural, long-term unemployment, which is a very bad thing for our economy.      

The Unemployment Rate: how it's measured, what it means

The unemployment rate is often used as a signal of how well an economy uses its resources. The social costs of involuntary unemployment are evidence of a poorly functioning economy. The unemployment rate in the U.S. currently stands at about 9.7%, causing deep concern about the overall health and viability of our economy.

Let's first make sure we know how this reported unemployment statistic is measured. An economy’s population is divided into two mutually exclusive and exhaustive groups:

            Population = Those in Labor Force (L) + Those Not in the Labor Force (NL)

            The Labor Force, L, is composed of the Employed (E) and the Unemployed (U) 

    The Unemployment Rate, u, is the Number Unemployed, U, over the Labor Force, L.

You are generally considered unemployed only if you self-report that you are looking for work but have not yet found any.   If you are employable, currently unemployed, but have stopped looking for work, you move from the Labor force into "those not in the Labor Force." As people move out of the labor force, the measured Unemployment rate actually falls. For example, if the Labor Force is 100,  and 4 of the 100 are unemployed, the unemployment rate u = 4/100 = 4%. If one person leaves the labor force, u now falls to 3/99 = 3%.  

Is this fall in the unemployment rate good news or bad news?  It depends on why the individual left the labor force.  If they simply gave up trying to become gainfully employed, the drop in the Unemployment rate is not a good thing.  If the person left because they met the love of their life who could support them in comfort, and they now devote their time volunteering in the community, the fall in the unemployment rate is a positive development.

In the next installments, I will talk about the "natural rate of unemployment," and what it means and how it is calculated.   I will discuss why it is optimal to have some positive level of unemployment in an economy, and why our government policies should focus on.ly on the structurally unemployed.  Finally, I will lay out the remarkable amount of movement into and out of the labor force in any given period that is masked by the unemployment rate that is reported on the national and local news, and how the unemployment rates vary between regions, states, even counties across the country.  

Government Policy encourages next round of foreclosures!

Call me crazy but I thought that the sudden rise in single-family home mortgage foreclosures that began a year or so back was one of the main causes of the current financial crisis.  And that many of these foreclosures resulted from families over-extending themselves, taking on too much debt given their income and other financial obligations, in part because of incentive programs designed to reduce the upfront cost of the home and the monthly mortgage payments during the first several years of home ownership.

So why is Washington pushing to expand and extend the first-time home buyer tax credit?

 

According to the National Association of Realtors (NAR), <see link> as discussed in Calculated Risk: Finance & Econ,  http://www.calculatedriskblog.com/2009/09/first-time-home-buyer-nar-numbers.html approximately 2 million first-time home buyers will take advantage of the credit by the end of 2009. How many of these individuals would have waited to buy their first home until they were more financially secure, had more of a down payment saved, and were better able to weather the inevitable financial challenges that will come their way, without the incentive program?  Basic economics tells us one thing, if nothing else:  when the price of a good is reduced, demand goes up.  These incentive programs reduce the price of home ownership to qualifying individuals, and demand goes up.  Demand that would not have arisen at the higher price. We know this because this is exactly what the incentive programs are designed to do; encourage demand that would have otherwise not occurred.

Have we learned nothing from the latest failed experiment at social engineering?