The current protest, known as “Occupy Wall Street”, has engendered a growing number of epithets from the far right. Paul Krugman called it: “Panic of the Plutocrats.” The conflict arises from the fact that the interests of the plutocrats and the interests of the general investors are at odds with each other.
The Plutocrats that Krugman mentioned are comprised of three groups: The first group is the Brokerages who make more money as trading increases. Most of the stock analysts, who make recommendations, work for the brokerage firms and are prone to recommend trading as opposed to investing strategies because these increase the profits of the brokerages that they work for. Included in this first group are the stock brokers themselves who make their living off the numbers of trades they receive commissions on. The second group is comprised of the traders who have a shorter perspective and merely buy and sell based upon small movements in share prices. Neither of these groups adds any real economic value to society. They engage in financial asset swaps ignoring and some times discourage real value creation because it can lead to short-term reductions in profits. The third level of plutocrat is made up of corporate executives who, along with the boards of directors, are charged with looking out for the interests of the shareholder. There are, however, two classes of common stock ownership in most publicly traded companies. Looking out for the interest of two separate classes may lead to mutually exclusive goals.
The two groups of share holders may be classified as the investor and the trader. The investor has a long-term perspective wherein stock is purchased on the basis of expected growth and profitability over time. The trader, on the other hand, is looking for short-term profits that will lead to rapid rises in the company’s share price resulting in a rapid resale of the shares. The value of a company’s shares is often thought of as the discounted present value of future profits. The conflict between the two classes of shareholders comes from the fact that a trader puts an exceptionally high discount on future earnings thereby reducing the present value of those earnings. The trader wants it all now. As a result, a trader will put pressure on companies not to reinvest in themselves because reinvestment could lead to short-term profit reduction and leave less cash available for current distribution to the trader. This is exemplified by the last time the government allowed a tax free repatriation of foreign earnings. Companies, rather than investing in new plant and equipment, engaged in Stock Buy-Back programs which merely raised the price of stocks so traders could cash in. This lack of reinvestment is the same as disinvesting. In other words, by not reinvesting, the firm is headed toward a long-term decline. This is in direct opposition to the interests of the longer term investor.
Executives and boards are under severe pressure from broker/analysts to maximize short term profits. There is however a positive relationship between higher risk and high returns. Needing higher returns means that managements are constantly engaging in higher risk activities. Boards, looking out for the interests of traders rather than investors, issue contracts to executives that reward the high risk/return trade off and insulate management from the potential downside if the risks don’t payoff as projected. On top of all of this, companies can leverage profits up through increased borrowing. The downside is that the company is stuck with fixed cash payouts during an economic downturn. This could be harsh enough to force the company into bankruptcy. Traders don’t care. They are usually in and out so quickly that they have made their profits before the collapse. It is the investor who is stuck with worthless stock.
UPDATE AS OF 12/16/11: The New York Times has an article - "Amazon Says Long Term and Means It" which points out my contention that the market is dominated by organizations with short time horizons and therefore punishes firms such as Amazon because it has a long time horizon."Whatever they might say about long-term shareholder value, this is simply too much for many of today’s investors, many of whom are hedge funds, pension funds and institutions who measure their results — and earn their pay — based on quarterly benchmarks. “If you look at the average length of ownership of a stock, the period is declining,” Mr. Devitt said. “Amazon is marching to a different drumbeat, which is long term. Are they doing the right thing? Absolutely. Amazon is growing at twice the rate of e-commerce as a whole, which is growing five times faster than retail over all. Amazon is bypassing margins and profits for growth.” Also, according to another section of the article: " In October, when Amazon reported strong third-quarter revenue growth and earnings that were pretty much what the company had predicted, but indicated it would be spending more to support continued growth, investors hammered its stock. Amazon shares dropped nearly $30, or 13 percent, to $198 a share in just one day, Oct. 25. "
In addition, short-term profitability can be increased by reducing the company workforce. This lowers cost in the short-run but, because the layoffs are often aimed at higher paid workers, also means that the most skilled and productive workers are lost. In addition, historical knowledge is lost and firms end up repeating past mistakes because nobody still around remembers that certain activities did not work. On a national level this approach leads to falling real incomes, high levels of unemployment, and slow growth with high volatility in the value of 401ks.
Looking at all of this, is there any wonder that there is a growing anti-Wall Street movement in this country? Although the Occupy Wall Street movement has not expressed its discontent in the terms described here, the problem has gotten so bad that the participants have developed a visceral understanding of the underlying cause of the economic problems facing us all.
Wednesday, October 12, 2011
Tuesday, October 11, 2011
Hooray for the SEC
The SEC has recently announced that it will be looking into the practices of Hedge Funds that seem to be consistently beating the market. The financial sector has begun to scream its collective head off at the “…effrontery of the SEC for targeting success….” They say that the successful firms are merely identifying inefficiencies in the market and are making money by capitalizing on those inefficiencies.
Efficient market theories say that this is possible in the short term, identifying market inefficiencies brings about efficient markets because those inefficiencies disappear due to the identification. However, it is hard to believe that one or more firms can consistently identify problems in a manner that lets them beat the market in the long run. According to the efficient markets theorists, long term returns in excess of the market return can come about from either trading on inside information, e.g. Raj Rajaratnam or by outright lying, ala Bernie Madoff. Either way, the means would be illegal.
In terms of the finance industry, the insistence that the market can be beaten on a consistent basis is a negation of the theory of efficient markets. Wall Street is constantly touting that the small player, the middle class saver and 401k or IRA owner, can trust in the future of their investments because the market is efficient. However, the existence of long term gains in excess of market returns is a strong indication that markets may not be efficient. Wall Street’s screaming is understandable only in the self-serving context that legal scrutiny would reduce its profits.
The Street cannot have it both ways. Either markets are efficient and long term gains in excess of the market need to be scrutinized or they are inefficient and the small player needs to stay out of the big boys’ game. In either case, Wall Street profits will suffer.
Efficient market theories say that this is possible in the short term, identifying market inefficiencies brings about efficient markets because those inefficiencies disappear due to the identification. However, it is hard to believe that one or more firms can consistently identify problems in a manner that lets them beat the market in the long run. According to the efficient markets theorists, long term returns in excess of the market return can come about from either trading on inside information, e.g. Raj Rajaratnam or by outright lying, ala Bernie Madoff. Either way, the means would be illegal.
In terms of the finance industry, the insistence that the market can be beaten on a consistent basis is a negation of the theory of efficient markets. Wall Street is constantly touting that the small player, the middle class saver and 401k or IRA owner, can trust in the future of their investments because the market is efficient. However, the existence of long term gains in excess of market returns is a strong indication that markets may not be efficient. Wall Street’s screaming is understandable only in the self-serving context that legal scrutiny would reduce its profits.
The Street cannot have it both ways. Either markets are efficient and long term gains in excess of the market need to be scrutinized or they are inefficient and the small player needs to stay out of the big boys’ game. In either case, Wall Street profits will suffer.
Sunday, August 21, 2011
It All Nets to Zero
Earlier today I watched the Governor of Virginia, Bob McDowell, expound upon the virtues of lowering taxes to stimulate employment growth. He said that every state with a Republican governor had lowered taxes and seriously increased employment.(He neglected to mention New Jersey which cut taxes and had an increase in unemployment) Therefore, the Federal Government should do the same and we'd all be better of. What he neglected to say is that this only works if you have a higher tax state from which to steal jobs. This is how it work: Assume two states with equal, including state taxes, employment costs to employers: State Goniff decides to cut its business taxes in half while state Schlemasel keeps everything the same. A business located in Schlemasel moves to Goniff in order to lower its cost. The unemployment rate in Goniff drops while the rate in Schlemasel increases. For the USA, unemployment remains unchanged. It is a zero sum game with one state winning and another losing.
The only way to make this cost cutting technique work on a national scale would be to eliminate the middle class entirely. This means paying computer programers $5,000 per year,as they do in India, or using sweat shop techniques, as it is reported are used in China. The "New Republicans" appear to be well on the road to this approach. All you need to do is listen to what they say and understand the implications.
The only way to make this cost cutting technique work on a national scale would be to eliminate the middle class entirely. This means paying computer programers $5,000 per year,as they do in India, or using sweat shop techniques, as it is reported are used in China. The "New Republicans" appear to be well on the road to this approach. All you need to do is listen to what they say and understand the implications.
Friday, August 12, 2011
Lets Give Them What They Ask For
Mitt Romney and the U.S. Supreme Court have stated that Corporations are people. If that is so, then we should carry their options to their ultimate conclusions:
1. Corporations should be subject to the all of the rules for personal income taxation.
2. When convicted of a felony, instead of just being subject to a fine, the company should be put into a receivership, for the term of the normal prison sentence for the crime. The receiver would allow only those actions which would allow the company to continue to live and disallow those actions which would allow the company to prosper.
3. Executives of companies which are convicted should be charged as accessories to the crime and be subject to conviction and punishment as any accessory would when a crime is committed by a real person.
Let's see what the right thinks about these rules.
Update 9/27/11 I just saw a great Bumper Sticker
"I'll Believe Corporations Are People When Texas Executes One"
1. Corporations should be subject to the all of the rules for personal income taxation.
2. When convicted of a felony, instead of just being subject to a fine, the company should be put into a receivership, for the term of the normal prison sentence for the crime. The receiver would allow only those actions which would allow the company to continue to live and disallow those actions which would allow the company to prosper.
3. Executives of companies which are convicted should be charged as accessories to the crime and be subject to conviction and punishment as any accessory would when a crime is committed by a real person.
Let's see what the right thinks about these rules.
Update 9/27/11 I just saw a great Bumper Sticker
"I'll Believe Corporations Are People When Texas Executes One"
Wednesday, August 10, 2011
The Pre-Ordained Failure of the Super Debt Commission
When I opened my copy of today's "The Morning Call" (Allentown, PA) I found that the lead article was a piece about Sen (R) Pat Toomey's recent meeting with local business people in Pottsville, PA. Toomey asked the loaded question of who felt that government regulations had worsened their businesses in recent years. Obviously, what followed was a litany of woes cited by the business people. They attacked labor laws and environmental laws as being costly and burdensome. What they did not address was who would pay the costs of the damages caused by the absence of the rules they criticized.Shortly after reading this I heard that Toomey has been appointed to the Super Debt Commission which is designed to create policies to reduce the Federal Deficit.
The problem ignored by Toomey is that businesses generate costs that are not included as cost of production because the consequences are external to the production process. Polluted water means that drinking water facilities have to be more robust to reduce the industrial pollution. Air pollution increases the incidence of lung diseases and subsequent medical costs. The costs of mitigating these problems are put on people who may not even be consumers of the products. Regulation puts the cost of the damages into the cost of the goods or services produced. This way, consumers pay the true cost of the products they use.
I have often heard business people state that they would not pollute because they and their families also live in this world. It may sound like a good argument until you begin to question specific actions. Several years ago a Vice-President for Manufacturing (at an unnamed company) was complaining to me that a certain state's (also unnamed) water rules were unreasonable. He said that the water his company used had come from the ground and, after being used and treated, what went back in was completely potable. I asked him if I could go to the water return system, get a glass of water, and serve it to him. His response was: "...you mean you want me to drink it?" When I said yes, his reply was: "no way in hell will I drink that stuff!" I then asked how he could state that the water was potable if he wouldn't drink? He sputtered and asked me to leave his office.
Toomey, and the rest of his Regressive cohorts play on a well known problem in the realm of public choice. The problem is that governments must create programs that come out somewhere in the middle of the public wants. This means that everybody is unhappy. Lets face it, when you want a cell phone there is a wide variety of models available. You can pick what you want. When the government tries to set policies regarding the parts per million that of a pollutant that are acceptable nobody is happy because some people think the level is too low and some think it is too high. The same applies to average classroom sizes in schools. In elementary schools I have seen studies indicating that 15 - 18 pupils would be optimal.However, I went to school in an era when our average class size was between 35 and 40. Most of my classmates went on to college and have entered fairly high level professions. If a school district sets a class size at 23, the only people who will be happy are those that think 23 is appropriate.
The right wing in this country, including Toomey, play up on this dissatisfaction with government decisions in an attempt to convince people that government can't do anything right. If Toomey and his cadre of conservatives continue to pander to this discontent and they only accept spending reductions, I expect that the commission is predestined to failure.
The problem ignored by Toomey is that businesses generate costs that are not included as cost of production because the consequences are external to the production process. Polluted water means that drinking water facilities have to be more robust to reduce the industrial pollution. Air pollution increases the incidence of lung diseases and subsequent medical costs. The costs of mitigating these problems are put on people who may not even be consumers of the products. Regulation puts the cost of the damages into the cost of the goods or services produced. This way, consumers pay the true cost of the products they use.
I have often heard business people state that they would not pollute because they and their families also live in this world. It may sound like a good argument until you begin to question specific actions. Several years ago a Vice-President for Manufacturing (at an unnamed company) was complaining to me that a certain state's (also unnamed) water rules were unreasonable. He said that the water his company used had come from the ground and, after being used and treated, what went back in was completely potable. I asked him if I could go to the water return system, get a glass of water, and serve it to him. His response was: "...you mean you want me to drink it?" When I said yes, his reply was: "no way in hell will I drink that stuff!" I then asked how he could state that the water was potable if he wouldn't drink? He sputtered and asked me to leave his office.
Toomey, and the rest of his Regressive cohorts play on a well known problem in the realm of public choice. The problem is that governments must create programs that come out somewhere in the middle of the public wants. This means that everybody is unhappy. Lets face it, when you want a cell phone there is a wide variety of models available. You can pick what you want. When the government tries to set policies regarding the parts per million that of a pollutant that are acceptable nobody is happy because some people think the level is too low and some think it is too high. The same applies to average classroom sizes in schools. In elementary schools I have seen studies indicating that 15 - 18 pupils would be optimal.However, I went to school in an era when our average class size was between 35 and 40. Most of my classmates went on to college and have entered fairly high level professions. If a school district sets a class size at 23, the only people who will be happy are those that think 23 is appropriate.
The right wing in this country, including Toomey, play up on this dissatisfaction with government decisions in an attempt to convince people that government can't do anything right. If Toomey and his cadre of conservatives continue to pander to this discontent and they only accept spending reductions, I expect that the commission is predestined to failure.
Tuesday, August 09, 2011
I Hope I'm Wrong
As I read the news and listen to the commentators I begin to fear that a prediction I made during the election campaign of 2010 will come true. At the time I told those who asked for a forecast:"...if the Tea Party gains significant control in the new congress we can expect 14% unemployment by the time of the 2012 election." I based my conclusion on a belief, which has proven itself in the recent debt ceiling debate, that right wing obstructionism would prevent any governmental ability to bring us out of the economic doldrums.
I pointed out, at the time, that the bulk of the stimulus ended up replacing tax income that state and local governments lost during the recession; with the expiration of the stimulus spending and the subsequent cuts in state and local spending accomplished through layoffs we could expect to see a rise in unemployment and a possible double dip recession. As we have seen, the new debt ceiling legislation not only eliminates the renewal of the stimulus package, but it also cuts additional spending from the federal budget. This lowered level of spending means that there will be fewer jobs in many different sectors with a subsequent reduction in consumer spending. In addition, extended unemployment benefits have also been eliminated. Unemployment benefits act as an automatic stabilizer in that they allow the unemployed to maintain at least a minimal level of spending.
The evidence that my prediction for an economic downturn may come true came in yesterday's announcement that worker productivity dropped and today' announcement by the FED that economic growth has been less robust than they had thought.A reduction in productivity is usually an indicator that firms will be laying off more people. It is a sign that they have more workers than they need. If we add slower economic growth and state and local layoffs to this scenario it is not unreasonable to expect growth to turn negative. Given the prevailing attitude in the House of Representatives getting any type of government stimulus into effect will be virtually impossible. In the absence of government intervention to stabilize the economy we can expect an accelerated downturn.
Some might ask what the FED can do. Bernanke has said the FED will do all in its power to stabilize the economy. The problem is that the Fed's greatest tool is the ability to raise and lower interest rates. The problem is that lowering interest rates is a method of stimulating business investment and consumer purchases of homes of durable goods. Business investment is not only dependent upon the interest rate but is also dependent upon demand for the goods and services produced. If consumers are not working, or expect that hey might be laid off, they will not be buying durable goods and houses. As a result the demand that is necessary to set off business investment will not be there. Add to this the fact that banks might not want to lend if they foresee a downturn. Excess reserves, funds that banks can lend, are already extremely high and in the event that bankers are less than enthusiastic about economic prospects can go higher.
All in all, the more I observe about what is going on the more pessimistic I get. I truly hope that I am wrong and that somehow our elected representatives will wake up and do the right thing as opposed to the dogmatic. If so my predictions would not come true. If they follow the current course there is a high probability that I will be right.
I pointed out, at the time, that the bulk of the stimulus ended up replacing tax income that state and local governments lost during the recession; with the expiration of the stimulus spending and the subsequent cuts in state and local spending accomplished through layoffs we could expect to see a rise in unemployment and a possible double dip recession. As we have seen, the new debt ceiling legislation not only eliminates the renewal of the stimulus package, but it also cuts additional spending from the federal budget. This lowered level of spending means that there will be fewer jobs in many different sectors with a subsequent reduction in consumer spending. In addition, extended unemployment benefits have also been eliminated. Unemployment benefits act as an automatic stabilizer in that they allow the unemployed to maintain at least a minimal level of spending.
The evidence that my prediction for an economic downturn may come true came in yesterday's announcement that worker productivity dropped and today' announcement by the FED that economic growth has been less robust than they had thought.A reduction in productivity is usually an indicator that firms will be laying off more people. It is a sign that they have more workers than they need. If we add slower economic growth and state and local layoffs to this scenario it is not unreasonable to expect growth to turn negative. Given the prevailing attitude in the House of Representatives getting any type of government stimulus into effect will be virtually impossible. In the absence of government intervention to stabilize the economy we can expect an accelerated downturn.
Some might ask what the FED can do. Bernanke has said the FED will do all in its power to stabilize the economy. The problem is that the Fed's greatest tool is the ability to raise and lower interest rates. The problem is that lowering interest rates is a method of stimulating business investment and consumer purchases of homes of durable goods. Business investment is not only dependent upon the interest rate but is also dependent upon demand for the goods and services produced. If consumers are not working, or expect that hey might be laid off, they will not be buying durable goods and houses. As a result the demand that is necessary to set off business investment will not be there. Add to this the fact that banks might not want to lend if they foresee a downturn. Excess reserves, funds that banks can lend, are already extremely high and in the event that bankers are less than enthusiastic about economic prospects can go higher.
All in all, the more I observe about what is going on the more pessimistic I get. I truly hope that I am wrong and that somehow our elected representatives will wake up and do the right thing as opposed to the dogmatic. If so my predictions would not come true. If they follow the current course there is a high probability that I will be right.
Monday, August 08, 2011
The Sophistry of the Job Creator Argument
About an hour ago I was on the treadmill in the gym watching Rep. Phil Gingrey (R, 11th GA) explain how he disagreed with the 63% of the American public that believes that the recent debt ceiling agreement benefited the rich at the expense of the middle and lower classes. He used the argument that people making more than $250,000 were the entrepreneurial job creators and that higher taxes would stifle job creation by this class. This is an argument that has been coming up since the Bush administration and it appears to me that hearing it while on a treadmill is extremely appropriate.
Once again, the right wing is showing that their approach to economics is religious rather than reasoned. I state this because someone once said that religion is the suspense of reason and reason based upon research shows that taxes do not have the effect that the Gingrey and his cohorts claim:
1. Around the time of the 2010 election a small business association asked its members what it would take to get them to hire more people. The response was: an increase in the demand for the goods and services that they produce.
2. A article published in CFO.com (April 2004)reported on a study entitled "Tax Breaks Don't Boost Investment". The research looked at 275 companies that were given tax breaks to stimulate investment. The smaller companies, which were closer to the entrepreneurial level, actually decreased their investment by an average of 13%. The researchers conclusion was that demand was the true determiner of planned investment.
I believe that there are only two possible explanations for the Right's persistence in their opposition to tax increases: as I stated earlier they have turned their economic philosophy into a religion or they believe that its okay because they've got theirs and '...to hell with everyone else...'. This holds true especially in light of the fact that S&P included the seeming impossibility of raising taxes in the current environment as one of their reasons for downgrading U.S. Government debt.
Once again, the right wing is showing that their approach to economics is religious rather than reasoned. I state this because someone once said that religion is the suspense of reason and reason based upon research shows that taxes do not have the effect that the Gingrey and his cohorts claim:
1. Around the time of the 2010 election a small business association asked its members what it would take to get them to hire more people. The response was: an increase in the demand for the goods and services that they produce.
2. A article published in CFO.com (April 2004)reported on a study entitled "Tax Breaks Don't Boost Investment". The research looked at 275 companies that were given tax breaks to stimulate investment. The smaller companies, which were closer to the entrepreneurial level, actually decreased their investment by an average of 13%. The researchers conclusion was that demand was the true determiner of planned investment.
I believe that there are only two possible explanations for the Right's persistence in their opposition to tax increases: as I stated earlier they have turned their economic philosophy into a religion or they believe that its okay because they've got theirs and '...to hell with everyone else...'. This holds true especially in light of the fact that S&P included the seeming impossibility of raising taxes in the current environment as one of their reasons for downgrading U.S. Government debt.
Tuesday, August 02, 2011
Capitulation
Barack Obama has just given the Tea Party the Victory that they need to sell themselves in 2012 election. They can point to what has been done and say "See what we have done. Elect more of us and we'll do even better". They've already stated that this "compromise" didn't go far enough, and they mean it.
What could Obama have done? In his first two years he could have used the regular congressional sessions to obtain the needed legislation. However,he was just too accommodating to use the Bully Pulpit and the presidential "...aura..." against the Blue Dogs of his own party let alone the opposition.
In the current deal my contention is that he was open to being snookered because he truly believed that the Republicans were willing to deal. He never realized that their only goal was to see that he didn't get re-elected "...come hell or high water..." I'm afraid that he still doesn't get it. He lost not only the battle but the war.
Hello 19th century. The Republicans (... Tea Party...) want to repeal every piece of social legislation since Teddy Roosevelt. Yes, I said Teddy. There has been talk of repealing child labor laws and the anti regulation attitude will lead to the end of anti trust legislation. Remember, they see the 19th century as a Golden Age just as they falsely see the Antebellum South with slavery resulting in stable families for African Americans. They are deluded and are very good at using Goebbels methods to convince average Americans that their warped views are accurate.
For the first time I'm actually pessimistic about the country's future. In the past when my students asked about the country's economic problems I talked about the resilience of the American people and our can do attitude. Now, with our leadership believing that most of the unemployment is structural and a belief by most people who are working that the deficit is our highest priority, I think we are in for a long period of decay:
1. Reducing payments to education will reduce our competitiveness and leave our workers unprepared for the newer high tech jobs. Our best bet will be to teach students how to say "Would you like to Super Size That?"in several languages (Chinese,Spanish,and Hindi).
2. Without investment in our infrastructure we will be unable to ship our goods, keep our water clean, and maintain our cities.
3. The failures in the items listed above can lead to the USA resembling a 3rd world nation.
What could Obama have done? In his first two years he could have used the regular congressional sessions to obtain the needed legislation. However,he was just too accommodating to use the Bully Pulpit and the presidential "...aura..." against the Blue Dogs of his own party let alone the opposition.
In the current deal my contention is that he was open to being snookered because he truly believed that the Republicans were willing to deal. He never realized that their only goal was to see that he didn't get re-elected "...come hell or high water..." I'm afraid that he still doesn't get it. He lost not only the battle but the war.
Hello 19th century. The Republicans (... Tea Party...) want to repeal every piece of social legislation since Teddy Roosevelt. Yes, I said Teddy. There has been talk of repealing child labor laws and the anti regulation attitude will lead to the end of anti trust legislation. Remember, they see the 19th century as a Golden Age just as they falsely see the Antebellum South with slavery resulting in stable families for African Americans. They are deluded and are very good at using Goebbels methods to convince average Americans that their warped views are accurate.
For the first time I'm actually pessimistic about the country's future. In the past when my students asked about the country's economic problems I talked about the resilience of the American people and our can do attitude. Now, with our leadership believing that most of the unemployment is structural and a belief by most people who are working that the deficit is our highest priority, I think we are in for a long period of decay:
1. Reducing payments to education will reduce our competitiveness and leave our workers unprepared for the newer high tech jobs. Our best bet will be to teach students how to say "Would you like to Super Size That?"in several languages (Chinese,Spanish,and Hindi).
2. Without investment in our infrastructure we will be unable to ship our goods, keep our water clean, and maintain our cities.
3. The failures in the items listed above can lead to the USA resembling a 3rd world nation.
Thursday, July 28, 2011
Ignoring Downside Risk - Again
As I listen to, and read about, the debate about raising the debt limit, I am stuck by the fact that we making the same mistakes that got us into the financial crisis of 2008. That is, we are under playing the downside risk that comes from being wrong. A good chunk of the problem that led to the financial meltdown resulted from the assumption that housing prices could not fall; therefore, it was not necessary to measure the downside risk that would come from falling house prices. People therefore invested in dubious financial instruments that could only cause problems if real estate prices dropped.
Tea Party members of congress have essentially said the same thing about default. They are saying that any negative would be short term. They believe that the market knows that USA credit is sound and there would be no consequences from default. What they fail to see is that the world and the markets may not act the way the Tea Partiers suppose. Lets look at some potential consequences of default:
1. The Government could still borrow to replace debt that is maturing as long as it does not exceed the debt limit. This will lead to:
A. Buyers demanding higher interest rates because they are
unsure of the payment of interest.Increasing the deficit.
B. Because the debt sells at auction this higher interest
means that the actual collection from the auction could be
substantially less than the debt being incurred.Increasing
the deficit.
C. To offset this the government could put a higher coupon
rate on the debt. But this will result in higher annual
interest payments. Increasing the deficit.
D. Most of the debt is short term and is sold at discount.
Higher interest rates mean the discount is deeper, interest
payments are higher, and the deficit increases.
2. Rating agencies lower the rating on US debt to AA from AAA. This leads to further increases in the interest on US debt because:
A. Many Fixed Income mutual funds require that they have a
certain percentage of their portfolios in AAA debt. This
means that they would have to dump some of their USA
Securities onto the market thereby lowering the price
of US debt and raising interest rates.
B. Many insurance companies are under similar NAIC rules that
would cause similar restructuring.
C. Many countries have their reserves in U.S.Dollars that
are invested in U.S. Government Securities. They might be
tempted to move to the Euro, the Pound, or the Yen.
D. Oil and many other commodities are priced in U.S. Dollars.
If these move to other currencies, the price effects for
U.S. consumers could be extremely uncomfortable.
E. All of the preceding items 2 A - D would lead to negative
effects on the U.S. economy. A shrinking economy means
automatic decreases in tax collections and automatic
increases in other programs. All leading to an increase in
the deficit.
The Tea Party actions, instead of helping, would lead to a long term worsening of the debt problem. There is an old saying: "Be careful of what you wish for. You may get it"
Tea Party members of congress have essentially said the same thing about default. They are saying that any negative would be short term. They believe that the market knows that USA credit is sound and there would be no consequences from default. What they fail to see is that the world and the markets may not act the way the Tea Partiers suppose. Lets look at some potential consequences of default:
1. The Government could still borrow to replace debt that is maturing as long as it does not exceed the debt limit. This will lead to:
A. Buyers demanding higher interest rates because they are
unsure of the payment of interest.Increasing the deficit.
B. Because the debt sells at auction this higher interest
means that the actual collection from the auction could be
substantially less than the debt being incurred.Increasing
the deficit.
C. To offset this the government could put a higher coupon
rate on the debt. But this will result in higher annual
interest payments. Increasing the deficit.
D. Most of the debt is short term and is sold at discount.
Higher interest rates mean the discount is deeper, interest
payments are higher, and the deficit increases.
2. Rating agencies lower the rating on US debt to AA from AAA. This leads to further increases in the interest on US debt because:
A. Many Fixed Income mutual funds require that they have a
certain percentage of their portfolios in AAA debt. This
means that they would have to dump some of their USA
Securities onto the market thereby lowering the price
of US debt and raising interest rates.
B. Many insurance companies are under similar NAIC rules that
would cause similar restructuring.
C. Many countries have their reserves in U.S.Dollars that
are invested in U.S. Government Securities. They might be
tempted to move to the Euro, the Pound, or the Yen.
D. Oil and many other commodities are priced in U.S. Dollars.
If these move to other currencies, the price effects for
U.S. consumers could be extremely uncomfortable.
E. All of the preceding items 2 A - D would lead to negative
effects on the U.S. economy. A shrinking economy means
automatic decreases in tax collections and automatic
increases in other programs. All leading to an increase in
the deficit.
The Tea Party actions, instead of helping, would lead to a long term worsening of the debt problem. There is an old saying: "Be careful of what you wish for. You may get it"
Wednesday, July 20, 2011
They're At It Again
Einstein is credited with the statement:"...Insanity is doing the same thing over and over again expecting different outcomes...". I guess this is an apt description of the IMF. Let me explain: Yesterday, July 19th, an IMF representative said that any arrangement for a EURO bailout of Greece needs to be structured so that credit insurance will not kick-in.
It appears that European banks have continued to issue Credit Default Swaps, a form of insurance against financial instrument defaults,despite the experience of AIG in the last financial crisis. The IMF is worried that exercise of the provisions of the swaps will sink Europe's banking system.However, nobody has instituted regulations to prevent the issuance of these swaps.If the consequences of people collecting on these pseudo insurance policies are so dire then they should be banned.
The problem with banning Credit Default Swaps is that too many people are making money on them; in the event that they have to be paid on, everyone is sure that governments will bail out the issuers to prevent a financial collapse. Adding to the problem is the fact that the Swaps are in fact financial instrument and not insurance policies. They are securities which can be bought and sold on the open market. The current owners of these securities probably do not own the bonds (Greek Debt) that are being insured. Therefore,they do not have an insurable interest in debt which may default. However,if there is a default,they would get paid anyway.
Now to get back to who is making money:
1. The issuing institution is paid to write the securities.
2. The debt issuer gets a lower interest rate because the buyers of the debt can buy the Swaps.
3. The buyers of the Swaps can then sell them at a premium if it looks as if they will ever have to be paid off.
4. The original issuer gets paid off by various governments in order to avoid collapse.
5. Brokerages make commission money buying and selling the swaps to 3rd parties
6. The losers are the tax payer and the unsophisticated buyers who are holding swaps which will never be paid on because of government bailouts to the debt issuers.
So, our governments keep allowing these transactions because the Swap issuers are the same people who make large donations to their campaigns. On top of this, the government officials in charge of regulating these activities usually came from the offending financial institutions and will probably return to them when they leave government service.
"WE HAVE THE BEST GOVERNMENT MONEY CAN BUY"
It appears that European banks have continued to issue Credit Default Swaps, a form of insurance against financial instrument defaults,despite the experience of AIG in the last financial crisis. The IMF is worried that exercise of the provisions of the swaps will sink Europe's banking system.However, nobody has instituted regulations to prevent the issuance of these swaps.If the consequences of people collecting on these pseudo insurance policies are so dire then they should be banned.
The problem with banning Credit Default Swaps is that too many people are making money on them; in the event that they have to be paid on, everyone is sure that governments will bail out the issuers to prevent a financial collapse. Adding to the problem is the fact that the Swaps are in fact financial instrument and not insurance policies. They are securities which can be bought and sold on the open market. The current owners of these securities probably do not own the bonds (Greek Debt) that are being insured. Therefore,they do not have an insurable interest in debt which may default. However,if there is a default,they would get paid anyway.
Now to get back to who is making money:
1. The issuing institution is paid to write the securities.
2. The debt issuer gets a lower interest rate because the buyers of the debt can buy the Swaps.
3. The buyers of the Swaps can then sell them at a premium if it looks as if they will ever have to be paid off.
4. The original issuer gets paid off by various governments in order to avoid collapse.
5. Brokerages make commission money buying and selling the swaps to 3rd parties
6. The losers are the tax payer and the unsophisticated buyers who are holding swaps which will never be paid on because of government bailouts to the debt issuers.
So, our governments keep allowing these transactions because the Swap issuers are the same people who make large donations to their campaigns. On top of this, the government officials in charge of regulating these activities usually came from the offending financial institutions and will probably return to them when they leave government service.
"WE HAVE THE BEST GOVERNMENT MONEY CAN BUY"
Wednesday, July 13, 2011
THE FALLACY OF REFUSING TO RAISE TAXES FOR THE RICH
In February of 2005 I wrote a blog in support of the progressive income tax. Given the current Republican refusal to consider any tax increase for the rich and the proposals to substitute a Value Added Tax for a large portion of the Income Tax, I believe that my blog comments retain their relevancy. As a result I am reprinting the original blog below with some added comments at the end:
PROGRESSIVE INCOME TAXES EQUALIZE THE PAIN
Tax policy usually relies on either of two principles: The “Ability to Pay Principle” or the “Benefit Principle”. Both of these forget the fact that paying taxes is painful. If possible we would all like to pay as little as possible to the various levels of government. However, as long as we have to support our government we should make sure that when we pay taxes we are “equalizing the pain” to each of us. The problem with “Flat Taxes”, “Value Added Taxes”, and the various consumption taxes is that they tend to distribute the pain to the lowest economic levels in society. To see how this applies we need to look at the satisfaction people get from having income and/or wealth.
It is well known that as people obtain more and more of a good or service the satisfaction they get from the last unit of the good is lower than the satisfaction received from the immediately prior unit. In economics this is known as the Law of Diminishing Marginal Utility. This “law” applies to income and wealth as well as the consumption of goods and services. The more income or wealth you have, the less each additional dollar of income or wealth means to you in terms of your over all satisfaction.
Applying this to tax policy we can see that a 20% flat tax would cost $4,000 to a person with a taxable income of $20,000 per year and $20,000 to a person with a taxable income of $100,000 per year. In terms of the ability to enjoy the fruits of the economic system, the $4,000 to the low income individual is a much greater sacrifice than the $20,000 is to the high income individual. Equalizing the pain of paying taxes would require that the low income person pays a lower tax rate or the higher income person faces a higher tax rate or some combination of lower and higher rates.
Progressive income taxation is not a “soak the rich” scheme. It is the only system which has the capability of equalizing the pain of supporting government.
The problem with a VAT (Value Added Tax) is that it has lower income households paying a large portion of their income in taxes than higher income households. This is because all spending is taxes under a VAT. Assume that the VAT is 14% (this is low compared to most VAT countries). A family of 4 with an income of $40,000 per year will probably have no Saving. This means that the whole $40,000 would be subject to VAT and the Tax paid of $5,600 would be 14% of their income. A household with an income of $400,000 per year would have a saving rate approximately 20%. They would be spending $320,000 with a VAT of $44,800. This is 11.2% of the higher income family's gross income. In other words the low income family has a higher effective rate of taxation than the high income family.
ADDITIONAL COMMENTS REGARDING THE VAT
Please remember that the VAT results in a lower quality of life at the lower income level because the low income VAT payment means that true spending on goods and services is $34,400 which is the $40,000 less the $5,600 VAT. The higher income families can opt lower net spending of reduce their saving to maintain the quality of life. Even if this decision is made, the high income effective tax rate would still be lower than the effective rate paid by the lower income family. The numbers are slightly off for the low income family because the VAT would be applied to only their spending.The math works out to Spending of $35.087.72 and VAT Taxes of $4,912.28 or 12.2% of gross income.The high income family still has a lower effective tax rate of 11.2% if they pay the tax by reducing their saving. If they reduce their spending the would spend $280,701.75, have a VAT of $39,298.25, and have a effective tax rate of 9.82%.
All in all the lower income people pay a higher percentage of their income than the higher income people. This is the definition of a regressive tax system.
PROGRESSIVE INCOME TAXES EQUALIZE THE PAIN
Tax policy usually relies on either of two principles: The “Ability to Pay Principle” or the “Benefit Principle”. Both of these forget the fact that paying taxes is painful. If possible we would all like to pay as little as possible to the various levels of government. However, as long as we have to support our government we should make sure that when we pay taxes we are “equalizing the pain” to each of us. The problem with “Flat Taxes”, “Value Added Taxes”, and the various consumption taxes is that they tend to distribute the pain to the lowest economic levels in society. To see how this applies we need to look at the satisfaction people get from having income and/or wealth.
It is well known that as people obtain more and more of a good or service the satisfaction they get from the last unit of the good is lower than the satisfaction received from the immediately prior unit. In economics this is known as the Law of Diminishing Marginal Utility. This “law” applies to income and wealth as well as the consumption of goods and services. The more income or wealth you have, the less each additional dollar of income or wealth means to you in terms of your over all satisfaction.
Applying this to tax policy we can see that a 20% flat tax would cost $4,000 to a person with a taxable income of $20,000 per year and $20,000 to a person with a taxable income of $100,000 per year. In terms of the ability to enjoy the fruits of the economic system, the $4,000 to the low income individual is a much greater sacrifice than the $20,000 is to the high income individual. Equalizing the pain of paying taxes would require that the low income person pays a lower tax rate or the higher income person faces a higher tax rate or some combination of lower and higher rates.
Progressive income taxation is not a “soak the rich” scheme. It is the only system which has the capability of equalizing the pain of supporting government.
The problem with a VAT (Value Added Tax) is that it has lower income households paying a large portion of their income in taxes than higher income households. This is because all spending is taxes under a VAT. Assume that the VAT is 14% (this is low compared to most VAT countries). A family of 4 with an income of $40,000 per year will probably have no Saving. This means that the whole $40,000 would be subject to VAT and the Tax paid of $5,600 would be 14% of their income. A household with an income of $400,000 per year would have a saving rate approximately 20%. They would be spending $320,000 with a VAT of $44,800. This is 11.2% of the higher income family's gross income. In other words the low income family has a higher effective rate of taxation than the high income family.
ADDITIONAL COMMENTS REGARDING THE VAT
Please remember that the VAT results in a lower quality of life at the lower income level because the low income VAT payment means that true spending on goods and services is $34,400 which is the $40,000 less the $5,600 VAT. The higher income families can opt lower net spending of reduce their saving to maintain the quality of life. Even if this decision is made, the high income effective tax rate would still be lower than the effective rate paid by the lower income family. The numbers are slightly off for the low income family because the VAT would be applied to only their spending.The math works out to Spending of $35.087.72 and VAT Taxes of $4,912.28 or 12.2% of gross income.The high income family still has a lower effective tax rate of 11.2% if they pay the tax by reducing their saving. If they reduce their spending the would spend $280,701.75, have a VAT of $39,298.25, and have a effective tax rate of 9.82%.
All in all the lower income people pay a higher percentage of their income than the higher income people. This is the definition of a regressive tax system.
Sunday, July 05, 2009
Profit vs. Value
To those few of you who read my blog on a regular basis, I want to apologize in advance for what will be a fairly technical blog.
As I read about the various arguments regarding how to revise the financial regulatory system, I am amazed at the fact that the discussions never seem to get to the basis of modern financial decision making. In the modern world we use the term “Value Creation” to describe the goal of maximizing shareholder value. This means keeping the price of a stock as high as possible. Almost all of the executive compensation packages are based upon the principle that maximizing the current price of a share of stock is the goal of all companies. This is based upon the assumption that we have perfect markets with perfect information. However, as we have found out, al la ENRON, the market often does not have the information necessary to properly value a company’s shares. In fact, the management has huge incentives to engage in long run value destroying activities because they appear to add value in the short run.
The whole value maximization approach is aimed at a trading rather than an investing mentality. This is an outgrowth of the work of Nobel Laureates Miller, Modigliani, and Sharpe. Miller and Modigliani establish that the value of a company is independent of the debt/equity ratio of the firm. They even establish that the optimal financial structure in the presence of taxes is 100% debt. Sharpe, through the Capital Asset Pricing Model establishes that a firm’s expected return is related to the variability of the returns a firm earns as compared to market returns and returns on risk free assets. For both of these systems to be applicable firms need to be traded in efficient markets and risk associated with specific firms can be diversified away. It appears that the people implementing value maximization forgot these underlying assumptions.
When we look at a firm’s capital structure, i.e. debt/equity ratio, we need to remember that higher debt leads to a wider variation in the returns available to the shareholder. Higher debt equals higher risk. As more and more firms follow the approach of increasing debt the less likely it becomes that risk can be successfully diversified. As a result, we demand higher and higher returns to off-set the higher risk. In an attempt to meet these higher expectations, managements increase the risk of the projects they undertake because higher risk usually results in higher returns. The whole system becomes subject to the types of risks that, in the past, had only been associated with specific firms (Specific Risk). The Financial System starts to rise on a spiral staircase that has a drop-off at the top. The financial meltdown of 2008 was the result of the system going over the top of the staircase just described.
Going back to Miller, Modigliani, and Sharpe we find that they appear to work under the assumption that managements look toward valuing a firm as the present value of the future stream of income. In the absence of Wall Street Analysts this might be true. However, analysts seem to have a trading mentality. As a result, the concept of investing in solid profit earning firms on a long term basis is lost. Even many of our institutions, such as pension plans, which should be long-term investment oriented have turn-over ratios nearing or over 100%. The resultant trading mentality combined with higher levels of specific risk leads to very high levels of risk for the entire system. We have turned into speculators and gamblers rather than investors.
Please do not misinterpret what I am saying:
1. I do not have the hubris to place my ideas on the level of Nobel Laureates. I am, however, criticizing those who have misused their works.
2. Speculators serve an excellent purpose in an economic system. Through arbitrage, they act to effectively stabilize the markets. However, this only works if we have markets dominated by investors. When speculation dominates the system we find that we are operating a casino instead of a financial market.
Our regulation writers have to take into consideration how we got where we are. I believe that they are spending too much time looking at specifics rather than the general approach which got us into trouble to begin with. “…We can’t see the forest for the trees…”
As I read about the various arguments regarding how to revise the financial regulatory system, I am amazed at the fact that the discussions never seem to get to the basis of modern financial decision making. In the modern world we use the term “Value Creation” to describe the goal of maximizing shareholder value. This means keeping the price of a stock as high as possible. Almost all of the executive compensation packages are based upon the principle that maximizing the current price of a share of stock is the goal of all companies. This is based upon the assumption that we have perfect markets with perfect information. However, as we have found out, al la ENRON, the market often does not have the information necessary to properly value a company’s shares. In fact, the management has huge incentives to engage in long run value destroying activities because they appear to add value in the short run.
The whole value maximization approach is aimed at a trading rather than an investing mentality. This is an outgrowth of the work of Nobel Laureates Miller, Modigliani, and Sharpe. Miller and Modigliani establish that the value of a company is independent of the debt/equity ratio of the firm. They even establish that the optimal financial structure in the presence of taxes is 100% debt. Sharpe, through the Capital Asset Pricing Model establishes that a firm’s expected return is related to the variability of the returns a firm earns as compared to market returns and returns on risk free assets. For both of these systems to be applicable firms need to be traded in efficient markets and risk associated with specific firms can be diversified away. It appears that the people implementing value maximization forgot these underlying assumptions.
When we look at a firm’s capital structure, i.e. debt/equity ratio, we need to remember that higher debt leads to a wider variation in the returns available to the shareholder. Higher debt equals higher risk. As more and more firms follow the approach of increasing debt the less likely it becomes that risk can be successfully diversified. As a result, we demand higher and higher returns to off-set the higher risk. In an attempt to meet these higher expectations, managements increase the risk of the projects they undertake because higher risk usually results in higher returns. The whole system becomes subject to the types of risks that, in the past, had only been associated with specific firms (Specific Risk). The Financial System starts to rise on a spiral staircase that has a drop-off at the top. The financial meltdown of 2008 was the result of the system going over the top of the staircase just described.
Going back to Miller, Modigliani, and Sharpe we find that they appear to work under the assumption that managements look toward valuing a firm as the present value of the future stream of income. In the absence of Wall Street Analysts this might be true. However, analysts seem to have a trading mentality. As a result, the concept of investing in solid profit earning firms on a long term basis is lost. Even many of our institutions, such as pension plans, which should be long-term investment oriented have turn-over ratios nearing or over 100%. The resultant trading mentality combined with higher levels of specific risk leads to very high levels of risk for the entire system. We have turned into speculators and gamblers rather than investors.
Please do not misinterpret what I am saying:
1. I do not have the hubris to place my ideas on the level of Nobel Laureates. I am, however, criticizing those who have misused their works.
2. Speculators serve an excellent purpose in an economic system. Through arbitrage, they act to effectively stabilize the markets. However, this only works if we have markets dominated by investors. When speculation dominates the system we find that we are operating a casino instead of a financial market.
Our regulation writers have to take into consideration how we got where we are. I believe that they are spending too much time looking at specifics rather than the general approach which got us into trouble to begin with. “…We can’t see the forest for the trees…”
Friday, June 19, 2009
NOT ALL MARKETS BENEFIT FROM COMPETITION
Having been trained in Economics and Finance, I am a strong believer in the benefits of market based competition. However, I also recognize that there are many markets where for some reason the free market does not lead to economic efficiency which economists often define as producing at the lowest possible cost. The medical industry may fall into this category of non-market based efficiency.
This can be illustrated by the following: About 25 to 30 years ago the Blue Cross/Blue Shield system dominated the health insurance industry. There was sharp criticism because the hospital portion of medical care was paid on a cost plus basis. Those who did not understand the system assumed that this led to uncontrolled growth in hospital costs. Governments forced the Blues into a different payment system and hospital costs skyrocketed. What the critics failed to understand is that the Blues audited hospital costs and refused to include many costs in the payment base. In fact, hospitals were required to get advance approval for major capital purchases. This means that if one hospital had an underutilized MRI the blues would not reimburse another hospital in the area that acquired an additional MRI. The Blues encouraged the second hospital to contract for MRI services with the first hospital. This led to lower overall costs in the system. The elimination of the Blue Cross single payer cost-plus system led to duplication of services and higher per unit costs due to under utilization at some institutions and higher over-all costs due to scheduling of unnecessary tests designed to justify the acquisition of the equipment at others. In this case competition led to higher costs instead of economic efficiency.
Now we are hearing health insurers and their congressional apologists screaming that a single payer system would not be economically efficient because we would eliminate competition. In addition, they claim that a single payer system would lead to rationing. What they fail to consider is that we already have rationing. In a world of scarce resources the market based system allocates, i.e. rations, resources on the basis of prices. In the realm of health care, those who can afford to pay the price get the care. Medical care is rationed to those with either high wealth or good insurance. Those without either get poor or no care. In addition, as was explained earlier, market based health care leads to higher costs.
The time has come for Americans to join the rest of the developed world and treat health care as a non-market service. Those who claim that the government cannot operate efficiently just need to look at Medicare as a model. I have many friends, over 65, who rail against government involvement in health care. When I ask them if they’re going to give up their Medicare coverage their universal response is that Medicare is great. Why would they give it up? When I point out their contradictory attitudes they just ignore me. They fall into the category of those people who dislike economists because economics often disproves their preconceived notions and people are reluctant to change cherished beliefs when evidence contradicts them.
This can be illustrated by the following: About 25 to 30 years ago the Blue Cross/Blue Shield system dominated the health insurance industry. There was sharp criticism because the hospital portion of medical care was paid on a cost plus basis. Those who did not understand the system assumed that this led to uncontrolled growth in hospital costs. Governments forced the Blues into a different payment system and hospital costs skyrocketed. What the critics failed to understand is that the Blues audited hospital costs and refused to include many costs in the payment base. In fact, hospitals were required to get advance approval for major capital purchases. This means that if one hospital had an underutilized MRI the blues would not reimburse another hospital in the area that acquired an additional MRI. The Blues encouraged the second hospital to contract for MRI services with the first hospital. This led to lower overall costs in the system. The elimination of the Blue Cross single payer cost-plus system led to duplication of services and higher per unit costs due to under utilization at some institutions and higher over-all costs due to scheduling of unnecessary tests designed to justify the acquisition of the equipment at others. In this case competition led to higher costs instead of economic efficiency.
Now we are hearing health insurers and their congressional apologists screaming that a single payer system would not be economically efficient because we would eliminate competition. In addition, they claim that a single payer system would lead to rationing. What they fail to consider is that we already have rationing. In a world of scarce resources the market based system allocates, i.e. rations, resources on the basis of prices. In the realm of health care, those who can afford to pay the price get the care. Medical care is rationed to those with either high wealth or good insurance. Those without either get poor or no care. In addition, as was explained earlier, market based health care leads to higher costs.
The time has come for Americans to join the rest of the developed world and treat health care as a non-market service. Those who claim that the government cannot operate efficiently just need to look at Medicare as a model. I have many friends, over 65, who rail against government involvement in health care. When I ask them if they’re going to give up their Medicare coverage their universal response is that Medicare is great. Why would they give it up? When I point out their contradictory attitudes they just ignore me. They fall into the category of those people who dislike economists because economics often disproves their preconceived notions and people are reluctant to change cherished beliefs when evidence contradicts them.
Tuesday, April 14, 2009
IS ECONOMICS REALLY DEAD?
More and more, today, we are reading the current economic crisis proves that Market Economics is dead. Looking at the behaviors exhibited in the last twenty years, the detractors tell us, proves that people do not follow the rational economic choices that are espoused by classical economists. They claim that the new wave of economics is behaviorist and behaviorism destroys all classical analysis. In other words: “Adam Smith is no longer relevant.”
Although there are strong arguments for this approach, I believe that the classical Supply/Demand Model still works. It only needs a minor modification to remain relevant and reliable predictor of human behavior. Most of us, who only had a cursory course or two in economics, remember that the Supply/Demand approach looks at prices and quantities. There is an assumption that all of our decisions are based upon changes in prices. What we forget is that the price quantity relationships are stipulated as operating ceteris paribus. This means that everything else remains constant. Economists are not stupid. They know that people spend based upon their tastes and preferences, their income, their wealth, their expectations and many other factors. The model, however, holds these items constant and says that people will act rationally in a supply demand situation.
Where our model appears to fall apart is that people seem to be acting irrationally. If this is the case, then maybe economics is irrelevant. Looking at the same behaviors, I have come to a different conclusion. I concentrate on peoples’ expectations. I believe that people act with economic rationality based upon their expectations. However, there is nothing in the model that says peoples’ expectations have to be rational. So, if you believe that the basics of the economy have changed and there will never be a down real estate market again, you will be willing to take on an in ordinate amount of debt because the rising asset value will give you a growing net worth. Expecting a market with no down side risk is irrational. But, if you are faced with experience that has never seen a down side in real estate you will act as if the lack of a downside is reality. Your actions are rational within the context of your belief and follow standard economic models regarding supply and demand.
This approach also helps us understand why people buy high and sell low in the stock market: If the market has been growing for a long time but you are afraid of market cycles there is a high probability that you stayed out of the market during its early growth phase. As the market keeps growing you begin to experience cognitive dissonance. That is, your behavior is at odds with everything you now appear to know about the market. You finally give in and go into a buy mode. However, you waited too long and the market drops shortly after your purchases. You are now in the “…I knew I never should have done this…” mode. Your real expectations have been reinforced and you decide to “…cut your losses…” Your observed behavior is irrational. But, based upon your expectations you behaved rationally.
We do need to spend more time addressing how expectations are created. We also need to do more in the realm of education that allows expectations to be created based on rationality. The problem we have had is that the experts, who should have known better, were making so much money that they were reluctant to burst the balloon and eventually began to have irrational expectations of their own. They began to believe their own hype.
Although there are strong arguments for this approach, I believe that the classical Supply/Demand Model still works. It only needs a minor modification to remain relevant and reliable predictor of human behavior. Most of us, who only had a cursory course or two in economics, remember that the Supply/Demand approach looks at prices and quantities. There is an assumption that all of our decisions are based upon changes in prices. What we forget is that the price quantity relationships are stipulated as operating ceteris paribus. This means that everything else remains constant. Economists are not stupid. They know that people spend based upon their tastes and preferences, their income, their wealth, their expectations and many other factors. The model, however, holds these items constant and says that people will act rationally in a supply demand situation.
Where our model appears to fall apart is that people seem to be acting irrationally. If this is the case, then maybe economics is irrelevant. Looking at the same behaviors, I have come to a different conclusion. I concentrate on peoples’ expectations. I believe that people act with economic rationality based upon their expectations. However, there is nothing in the model that says peoples’ expectations have to be rational. So, if you believe that the basics of the economy have changed and there will never be a down real estate market again, you will be willing to take on an in ordinate amount of debt because the rising asset value will give you a growing net worth. Expecting a market with no down side risk is irrational. But, if you are faced with experience that has never seen a down side in real estate you will act as if the lack of a downside is reality. Your actions are rational within the context of your belief and follow standard economic models regarding supply and demand.
This approach also helps us understand why people buy high and sell low in the stock market: If the market has been growing for a long time but you are afraid of market cycles there is a high probability that you stayed out of the market during its early growth phase. As the market keeps growing you begin to experience cognitive dissonance. That is, your behavior is at odds with everything you now appear to know about the market. You finally give in and go into a buy mode. However, you waited too long and the market drops shortly after your purchases. You are now in the “…I knew I never should have done this…” mode. Your real expectations have been reinforced and you decide to “…cut your losses…” Your observed behavior is irrational. But, based upon your expectations you behaved rationally.
We do need to spend more time addressing how expectations are created. We also need to do more in the realm of education that allows expectations to be created based on rationality. The problem we have had is that the experts, who should have known better, were making so much money that they were reluctant to burst the balloon and eventually began to have irrational expectations of their own. They began to believe their own hype.
Tuesday, March 24, 2009
GEITHNER IS TOO CLOSE TO THE STREET
Up until now I had the attitude that Secretary Geithner needed all the support we could give him. The country needed to have a solid voice that could implement plans without creating a sense of uncertainty. However, I now believe the time has come for him to go. His recent plan to deal with the “toxic assets’ is fatally flawed. It is based upon the assumption that the markets have undervalued the assets and government guarantees will get the private sector to buy them. The problem with this approach is that it relies upon the banks being willing to sell the assets at the price the market is willing to pay. The private sector which has already priced the assets at extremely low levels and the Geithner plan expects it to miraculously start buying at inflated prices due to government guarantees. There is not even an assurance that the banks holding the assets will sell them at anything less than face value.
In addition, if the assets prove to have little worth, the US government, read you and me, will have to pay off the guarantees. It would be a lot cheaper to the taxpayer if we nationalized the illiquid, read that as insolvent, banks, let the assets mature, and pay back the taxpayer to the extent that the maturing assets will allow. We, in aggregate (government), have a much greater capacity to wait out the market than do profit making institutions. In the long run a single “Bad Bank” will have a greater capacity to renegotiate loans, the disruption to the market from bank bankruptcy will be mitigated, and the costs to the tax payer will be lower.
Mr. Geithner appears to be too obsessed with preserving the current insolvent banks rather than solving the problems facing the financial system. I believe that in his role as President of the Federal Reserve Bank of New York he may have gotten too close to the “Movers and Shakers” who caused the problem to begin with. This makes him overly amenable to their approaches that are design to preserve their own positions. Once again the economics of greed is winning out over Adam Smith’s “Enlightened Self Interest”
In addition, if the assets prove to have little worth, the US government, read you and me, will have to pay off the guarantees. It would be a lot cheaper to the taxpayer if we nationalized the illiquid, read that as insolvent, banks, let the assets mature, and pay back the taxpayer to the extent that the maturing assets will allow. We, in aggregate (government), have a much greater capacity to wait out the market than do profit making institutions. In the long run a single “Bad Bank” will have a greater capacity to renegotiate loans, the disruption to the market from bank bankruptcy will be mitigated, and the costs to the tax payer will be lower.
Mr. Geithner appears to be too obsessed with preserving the current insolvent banks rather than solving the problems facing the financial system. I believe that in his role as President of the Federal Reserve Bank of New York he may have gotten too close to the “Movers and Shakers” who caused the problem to begin with. This makes him overly amenable to their approaches that are design to preserve their own positions. Once again the economics of greed is winning out over Adam Smith’s “Enlightened Self Interest”
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