Simon Johnson's Blog, page 24

Retirement Inequality

By James Kwak

The Economic Policy Institute put out a series of charts detailing inequality in retirement savings across several different demographic characteristics. The most obvious picture is that the shift to 401(k) plans has produced vast increases in retirement inequality across income groups.

Here’s one:

 

And that’s not just a product of increasing income inequality. As a percentage of income, the retirement savings gap has been increasing over time:

(Don’t be encouraged by the fact that all the lines are trending upward: that’s simply defined contribution plans, which are counted as retirement savings accounts, replacing defined benefit plans.)

These trends are entirely predictable. The most important determinant of lifetime retirement savings accumulation is the amount you are able to save during your working years. Someone who makes $200,000 can’t just save five times as much as someone making $40,000. In today’s world, the person making $40,000 often can’t afford to save anything, while the person making $200,000 can save the full $17,500 tax-deductible amount (and she is more likely to have an employer match as well). In the process, of course, the high-income person is also claiming about $6,000 in cash subsidies from federal and state governments, while the low-income person gets nothing.

Who would ever have designed such a system? Oh, of course: the people making a lot of money who can maximize their tax deductions. (And the asset management firms that skim a percentage of everyone’s money off the top.)

 

How VCs Are like Colleges

By James Kwak

College application essays? They’re all the same. That’s according to Rick Clark, the head of admissions at Georgia Tech, who kicks off this past weekend’s episode of This American Life by, in part, mocking the tired trope of “idealistic teenager goes to Central America to help the people there but becomes transformed by the experience.” Clark, however, is self-aware enough to realize that the colleges are equally bad: the glossy brochures they send out to high school students, trying to attract their application fees if not their tuition checks, are all exactly the same in virtually every respect.

This reminded me of what it’s like trying to raise money from venture capitalists. The number one thing they care about is your sustainable competitive advantage (unless you’ve already started a successful company, in which case they’ll write you a check to deliver peanut butter sandwiches by text message, but you don’t need their money anyway). Why, if your idea is so good, won’t big company X (in our case, SAP or Oracle) just copy you and crush you? It’s like they all took the same class in business school and only paid attention for the first fifteen minutes.

Then, at the end of the meeting (occasionally at the beginning), they talk about themselves and why you should want their money as opposed to the equally green money of the identical-looking, khakis-wearing, bicycle-riding people on the other side of Sand Hill Road. They really focus on improving operations; they sit on a small number of boards; they care about developing entrepreneurs; blah blah blah. They all have exactly the same pitch. But they can get away with it because they have the thing that matters: money. The one VC I liked the most was the only one who said, “Basically, we’re the money, and we try not to mess things up too much.”

(The rest of that TAL episode is a fantastic story about Emir Kamenica and how he made it from being shot at in Bosnia to going to Harvard—so good I almost took the wrong exit on the way to work yesterday.)

Non-Lessons of the Financial Crisis

By James Kwak

As the fifth anniversary of the Lehman bankruptcy approaches, the Internet is filling up with reflections on the financial crisis and the ensuing years. My main feeling, as expressed in my latest Atlantic column, is amazement at how little we seem to have learned. Looking back, the period in late 2008 and early 2009, when it was obvious that the financial sector would have to change in important, structural ways, now seems like a naïve, youthful delusion. Sure, there are some new rules around the margins, but for the most part little has changed—not just in the financial sector itself, but more importantly in the political and ideological landscape that shapes regulatory policy.

Of course, this isn’t simply the product of collective amnesia. It’s the result of the fact that ideas are shaped by money and political power. And that’s where little has changed.

Entrepreneurship Around the World: An MIT Course

By Simon Johnson

“Entrepreneurship Without Borders” is an MIT Sloan class, primarily designed for MBA students.  The course looks at economic growth, financial crises, and the distribution of income through the details of entrepreneurship in various parts of the global economy.  Below is a summary of class #1, from September 4, 2013.  The full running order of classes is here; all readings are freely available, with the exception of Harvard Business School cases.  The course consists of 12 sessions through mid-October, and summaries or other perspectives will appear regularly in this space. 

Entrepreneurship is a broad and sometimes amorphous concept, particularly when we try to compare business conditions around the world.  Who has a lot of entrepreneurs and what does that mean?  Should policymakers always want more people to start their own firms?  Who exactly is an entrepreneur and does using the same definition make sense in all places?

The Global Entrepreneurship Monitor (GEM) has done a great service by bringing clarity and some transparent data into this discussion.  (The specifics below refer to their 2012 report.)

A particular strength is that GEM looks, through opinion surveys, at what the broader public believes about starting their own business – including whether they think there are opportunities, whether they have the right personal capabilities to be an entrepreneur, and whether they are afraid of failing.

Three points are striking.  First, in many countries people would be very happy – or are actively striving – to become entrepreneurs (Table 2.2 in the GEM report).  These numbers are impressive, although perhaps sometimes higher than might be plausible.  Some countries with low entrepreneurial intentions include: Russia, Norway, Japan, and South Korea.  But these are exceptions – entrepreneurship has appeal in many places; don’t let anyone tell you otherwise.

Second, in lower income countries there are more perceived opportunities and more early stage entrepreneurs (business up to 3 ½ years old) – but the established business ownership rate is only a bit higher than in richer countries.  Presumably, much of this is driven by the lack of other good employment opportunities, so many people engage in informal small-scale activity that does not generate many jobs and perhaps not even stable income.  Compared with most other rich countries, the US has slightly higher early stage entrepreneurial activity.

Third, Greece and Spain have shown a big decline in perceived opportunities since 2008 – while there has been no such decline in Scandinavia (Figure 2.2).  This is presumably the effect of the euro crisis – and helps explain the lack of an economic recovery.  This is not always the pattern in crises – e.g., when the real exchange rate depreciates, that often encourages new business formation for exports or to compete against imports.

Overall, there is a general perception that the US has an advantage in some dimension of entrepreneurship, but this is hard to see in these numbers.  GEM may not be fully picking up the potential for technological breakthroughs developed by entrepreneurs.

These data raise a number of important policy questions (see also this perspective).

Should governments try to increase the number of entrepreneurs?
What is the best way to help encourage people to set up their own businesses?
What do entrepreneurs really need to have?  What would be nice to have?
Should we think in terms of “forms” of entrepreneurship, with some being more likely to have a more positive effect on productivity and economic growth than others?

While this course will not provide full answers to all these questions, we will find some perspectives by taking the detailed viewpoint of entrepreneurs and people working to help them around the world.

Specifically, the running order of our remaining classes will be divided into three parts.

Part I: Understanding the environment for entrepreneurs – what is good, bad, indifferent and why

#2: Recovery from the euro crisis.  We will talk with someone who is working to help the private sector boom in Portugal.

#3: The Big Puzzle: why doesn’t everyone want a lot of entrepreneurs trying to find ways to apply new technology – or just generating new jobs by starting companies?

Part II: So you want to help entrepreneurs develop – what should you do?

#4: Endeavor, the gold standard for global entrepreneurship promotion.  We look in detail at a specific selection panel in Jordan (HBS case) and talk with an expert about the broader experience.

#5: We discuss alternative models, including recent ideas from Chile (HBS case).  What exactly do entrepreneurs need and want?  How exactly do you attract global talent and then persuade them to stay put?

#6: Women have been excluded from many economic opportunities around the world, but at least in some places this is now changing.  How much difference will this make – and how could or should US policy help?

#7: Perhaps it is all really about access to capital – and nothing else really matters?  We look at one specific case in Germany (HBS case).

Part III: New Frontiers

#8: A specific new venture in Africa, on which Sloan MBA students worked last year (and developed the case material).  We talk with the entrepreneur.

#9: Social housing in India: should we think more broadly about what is entrepreneurship and how new models can be transformative? (HBS case)

#10 and #11 are sessions that will be scheduled based on material suggested by students

#12: we come back to the original questions – how can you get more entrepreneurs and how much of a priority should this be?

Who Cares About the National Debt?

By James Kwak

Not Greg Mankiw. Or, to be precise, not “Republicans.”

This past weekend Mankiw wrote a column for the Times laying out the arguments for a carbon tax. They are so well known and so obviously correct that I won’t bother repeating them. (A tradable permit system could work equally well, depending on how it is designed.)

In addition, many people think that the national debt is a serious long-term problem. A carbon tax (or a tradable permit system where permits are auctioned off) would obviously bring in revenue. In White House Burning, we estimated this at about 0.7–0.9 percent of GDP by the early 2020s (citing Metcalf, Stavins, and the CBO).

So what’s the problem? According to Mankiw:

“The crucial point is what is done with the revenue raised by the carbon fee. If it’s used to finance larger government, Republicans would have every reason to balk. But if the Democratic sponsors conceded to using the new revenue to reduce personal and corporate income tax rates, a bipartisan compromise is possible to imagine.”

Republicans like to say that they are opposed to deficits and that debt is evil. (Debt ceiling, anyone?) But when confronted with a proposal that makes perfect economic sense and reduces deficits, they reject it—on the grounds that it would “finance larger government.” Instead, they insist on offsetting the tax increase—which, remember, is economically efficient standing on its own. Essentially, Mankiw’s argument (OK, he’s placing it in the mouths of “Republicans,” but he’s a Republican, too) is that a carbon tax is good, but additional tax revenue that would reduce the deficit is bad.

This is absurd. The argument necessarily relies on the premise that deficits cannot be reduced: increase tax revenues, and spending will just go up, leaving the deficit the same. If the deficit is fixed, then even spending cuts are pointless; the money saved will just get spent someplace else. (If you assume that new tax revenue will automatically get spent, then the same assumption must apply to savings from spending cuts.) As a further corollary, tax cuts will not increase the deficit; instead, they will cause spending to fall to offset the reduced revenue.

Unfortunately, not just the Republican congressional delegation but also one of the party’s most prominent economists has accepted this absurdity as a fact. Which is why the single most obvious thing we could do to protect the world for future generations and reduce deficits has no chance of happening anytime soon.

 

 

A Bit of Obvious Advice

By James Kwak

People occasionally ask me what it takes to succeed in the business world (since they assume at least that I know some successful people). Luck probably belongs at the top of that list. But I have a very clear idea of the most valuable skill to have in business (in part because I don’t really have it): the ability to pick up the phone, call someone, and convince her to do something that is in your interests—even though she has no other reason to do it.

I’m not saying this should be the most valuable skill in business. People like me would prefer it if all decisions were made on the basis of factual evidence and logical reasoning. But they’re not. And the people whom I have seen become very successful are the ones who are hard to say “no” to, whether in person or on the phone. How they do it can vary: some do it with charisma, some with logic, some with sheer stubbornness.  But they can all do it.

I thought of this when reading a recent WSJ article about how some businesses are trying to encourage their employees to use the phone instead of email. People claim they use email (or text messaging) because it’s more efficient, but that’s only true for some types of communications, particularly distributing information to many people that doesn’t require any type of interaction. For a simple example, if you have a question for one person, and the answer is complicated enough that you might need to ask more clarifying questions, the phone is far more efficient than email or text. Then there’s the relationship aspect. If I’m at the grocery store and my wife wants to add something to the list, she sends me a text, since she doesn’t feel the need to build on our relationship. But in business, when you’re dealing with people you don’t know, there’s no substitute for the phone.

The real reason why people avoid the phone in business contexts is that they’re uncomfortable. They don’t know the other person, they’re nervous about that, and it’s so much easier to send the email. But that’s precisely the problem. It’s so much easier to say “no” to someone by email, too. (Social media messages are even easier: I have no qualms about simply ignoring unsolicited direct messages in Twitter, Facebook, or what have you.) So if you’re new to the corporate world, your boss tells you to ask a supplier for a lower price, you send the email, you get the rejection, and you feel like you’ve done your job. But you haven’t done it very well.

This is all very simple and obvious, but it runs up against most people’s deep-seated feelings of insecurity and awkwardness. I don’t have a solution for that. But if you want to be CEO of a big company someday, get used to it.

Regulators Repeat Exactly What They Did During the Last Housing Boom

By James Kwak

The Dodd-Frank Act was supposed to require securitizers to retain 5 percent of the credit risk of the mortgage-backed securities that they issued, in order to reduce the risk of a repeat of the last housing bubble. Today, the federal financial regulators said, “Whatever,” and ignored that requirement. In particular, they created an exemption that would have covered at least 98 percent of all mortgages issued last year.

Why? Because

“adding additional layers of regulation would have contracted credit for first time home buyers and borrowers without large down payments, and prevented private capital from entering the market.”

That’s according to the head of the Mortgage Bankers Association.

This is the exact same argument that was made in favor of deregulation during the two decades prior to the last financial crisis, without the slightest hint of irony. It’s further proof that everyone has either forgotten that the financial crisis happened or is pretending that it didn’t happen because, well, maybe it won’t happen again?

Even leaving aside the specific merits of this decision, the worrying thing is that the intellectual, regulatory, and political climate seems to be basically the same as it was in 2004: no one wants to to anything that might be construed as hurting the economy, and no one wants to offend the housing industry.

Markets Aren’t That Stupid

By James Kwak

In finance, there are rarely battles between good and evil. Instead, you have battles of, say, greedy and corrupt versus greedy and ruthless. This is roughly the case in the debate between entrenched corporate CEOs (and boards) and activist hedge funds.

Activist hedge fund managers, like Daniel Loeb or Bill Ackman, buy large blocks of stock in a target company and agitate for change (new board members, asset sales, dividends or buybacks, etc.). The idea is that either they will get their way, or the company will respond to the pressure by doing a better job for shareholders; either way, the stock goes up, and they sell at a big profit.

Entrenched CEOs and boards (and their lawyers) don’t like this because, well, they don’t like outsiders telling them what to do and stirring up shareholders to vote against them. They have responded by trying to make life more difficult for activist shareholders, both in the courts and with the SEC. Of course, they can’t come out and say that activist investors are bad for them as people, because that would seem too self-interested. Instead, they say that activists are bad for the companies they invest in and their other, “long-term” shareholders.* But they have to make this claim despite the fact that news of an activist investment typically causes a company’s share price to go up—which, if you believe in more or less efficient markets, means that activists are good or companies. So they have fallen back on another claim: that activists are bad for the company and the stock price in the long term, even though they appear to be good in the short term.

Unfortunately (for them), it just isn’t true. Martin Lipton, the king of the insider defense bar, said that activist investors’ impact on companies had to be judged over a 24-month period. So Lucian Bebchuk, Alon Brav, and Wei Jiang looked at how those companies did over a five year period (paper; WSJ summary). The bottom line is that, if anything, activist investors tend to improve the companies they invest in. They target companies that are underperforming (by operational measures); they improve their performance on those operational measures; and they provide an initial bump in stock price that does not get reversed over the next five years.

This shouldn’t be too surprising. The theory that activist investors are good in the short term but bad in the long term, while appealing, rests on the premise that there is something you can do that will help a company’s stock price in the short term but not in the long term. The problem with this premise is that a company’s stock price at any moment incorporates market expectations about how it will perform for the rest of time, so it is already a long-term measure. To pull off such a trick, you would have to do something that the market doesn’t know about or understand properly.

This is certainly possible: for example, you could engage in accounting fraud, pulling in revenues from future quarters. That would clearly boost stock prices in the short term at the expense of the long term, so long as the fraud was kept secret. But that’s illegal, and it isn’t as if there’s some lever you can pull that says “increase profits in short term while lowering profits in long term without anyone knowing about it.”

Sure, activist investors do stupid things sometimes (Ron Johnson as CEO of JCPenney?). But on balance, they seem to be a good thing—except for the CEOs and board members they push out.

* Whatever this means, in a day when the majority of trading is done by high-frequency traders, and even the typical actively managed mutual fund turns over its whole portfolio multiple times in a year.

The Problem with 401(k) Plans

By James Kwak

Apparently my former professor Ian Ayres has made a lot of people upset, at least judging by the Wall Street Journal article about him (and co-author Quinn Curtis) and indignant responses like this one from various interested parties. What Ayres and Curtis did was point out the losses that investors in 401(k) plans incur because of high fees charged at the plan level and high fees charged by individual mutual funds in those plans. The people who should be upset are the employees who are forced to invest in those plans (or lose out on the tax benefits associated with 401(k) plans.)

In their paper, Ayres and Curtis estimate the total losses caused by limited investment menus (small), fees (large), and poor investment choices (large). Those fees include both the high expense ratios and transaction costs charged by actively managed mutual funds and the plan-level administrative fees charged by 401(k) plans.

What really annoyed people in the 401(k)) industry (that is, the mutual fund companies that administer the plans and the consultants who advise companies on plans) was Ayres and Curtis’s charge that many plans are violating their fiduciary duties to plan participants by forcing them to pay these fees. Various parties connected with a plan (e.g., the named fiduciary, the administrator, the investment adviser) have fiduciary duties, which include duties of prudence (doing a reasonably diligent job) and loyalty (putting the participants’ interests first). Overpaying for investment management and administrative services would seem to constitute a breach of these duties.

The response of the industry has been one of righteous indignation and blanket assertion. For example, Drinker Biddle huffs, “In our experience, most plans are well-managed.”  401(k) plans provide different “services,” so different plan-level fees are appropriate; and high fund fees are OK because “it is commonly accepted that the use of actively managed funds is prudent.”

Just because lots of rent-seekers say so doesn’t make it so. Investment management is pretty close to a commodity business. Even if markets for illiquid assets aren’t that efficient, and even if publicly traded securities markets are a little inefficient around the edges (and I have no problem with rich people putting their excess cash into hedge funds trying to exploit those inefficiencies), paying money to gamble on fund managers is not something that companies should be encouraging their employees to do. There’s no good reason not to just provide a lineup of cheap, big index funds with low costs and low tracking error.

Plan administration is a commodity business, too. I’ve been in 401(k) or 403(b) plans at four companies (one of which changed administrators partway through), my wife has been in plans with two different administrators, and apart from fund choice I don’t recall any differences between them (and I’m pretty attentive to these things).

So yes, most plan sponsors and administrators are violating their fiduciary duties, as I argued in a paper (summary here). Not that they should stay up nights, at least for now. The courts have for the most part endorsed current behavior, probably “reasoning” that if everyone’s doing it, it must be OK. But anything Ayres and Curtis can do to draw attention to the problem of high fund fees and plan fees will help move us closer to the day when workers don’t have to pay for their companies’ poor choices.

The Lame “Uncertainty” Defense

By James Kwak

The indefatigable Brad DeLong has devoted his energies to singlehandedly protecting Larry Summers from the Internet (although, he makes pains to say, he likes Janet Yellen almost as much). Although I’m letting most of the Fed chair sideline debate pass me by, DeLong and others have raised one issue that played an important symbolic role in 13 Bankers and, more generally, the historical background to the financial crisis: Brooksley Born’s proposal to think about regulating OTC derivatives in 1998.

For those who don’t know the story, it basically goes like this. Born, as chair of the CFTC, was worried about the risk posed by OTC derivatives, which were effectively unregulated at the time. On May 7, 1998, the CFTC issued a “concept release”  asking for comments about the regulation of OTC derivatives. Summers, then deputy treasury secretary, along with Treasury Secretary Robert Rubin, Fed Chair Alan Greenspan, and SEC Chair Arthur Levitt, opposed Born, and they issued their own press release on the same day opposing the CFTC. Over the next several months they successfully blocked the CFTC from regulating OTC derivatives, convincing Congress to stop the CFTC from moving forward, a position that was enshrined in statute in the Commodity Futures Modernization Act of 2000.

Now that it is widely recognized that OTC derivatives needed to be regulated, this has been an uncomfortable bit of history for Summers et al. The current defense was put forward by an unnamed person and by DeLong:

One person close to the process described it this way: “The concern with Born’s concept release back then was that CFTC jurisdiction rested on the contracts being futures contracts, and if they were futures contracts, they had to be exchange traded, and existing hedging contracts were not exchange traded (at the time they basically couldn’t be), so there was a concern that the existing contracts would be void (illegal).” . . . Cal Berkeley professor J. Bradford DeLong, who has authored papers with Summers, Tweeted last night: “‘Brooksley Born approach’ made all existing derivatives contracts unenforceable. Very bad idea.”

There are several problems with this defense.

First, this argument targets one possible outcome of Born’s process, not the process itself—which is what Summers et al. shut down. The purpose of the concept release was ”to solicit comments on whether the regulatory structure applicable to OTC derivatives under the Commission’s regulations should be modified in any way . . . and to generate information and data to assist the Commission in assessing this issue.” Born wanted to discuss the issue. Yet her opponents then—and now—jumped to the “worst” possible outcome (for them, or rather for certain market participants) and equated that with what Born was doing.

Second, that isn’t how the law works. It was recognized at the time that OTC derivatives were in a legal gray area—hence the desire for “certainty” that was finally satisfied by the CFMA. If some activity is in a legal gray area, and you do it anyway, you can’t simply assert that now the activity must be allowed by law because you are doing it. If the contracts you wrote, knowing they might not be enforceable, now become definitively unenforceable—well, tough luck. You can’t dictate what the law is simply through your own actions.

Third, the argument proves too much. Again, Born was proposing to think about about whether and how OTC derivatives should be regulated. If that is a “very bad idea,” then, by implication, OTC derivatives can never be regulated—because you have to think about regulating something before you can regulate it. Is that really a position that Summers and DeLong want to defend?

Fourth, if the problem is existing contracts, then there’s an obvious solution: grandfather them. In fact, the concept release included this language:

“This release does not in any way alter the current status of any instrument or transaction under the CEA. All currently applicable exemptions, interpretations, and policy statements issued by the Commission regarding OTC derivatives products remain in effect, and market participants may continue to rely upon them.”

It is true that that language applied to the release itself, not necessarily to any regulations that might have been issued later. But those regulations would have to go through the usual notice-and-comment process, and the other regulatory agencies would obviously be at the table. If Summers’s real concern was past contracts, then that’s something he could have negotiated with Born.* (And if she refused, then he could have gone to Congress, or to the courts.) That concern doesn’t justify what happened.

Summers would be better off—at least as far as this Fed chair thing is concerned—simply admitting he was wrong, rather than trying to win a fifteen-year-old argument. At the end of the day, however, the whole Brooksley Born affair is a bit beside the point—if the question is trying to understand Larry Summers. The Summers camp thinks they can justify his anti-regulatory stance during the Clinton years by making Born look like an extremist; by implication, he was just a moderate.

But the Born affair (and, or course, the great “thirteen bankers” quote) is just one piece of evidence. We know that Summers opposed derivatives regulation. The report of the President’s Working Group on Financial Markets with his name on it unanimously recommended providing “legal certainty” by definitively exempting derivatives from the Commodity Exchange Act. He was secretary of the treasury when the CFMA was passed. Robert Rubin said in his 2003 memoir (before he had anything to be embarrassed about), “Larry characterized my concerns about derivatives as a preference for playing tennis with wooden racquets–as opposed to the more powerful graphite and titanium ones used today.” (Rubin now claims that he was in favor of derivatives regulation, although he didn’t do anything about it.)

And it isn’t as if Summers had some other, better proposal to regulate OTC derivatives. He was against it. That’s the issue—not whether the legal status of derivatives contracts under the CEA somehow changed because of a concept release issued by the CFTC.

* This is what Levitt now says he wishes he had done.