Simon Johnson's Blog, page 41

Magical Investment Thinking

By James Kwak

From a Times article on pension fund investing:

Mr. Dear cautioned that there were big differences in how various alternative investments performed during the financial crisis.

He said that Calpers's investments in real estate had been "a disaster" and that its hedge fund investments had not met their benchmarks and were under review. But he said that its private equity holdings had easily beaten public stock returns over the last decade.

"Over the longer term, that kind of outperformance represents real skill, not luck, and it's worth paying for," he said.

Holy confirmation bias, Batman! When one asset class beats the stock market that's skill. But when your other asset classes do badly—that's random variation? If high returns on private equity are evidence that you should continue investing in private equity, then low returns in hedge funds and real estate are evidence that you should pull your money out of them.

Public pension funds are obviously gambling on redemption. They don't have enough money to meet their long-term commitments. They can only meet those commitments by getting unrealistic returns, so they are piling into alternative asset classes in hopes of getting those returns.

This is the same as S&Ls piling into wacky commercial real estate ventures in the 1980s. If you're a pension fund manager, there's only upside. Either the bets pay off and you become a hero (and move into the private sector), or they fail and the losses get shifted to taxpayers and public employees. And either way, the hedge fund and private equity fund managers get their guaranteed fees (along with the pension consultants who supposedly know which funds you should invest in).

Volcker Rule Would Cause Irreparable Damage To The Muppets – And Much More Broadly

By Simon Johnson, April 1st, 2012

A major new research report – released this weekend by the renowned international consulting firm, IMS – finds conclusively that implementation of the proposed Volcker Rule would damage not just the irreplaceable Muppets but also "all children-oriented television or other media-based educational program content."

The logic in the report is straightforward and, quite frankly, compelling.  The Volcker Rule – which aims to limit proprietary trading and excessive risk-taking by the country's largest banks – would reduce the ability of "too big to fail" institutions to bet heavily on the price of commodities used to produce puppets (mostly cotton, but also apparently wood, aluminum, and some rare earths.)

"In response to the changing demands of their customers, banks have expanded their role of providing financial resources and services to include risk management and intermediation services to [various kinds of puppets]" (p. ES2)

These services are highly profitable and of great value to the skilled artisans who produce puppets, but if the very biggest banks are not allowed to engage in these activities, then no one else will.

This, of course, is elementary economics – dating back as far as Adam Smith.  If there is a profit-making opportunity to be had, then everyone will spurn it, unless they work for a massive international bank.

The history of the United States is replete with examples of business sectors that would never have come into existence were it not for the proprietary trading of banks that were large enough to damage the economy when they failed.

Thomas Edison worked long and hard for J.P. Morgan (the man) before being allowed into the speculative trading side of the business.  Henry Ford's entire model was a spin-off from Bankers' Trust – with a substantial equity investment from his former employer.  And the Wright Brothers' business concept – as well as their most basic notions of aeronautics – derived from their early work with paper airplanes on the trading floor of what became First National City Bank of New York (i.e., Citigroup today).

Put simply, there has never been real entrepreneurship in the U.S. financial markets or economy – other than what these banks have put there, directly or indirectly.  The fact these banks were very small relative to the economy until the 1980s is irrelevant.

And the fact that these banks now draw on huge government implicit subsidies – while also creating an enormous and dangerous tax payer liability – is neither here nor there.  Malfeasance by these banks has brought us to the brink of fiscal disaster.  In political terms, we are manipulated by bankers just as if they are pulling our strings.

But you have to consider the benefits, as well as the costs.  Do you enjoy watching the Muppets or not?

If the Volcker Rule is implemented as planned, that would have a major negative effect on the bond yields – the spread over the "risk-free" interest rate – paid by the Muppets and other leading providers of children's entertainment.  No one else will ever trade these bonds to any significant degree – just as no one would have produced cars or planes without the dominance of big banks in those sectors.  Even the electricity you are using to read this piece was made possible by the market dominance and overbearing presence of deeply entrepreneurial and ethical entities such as Enron.

The Muppets themselves have come out strongly in favor of the financial sector as currently structured.

As Lloyd Blankfein, head of Goldman Sachs, reportedly said recently,

"It's not the dealers and it's not the investment bankers and providers that have to grapple with regulation. It's users and [puppets of all kinds] in the market that have to deal with different margin requirements…have to deal with unfortunately and inevitably higher cost in managing their portfolios…and have to pay the price for the higher cost of holding inventories."

The IMS report was paid for by Morgan Stanley (see p. 3), further evidence of smart entrepreneurial investments by big banks that support the deeper development of the economy and help create puppets everywhere.

What's Liberty Got To Do With It?

By James Kwak

Constitutional law is not my field. I think we spent one day on the Commerce Clause in my constitutional law class. I've barely been following the Supreme Court oral arguments this week because I figured (a) they would be silly, (b) we won't know anything useful until June, and (c) with the rest of the commentariat focusing on it I would have nothing to add. But even at that distance, I can't help but be shocked by the ludicrous nature of the proceedings, best represented by the framing of the case in terms of individual freedom and government coercion. According to the Times, the case may turn on Anthony Kennedy's notion of liberty.

What's wrong with this? Liberty should have nothing to do with this case. I'll repeat the analysis, made my dozens of law professors more expert than I (Charles Fried, for example). The question is whether Congress has the power to impose the individual mandate under the Commerce Clause, which gives it the power to regulate interstate commerce. If the individual mandate does in fact regulate interstate commerce, then it's fine unless it violates some other part of the Constitution.

But there's nothing in the Constitution that guarantees you "liberty" in the abstract. The Bill of Rights guarantees you various freedoms, from the freedom of speech to the freedom from unreasonable searches and seizures, but those are all specific, not general. The Ninth and Tenth Amendments don't hold up against an enumerated power of Congress. The Fourteenth Amendment provides broad protection for liberty interests, but only protects them from being infringed without due process of law. The whole liberty thing, in the context of the individual mandate, is a pure ideological framing concocted by small-government fanatics who want the Constitution to be some kind of libertarian scripture that it isn't.

When Kennedy asks, "Can you identify for us some limits on the commerce clause?" you have to wonder where he's getting this stuff. The Commerce Clause doesn't have any internal limits. The limits are in the rest of the Constitution; you couldn't pass a bill under the Commerce Clause that violated the First Amendment, for example. The Commerce Clause itself has nothing to do with balancing individual freedoms against government action. The balance is in the Constitution as a whole; you have to find some other part of the Constitution that the individual mandate violates.

It's hard to imagine that the conservative justices don't understand this—at the very least, their clerks must understand this. Which makes one believe that they've swallowed the Tea Party line completely, whether cynically (because they want to reduce the size of government for ideological reasons) or unknowingly.

The only thing that should matter in this case is whether the individual mandate regulates interstate commerce. I think it's obvious that it does. If you disagree, fine—but that's where you have to make your case. The fact that, instead, the justices are making ominous warnings about the ever-expanding reach of the federal government implies that they don't have one.

Is the GOP Still the Party of Business?

By James Kwak

Jonathan Weisman of the Times wrote an article about the reluctance of many Republicans in Congress to extend policies that are traditionally favored by big business (and the Chamber of Commerce), such as infrastructure spending and funding for the Export-Import Bank. This points to a split between the traditional corporate wing of the GOP and the newer, ultra-conservative tax revolt wing.

My guess is that this will blow over and the Republicans will figure out a way to keep big business happy without upsetting the Tea Party too much. But it points out a potential shift among the people who fund the GOP.

Historically, the Republicans were the party of business. Businesses like to make money. That can mean a lot of different things for government policy. In some cases, they want less regulation, since regulatory compliance costs money. On the other hand, large companies often want more regulation, since they can absorb the costs of compliance better than small competitors. (See The Economist on tax preparers for a recent example.) Regulation can also be a mechanism for price fixing, as with the old Interstate Commerce Commission, which functioned as a legal cartel for railroads. Businesses definitely want lower corporate tax rates, since that increases their net income. But they also like some types of government spending. Most obviously, defense contractors like lots and lots of defense spending. Less obviously, businesses have historically been major beneficiaries of free public education, since it gave them a more skilled workforce. So in general, the business community is not obviously in favor of lower taxes or lower spending.

Contrast this with the interests of billionaires. The super-rich do have a lot of wealth tied up in company stock, so to some extent they share the interests of businesses. But as rich people, they have their own interests. In this case, they unequivocally gain from lower taxes and lower government spending; they get to keep more money and they don't need government services, as individuals. Besides, once you've made your first billion, it doesn't really matter how your business does after that point.

With increasing inequality and the relaxation of contribution limits, the balance of power within the Republican Party may be shifting from big business to billionaires. As USA Today reported, 25 percent of all super PAC money in this election cycle has come from five people. Furthermore, super PACs are accelerating an ongoing trend of decreasing party control over spending. Note that while major trade organizations like the National Association of Manufacturers and the Business Roundtable favor government spending that supports businesses, the Club for Growth, an antitax organization, is against.

As I said, I think the party will figure out a way to paper over its differences ahead of the elections in November. But in the long term, how long will it be before the business community figures out that the new Republican Party has fallen into the hands of antitax, antigovernment zealots who are willing to put low personal income tax rates ahead of high corporate profits?

Insurance or Redistribution?

By James Kwak

Mark Thoma makes an important point about the "individual mandate" that applies equally well to health care and to Social Security:

"I don't see anything wrong with asking people to pay the expected value of their health care — a mandate to get insurance to cover the catastrophic things that society would cover in any case — to avoid this type of gaming of the system. Yes, it's true that many healthy people will pay, remain healthy, and seem to get nothing. But that's the wrong way to look at it. They have insurance whether they pay for it or not. Society will not let them die of a standard, treatable illness so insurance services are present. In fact, it's the knowledge that society is providing these services that motivates many people to take a chance and go without."

This is the relatively common argument that, since people already have guaranteed access to a basic level of emergency care, they should have to pay for it.

There's a slightly different point in there that I emphasized above and that I want to focus on. Health insurance, like any kind of insurance, can be framed after the fact as redistribution. You pay health insurance premiums, you stay healthy, and therefore you "lose"—your money goes to pay for other people's losses. But this is true of any kind of insurance. It's equally true of homeowner's insurance: if your house doesn't burn down, you are the victim of redistribution from you to the people whose houses do burn down.

The other way to think of insurance is, well, as insurance. We want and value insurance in the current period, before we know if we'll be "winners" or "losers" in the future period. The insurance itself has value to us. In fact, whenever you buy insurance, you are hoping that you will end up as a loser.

The framing of the health care individual mandate as a transfer from the healthy to the sick is the exact same as the framing of tax-funded social insurance programs as a transfer from the rich to the poor. At the time you enter the system, you probably don't know which category you will fall into. You might have some knowledge of the probabilities, but you could turn out to be very wrong: there are plenty of people who are healthy in their twenties but get very sick later. In either case, the framing as redistribution and the focus on winners and losers is a way of making something that all people value—protection from risk, backed by the federal government's balance sheet—seem like a from of zero-sum redistribution brokered by that evil, meddling federal government.

New "Debt for Beginners" Section

By James Kwak

I created a new "Debt for Beginners" page on the White House Burning website. It's a collection of previous articles, mainly written for a general audience, on deficits, the national debt, government spending, taxes, and the politics thereof. It's intended as a starting point for people who want to get up to speed on these issues.

Loyal readers are probably familiar with all the material already.

Why White House Burning Is Wrong, Liberal Edition

By James Kwak

Dean Baker, a leading economic commentator and author of the Beat the Press blog, has written a review of White House Burning for the Huffington Post. Baker manages the admirable feat of being gracious and complimentary while delivering several serious criticisms of the book.

I'll skip over the nice things he said and get to Baker's main objections, of which I think there are three. The first is that long-term fiscal sustainability is the wrong problem to be focused on:

 "While the solutions do not especially upset me, I do very much disagree with the diagnosis of the problem. The most immediate issue is that we have a fire at the moment in the form of too little demand leading to too much unemployment. This is wrecking the lives of millions of workers and their families.

"Johnson and Kwak understand this and certainly do not argue for deficit reduction in the short-term, but their focus on a longer-term deficit problem can be distracting from the more urgent problem."

I certainly understand this unemployment-first attitude. For many people, especially Democrats, the political story of the past two years is that all of Washington focused on deficits instead of economic growth and jobs. The villain of the story is either conservatives for insisting that deficits must be addressed now or the Obama administration for going along with them. From a policy perspective, the position of most mainstream Democratic economists is this: fix unemployment first, then deal with the national debt.

In fact, I don't disagree with this position. But I don't think this should mean that everyone should only write books about unemployment because anything else is a distraction. In fact, I think the refusal of most progressives to say anything about the national debt (other than "Yes it's a problem, but let's worry about it later") is a tactical mistake. It means that the spectrum of people talking about the national debt ranges from Tea Partiers on the right to self-proclaimed deficit hawks like the Gang of Six on the "left."

When Paul Ryan pushes some hare-brained scheme to reduce the national debt (while slashing taxes for the rich), most Democrats point out that he's a tool of the 1%—but they don't have an alternative solution to what many Americans think is a major problem. One reason we wrote White House Burning was to show that one could take the national debt seriously while defending the current role of government in society, and that it is possible to address the debt problem without huge cutbacks to programs that the middle class relies on.

To be fair, Baker's criticism is not simply that a book about the national debt is an unwelcome distraction. His next major point is that foreign purchases of dollar assets artificially increase the value of the dollar, creating a trade deficit, and so budget deficits are necessary to maintain employment:

"until we reduce the value of the dollar enough to get our trade deficit down to more normal levels, we will need large budget deficits to sustain high levels of employment. Rather than being a problem, the budget deficit is a solution to a problem created elsewhere."

I'm not about to delve into international macro late at night and with new-baby brain (that will have to wait for another post), but I'm not entirely convinced. In 1999, for example, the trade deficit was 2.8% of GDP (BEA), the federal budget surplus was 1.4% of GDP (OMB), and real GDP grew at an annual rate of 4.8% (BEA). In 2011, the trade deficit was 3.8% of GDP. I know there are many differences between 1999 and 2011. But if a large budget surplus was consistent with rapid growth and low unemployment in 1999, it doesn't seem obvious that a modestly larger trade deficit in 2011 would change that.

Baker's third major criticism is that we "misdirect readers" on health care costs.

"At the end of the day, we cannot afford to pay for a broken health care system. This is not just an issue of public finances. We can't have a health care system that costs 25-30 percent of GDP when everyone else gets comparable or better outcomes spending 10 percent of GDP.

"The projected run-up in private sector health care costs is every bit as much a cause for concern as the projected increase on the public side of the ledger."

I completely agree with everything he says about health care costs. I think Baker's criticism is that we talk about health care primarily in the context of federal health care spending instead of trying to solve the broader problem. To some extent, this is true, since we were writing a book about federal fiscal policy and the national debt, not about health care overall.

At the same time, I thought we made it clear that the health care problem goes beyond the federal government. This is from pages 132–33:

"As the largest buyer of health care in the economy, the government has some influence on overall health care prices, but that influence is limited. . . . While the cost of Medicare and Medicaid has been growing over the past few decades, the cost of health care that is not paid for by the government has been growing as fast as faster because it is subject to the same pressures: technological innovation and rising incomes. And without structural change, there is no reason to expect private health care costs to start falling. . . .

"Our health care problems are broader than our deficit problems. . . .

"The best solution would be one that reduces the long-term growth of health care costs for everyone, including the government."

Later in the book we argue that reducing health care costs will require systemwide change:

"The best way to reduce spending is probably to shift toward new health care delivery models that make providers accountable for both costs and quality; this will give them the incentive to improve coordination, apply the lessons of comparative effectiveness research, and focus on outcomes rather than simply maximizing their revenues by supplying unnecessary services" (p. 196).

There are two reasons why we focus on federal health care spending. First, as mentioned above, this is a book about federal policy, not about health care in general; I don't think we're qualified to write the latter. Second, from a public policy perspective, federal policy is one of the biggest levers available to change the behavior of the private health care system. Most providers take Medicare patients, and Medicare has been a major driver of change in the industry, for better and for worse.

The big problem we face, in my opinion, is that no one really knows how to bring health care costs under control (short of single payer, which would work but is a political non-starter). The current budget policy fad (Domenici-Rivlin, Bowles-Simpson, Ryan-Wyden, etc.) is to set an arbitrary cap on government health care spending. That, however, would simply shift costs onto individuals, which does Americans in the aggregate no good.

Our approach can be summarized as follows:

It would be great if we could figure out how to reduce health care costs across the economy. We should try to do that. But given all the health care experts out there, Simon and I aren't going to come up with a magic bullet.
So from a budget standpoint, we have to be prepared for a world in which health care costs continue to rise. To avoid simply shifting costs onto individuals, we have to find a way to pay for those costs. And we can.

Why Do New York Times Columnists Keep Swooning for Paul Ryan?

By James Kwak

After David Brooks last year, now it's James Stewart who has fallen for Paul Ryan's rugged good looks. He attempts to defend Ryan's tax proposals against charges that they favor the rich:

"To me it sounds like a proposal to raise [the wealthy's] taxes by depriving them of cherished 'loopholes,' to use the proposal's word. . . .

"There's no getting around the fact that a 25 percent rate on the top earners would nearly double Mr. Romney's effective rate and more than double it for the 101 of the top 400 taxpayers who pay less than 10 percent, assuming the loopholes are indeed closed."

Stewart is at least smart enough to realize that a 25 percent rate is only a tax increase if you eliminate preferences for investment income (capital gains and dividends, currently taxed at a maximum rate of 15 percent):

"Despite Mr. Ryan's reluctance to specify which tax preferences might have to be curtailed or eliminated, there's no mystery as to what they would have to be. Looking only at the returns of the top 400 taxpayers, the biggest loophole they exploit by far is the preferential tax rate on capital gains, carried interest and dividend income."

So give Stewart credit for knowing the basics of tax policy. But he is basically assuming that Ryan must be proposing to eliminate those preferences: "there's no mystery as to what they would have to be."

Only they aren't. Stewart quotes directly from the FY 2012 budget resolution authored by Ryan's Budget Committee. But apparently he didn't notice this passage:

"Raising taxes on capital is another idea that purports to affect the wealthy but actually hurts all participants in the economy. Mainstream economics, not to mention common sense, teaches that raising taxes on any activity generally results in less of it. Economics and common sense also teach that the size of a nation's capital stock – the pool of saved money available for investment and job creation – has an effect on employment, productivity, and wages. Tax reform should promote savings and investment because more savings and more investment mean a larger stock of capital available for job creation."

In other words, taxes on capital gains should not be increased, but if anything should be lowered.

Stewart assumes that Ryan wants to raise capital gains taxes because that's the only way to justify a 25 percent top rate as anything other than a massive giveaway to the rich. But Ryan himself has said he doesn't want to raise capital gains taxes.* It really is a massive giveaway to the rich. The reason Ryan won't specify the "loopholes" he wants to close is that he can't: if he made a list of tax expenditures to eliminate but didn't touch the preferences for investment income, it would be patently obvious that he is waging class warfare on behalf of the 1%.

Like David Brooks before him, Stewart has fallen into the trap of believing that Paul Ryan is something other than a charlatan and a political hack. There are real tax reform proposals out there, like Domenici-Rivlin, which would cut the top rate to 27% but tax capital gains as ordinary income). I don't agree with Domenici-Rivlin because I think now, with looming structural deficits ahead, is not the time to cut tax rates. (In White House Burning, we propose to reduce or eliminate preferences for investment income, mortgage interest, sales of homes, employer-provided health care, charitable contributions, state and local taxes, and state and local bonds, among others.)

But Domenici-Rivlin is at least worth discussing. Paul Ryan's "proposal" is simply a transparent assault on ordinary Americans on behalf of the rich.

* How Stewart missed this is baffling, since the passage I quote is from page 51, and Stewart quotes directly from page 50.

Last Ditch Attempt To Save A Little Bit Of Investor Protection In The United States

By Simon Johnson

As it currently stands, the "JOBS" bill now before the Senate would gut investor protection in the United States.  The title of the bill is a complete misnomer – anything that weakens investor protection makes it more risky to invest in companies and increases the cost of capital to honest entrepreneurs.  (For more background on the bill and links, see this piece.)

Much of the 1930s-era Securities legislation, which served us well for more than 70 years, is about to be repealed in a moment of bipartisan madness.

Almost all attempts to amend the House version of this legislation – and to make it more favorable to investors – have now failed in the Senate, and the "cloture motion" received more than 60 votes (so the bill cannot be filibustered).  But Senator Jack Reed (D., Rhode Island) is leading one last charge to make the Senate version more reasonable.

Here is the issue with H.R. 3606 (as the House version of the bill is known), from Senator Reed's website:

"The SEC requires public companies to disclose meaningful financial information to the public. This provides a common pool of knowledge for all investors to judge for themselves whether to buy, sell, or hold a particular security. Only through the steady flow of timely, comprehensive, and accurate public information can people make sound investment decisions. The result of this information flow is a far more active, efficient, and transparent capital market that facilitates the capital formation so important to our nation's economy. H.R. 3606 would roll back key investor protections, denying the public critical information that is essential to make sound judgments and would ultimately not lead to the proposed goal of the bill: providing for access to capital, particularly for small emerging companies."

The "JOBS" bill would permit even very large companies to avoid all public disclosures.

Amazingly, it would also exempt these companies from having to comply with the federal regulation regarding mergers and acquisition.  Private equity firms would even be able to manipulate the market while making a tender offer for shares – the kind of behavior that has really been taboo (and illegal) since the 1930s.

Senator Reed has put forward an amendment, #1931, that will at least partially retain some of our existing investor protections and disclosure requirements.

Specifically, Senator Reed's amendment would close or limit a major loophole that will allow large companies to avoid registering with the SEC (and therefore escape much regulation).  The Reed Amendment would clarify how to define "shareholders" for the purpose of determining if a business is so widely owned that it must register with the SEC.  Under the Amendment, the count should be based on beneficial owners of the shares, i.e., real people.  The goal is to prevent evasion of the SEC registration threshold through "nominal" owners holding the shares for large numbers of beneficial owners.

Big companies like H.R. 3606 – they will be regulated less and if the cost of capital rises for start-ups, that actually helps them.  The Chamber of Commerce, the American Bankers' Association, and the Independent Community Bankers of America have all weighed in heavily against the Reed Amendment – the idea of escaping SEC scrutiny greatly appeals to them.

The Chamber of Commerce's letter against the Amendment to Senators closes with this statement – or you might call it a threat (bold and underlining in the original):

"The Chamber strongly opposes this amendment and may consider including votes on, or in relation to, this amendment in our How They Voted scorecard."

Under Senate rules, the Reed Amendment would need just 51 votes today in order to pass.  But against this kind of corporate firepower, does this entirely reasonable Amendment have any chance?

"JOBS" Disaster Looms

By Simon Johnson

The House "JOBS" bill is a thinly disguised repeal of investor protection in the United States.  This legislation would help unscrupulous people in the securities industry but it would be bad for nonfinancial businesses – by raising the risks to investors, it would push up the cost of capital for honest entrepreneurs.   Investment professionals belonging to the CFA Institute have expressed their serious concerns and strong opposition.  Attempts to amend this legislation – and to make it more sensible – failed in the Senate yesterday.

The Senate will vote today on whether to adopt the main provisions of the House bill.   Passing this bill would be a major public policy mistake – akin to the disastrous (and bipartisan) deregulation of the financial sector in the 1990s.  This kind of excessive deregulation leads to disaster – and to fiscal crisis.  (For more background and the historical comparison, see this piece.)

President Obama claims he wants strong investor protection.  Where is he on the specifics of the JOBS bill?  Why is the White House staying so much on the sidelines during this critical Senate process?  The president should rally Democratic Senators against the House bill and press again for an amended and more responsible piece of legislation.

If the Republicans refuse to agree to sensible investor protections – flying in the face of American tradition and established best practice (and lessons learned the hard way in the Great Depression) – that is a great issue for the general election in November.