Wednesday, February 27, 2013

Don't Spillover On Me, Don't Tread On Me

"Things tend to work out best when people have to live with the consequences of their own behavior"

or to put it another way

"Things tend to work out poorly when the consequences of our actions spill over onto other people"

This is probably one of the most insightful statements that I have ever seen. When I first read it I copied it and put this simple principle up on the wall to be reminded of it every day.

However, as simple and obvious as it is, it is amazing how often we ignore what is really one of the most important principles of economics.

I saw this statement in a book by Steven E. Landsburg who teaches economics at the University of Rochester who goes on to say,
Whether you're blowing leaves or discarding litter, having children or having sex, saving or spending, smoking or drinking, setting fires or reporting them-your actions have costs and benefits.  As long as you feel all the costs and benefits, you'll tend to get the quantity right.  You'll drop the right number of banana peels, or have the right number of children, or choose the right number of sex partners.  But, if you feel only the benefits while someone else feels the costs, you'll tend to overindulge.  And conversely, if you feel only the costs while someone else feels the benefits, you'll underindulge.
It makes a lot of sense doesn't it?

You know how it works. When you are out to dinner with friends and you have agreed to split the check equally, do you order the $10 dessert?  Of course you do.  Your skinny friend who does not like desserts is going to pay part of your cost.  You win.  He loses.  Your friend also stops going to dinner with the group in the future.  He is tired of the decisions of others spilling over on him.

The bottom line is that spillovers cause bad outcomes.   If someone wants to pollute their own swimming pool, feel free.  However, when the sludge spills over the edge of the pool and into the community stream that we all share they should be prepared to pay for the damage.

In my view one of the big problems we have in the country today is our inability to draw the line between rights and freedoms on the one hand and consequences and costs on the other.  Where do individual rights end and where does the the public interest begin?

First, we have too often ignored the primary principle that people should have to live with the consequences of their own behavior.  You fail to take advantage of the free public education that everyone has access to in this country and can't get a job.  That's ok, we have welfare assistance.  You have a child out of wedlock.  That's ok, we will give you money to pay for the child. You buy a flat screen tv rather than health care insurance.  That's ok, just go to the emergency room and someone else will pay your medical bill.

At the same time each of these actions is spilling over onto other people who were attempting to live their life responsibly without infringing on others. The person who studied and went to school, married, had children and bought healthcare insurance rather than the flat screen tv ends up paying these bills as well as their own.

A great example involves whether someone riding on a motorcyle should be required to wear a helmet. I'm all for giving someone that freedom.  However, what happens when they are in an accident and suffer brain damage and need medical care for the next thirty years?  Who is going to pay for that?  If it is me through my health care premiums or higher taxes I don't feel quite the same about that person's individual rights and freedom as I did before.

We have been living in an era over the last generation where individualism has reigned supreme in the United States.  Respect for the individual and their rights has been preeminent over the collective good in most instances.  It has been more about ME than WE.  A good example is the recent federal court ruling enjoining Florida from requiring welfare recipients to take a drug test before they can qualify for public assistance.  The court has ruled that such a requirement in the Florida law is an "unreasonable search".  Where do these judges come up with this logic?  A similar court decision enjoined the state of Florida from using random drug testing of state employees. Bear in mind that the majority of private sector employees today cannot get a job without submitting to a pre-employment drug test.

How does any of this make sense?  In effect, we know that most of the people in the private sector are clean, drug free and paying taxes.  However, those people are not allowed to even ask whether the people they are supporting have even a chance of getting off welfare at some point in the future.  After all, if you can't pass a drug test, you most likely are not going to get a job and get off welfare since it is a condition of pre-employment with the majority of employers.

Contrast this with some of the laws in the country of Singapore.  You can be arrested for not flushing the toilet in a public rest room or spitting anywhere.  They don't want germs spreading and spilling over on other people. It is also illegal to sell chewing gum in Singapore.  Who wants to walk down the street and look at all that gum on the sidewalk because someone just threw it down with no regard to the public good? Take a look down on any sidewalk in a major city in the United States and you will see what I mean.


Where do we draw the line?  What is the proper balance between liberty and tyranny that balances individual rights and the public interest?  I think this is the major question of the next decade in this country.  It is at the core of many of our big issues today.  Gun rights.  Immigration.  Health care.  Welfare.

Our largest failing over the last half century in this country is not coupling individual rights with individual responsibility.  You simply cannot have a well functioning society where these two are not in alignment.  There have to be clear incentives for people to do the right things and even clearer disincentives to prevent people from doing the wrong things.

William Strauss and Neil Howe predict in their book, The Fourth Turning, that we are entering a new cycle in which public interest will be on the ascendancy and special interests and individualism will wane.  There will be more calls for personal responsibility and civic duty.  Conformity with core values will become more important.   Perhaps this will lead to better alignment between individual rights and responsibility.  Unfortunately, the lessons of history often tell us this only comes about when society has got its back to the wall and it does not have much choice.  You either have got to focus on WE or there will be no ME left.

In the meantime, I only ask for two things.  If you are a fellow citizen, don't spillover on me.  If you are the government, don't tread on me.  If we can get both of these right, we are all going to be ok.

Monday, February 25, 2013

Sequestration Cuts or Confusion?

It looks like we will be hearing a lot about the so-called "sequestration cuts" this week.  These are the automatic spending cuts that the Obama Administration proposed 18 months ago as a way to avoid the debt ceiling showdown of August, 2011.

The idea at that time was to put some automatic "sequestration cuts" in place, split half between Defense and Domestic Discretionary programs, and hang like a Sword of Damocles over the heads of both Republicans (Defense) and Democrats (Discretionary) so that they would find a way to compromise before the sword dropped.  We are now less than a week away from the sword doing its work and there is no compromise deal in sight.  It all sounded so good a year and a half ago!

The Obama Administration is busy claiming these cuts are going to be so disastrous and draconian that you should believe that all government will immediately cease.  Of course, the worse nightmare for Obama and the Democrats would be that the cuts went into effect and nobody noticed.  Therefore, they are sure to try to insure that any cuts will be calculated to cause as much inconvenience for the taxpayers of the country as they can.  

You will be told that your tax refund will be delayed 6 months because of a cutback in the IRS refund processing section. We will see the TSA cut back so that you have to wait an hour and a half to get through airport security.  Once you get through security you will find that your flight has been cancelled because the air traffic controllers have had their hours cut.  Your child's 8th grade Spring trip to Washington, DC will be a bust because all of the national monuments were closed.  You need to wait an hour to fill up your tank because the oil refinery inspector got laid off and that delayed the gasoline delivery to your gas station. You get the idea.

Of course, billions and billions of dollars of waste and fraud in federal spending will continue.  There will no thought to looking into those areas to find the necessary cuts.  That might involve too much work.

How big are the sequester cuts?  This chart by Dan Mitchell puts it into context.

We are talking about $45 billion this year and about $85 billion per year in subsequent years.  For 2013, this represents a little more than 1% of projected total federal spending of $3.6 trillion for the year.  In 2014 and beyond it is a reduction of about 2.4% of projected spending per year.

Since the large entitlement programs like Social Security, Medicare and Medicaid are off limits in the sequestration cuts the actual cuts to Defense and Discretionary programs are larger.  For Defense in 2014 these cuts will trim about 8% of its budget.  For Discretionary programs it is about a 5% reduction.  However, in the case of Discretionary programs, they are already up about +17% since Obama took office so a 5% reduction should be hardly noticeable in the fullness of time.

Here is another chart prepared by the Heritage Foundation that shows the same thing in a different format.

As you can see from the chart above, there is nothing about the "sequestration cuts" that is cutting anything when it comes to overall federal spending.   Even with these "cuts" we will be spending $2.4 trillion more ten years from now according to the most recent CBO projections.  Between 2013 and 2021, it is about $1.6 trillion.  You can see the projected increases in federal spending categories in the chart below that was produced by Veronique de Rugy of George Mason University.

Even with sequestration in effect, both Defense and Discretionary programs end up with just a 2% smaller increase between now and 2021 than they would otherwise have.  In other words, Defense spending will only increase 18% rather than 20% and Discretionary spending will only go up 12% versus 14%.

I think the interesting thing about how this has played out is that President Obama suggested the sequestration alternative back in 2011 because he did not believe that the Republicans would ever allow the Defense sequestration cuts to take place.  He appears to have misjudged their resolve on this issue.  His only real plan to avoid the cuts seems to be to suggest another tax increase on the rich.  However, that appears to a non-starter since he got his tax increase last month.  That puts him in a tough spot.

The only way out for Obama is to make life as difficult as possible for the American people and blame the cuts on the "unreasonable" Republicans and hope he can carry public opinion his way.  For that reason, the Republicans have to tell the real story to the public and they need to provide authority for each federal government agency for the full discretion to make the cuts as non-dispuptive as possible.  This then allows them to call each agency head before them to explain how they could not manage their budget better if we see disruptions.  Are they not effective public servants?

It will not be easy.  It never is easy when Obama has the bully pulpit and he has the mainstream media in his pocket as well.  However, if we can't take these minimal steps to get our budget under control, I am not sure anything short of an outright crisis will force any action whatsoever on our out of control spending.  That movie will probably be coming to a theatre near you at some point.  Unlike Lincoln, Argo and Zero Dark Thirty, which all showed examples of where our government worked for good, I don't think the script of that movie is going to be as positive.  That may mean it may be a while before we see another Oscar presented at The White House.

Sunday, February 24, 2013

Living In And Leaving A Death Spiral State

Do you live in a death spiral state?  I do.

This was not good news to me but I can't say it was completely surprising.  Ohio has lost a lot of its traditional manufacturing base over the years.  It still is a state where there is a significant union presence.  Public sector unions are strong.  Government benefits are rich.  Public pension funds are underfunded.  The state voted for President Obama in the last two Presidential elections.

William Baldwin of Forbes magazine wrote an article late ast year where he identified eleven states that he considered to be "death spiral" states that were dangerous for investors who might be considering starting a business, buying a house or purchasing a municipal or state bond.

He based his list on a simple formula that took into account the ratio of takers compared to makers in the state.  In other words, the number of individuals in the state who were receiving some form of government benefits (as an employee, government pension or welfare recipient), "takers", compared to the number employed in the private sector, "makers".

To arrive at the number of takers, Baldwin used the number of individuals on Medicaid as a proxy for those on welfare, the number of total state and local employees for government employees and calculated the pension number as being 1 for every $100,000 of unfunded pension liabilities (this seems fair as if the pension is unfunded it will need to be covered by future taxpayers.  Funded pension assets should have no effect on taxpayers as the assets are in place to support the pension promise).

To arrive at the makers, he simply used the number of persons employed in the private sector.  After all,       the bill for any payments any government entity pays (worker, pensioner, welfare recipient) must be paid by someone.  And all that money ultimately must come from the private sector because government does not create anything.  It merely is a transfer agent or middleman.

The death spiral is so-named because as the number of takers increases in a state the more pressure it puts on the remaining makers.  Baldwin puts it this way.

Let us give those takers the benefit of our sympathy and assume that every single one of them is a deserving soul. This person is either genuinely needy or a dedicated public servant or the recipient of a well-earned pension.

But what happens when these needy types outnumber the providers? Taxes get too high. Prosperous citizens decamp. Employers decamp. That just makes matters worse for the taxpayers left behind.
Let’s say you are a software entrepreneur with 100 on your payroll. If you stay in San Francisco, your crew will support 139 takers. In Texas, they would support only 82. Austin looks very attractive.

I saw this first-hand a couple of weeks when I was in Austin, Texas for an investment symposium.  The  firm that sponsored the event used to be headquartered in Santa Monica, California.  It moved its offices to Austin several years ago and with it they took several hundred high paying jobs (and taxpayers) to Texas.   Good for Texas.  Bad for California.  And especially bad for the taxpayers left in California.  How long do they keep paying the bills before they also decide to move?

That is how the death spiral works.  Every spiral down creates another spiral down.  At some point you reach the point of no return.

Here are the 11 death spiral states according to Baldwin along with the Taker Ratio (the number of takers compared the the number of makers).

The five strongest states, in descending order, are North Dakota, Nebraska, Utah, South Dakota and Virginia.

What if you live in a death spiral state and you think about leaving to avoid the future tax bill?

Have you ever heard of an exit tax?

I was a tax attorney and CPA for a number of years and I must admit I never had heard about an exit tax until I saw this article in Real Clear Markets.  However, the determination and creativity of a government entity to find ways to raise revenues should never be underestimated.  Insatiable appetites require an infinite aptitude in separating taxpayers from their money.

What is an exit tax?  It is a tax imposed on a citizen who chooses to leave the jurisdiction of a government entity.
Exit taxes imposed on emigrants have a long history, including their use in both Nazi Germany and the Soviet Union. They were imposed under the theory that, since citizens were educated by the government and were either provided benefits or allowed to profit from jobs and business held while living under the government's protection, they were obligated to pay back some of that money on their way out.
Sounds like something only a Hitler or Stalin would love? If only. Try surrendering your U.S. citizenship and moving to another country. Thanks to a series of expatriation tax laws passed by Congress dating back to the 1960s, with the most recent revision sponsored by Rep. Charles Rangel (D-N.Y.) (no stranger to tax evasion himself), emigrants leaving the U.S. must pay capital gains tax, including on unrealized gains, across all their holdings marked to market as of the day of departure. In addition, expats are liable for gift taxes on amounts above $12,000 a year given to anyone in the U.S., for the rest of their lives, even though they are no longer citizens themselves.
To date, the Supreme Court has had no problem with any of these laws. So what is to stop, say, California from imposing exit taxes on the steady stream of citizens heading off for Texas, Arizona, and Nevada? More than 200,000 people flee the Golden State every year, taking their money with them while leaving behind their share of the state's $617 billion in state debt, which comes to about $16,000 per resident. That's $3.2 billion a year in tax evasion!
I would be especially be mindful of exiting stage left in a state with leftist politicians at some point in the future.  That is not to say that exiting stage right might be any better.  When a politician runs out of money they run out of power.  It does not matter what party they are in.  You never want to be the person between the government and its appetite for spending.  It would be better to be between a piece of red meat and a grizzly coming out of a long hibernation.

Tuesday, February 19, 2013

Fighting Wars on Two Fronts

In World War II, we fought a two-front war in both Europe and the Pacific. The War on Terror saw us fighting on two fronts-in Iraq and Afghanistan. Looking at the latest news we seem to find ourselves in another two front war that involves both cyber warfare and a currency war.

A report released today indicates that China's government has been systematically involved in cyberwarfare against American interests according to this story in the International Business Times.

China’s government is behind a vast, sophisticated campaign of cyberwarfare, according to private U.S. investigators and confirmed by Washington, a report published on Tuesday said.

U.S. security firm Mandiant, which was hired by the New York Times to investigate breaches of its own security, provided an advance copy of the 60-page report to the newspaper. The report describes how the People’s Liberation Army launches attacks against American companies, organizations and government agencies from or near a 12-story building on the outskirts of Shanghai.
The group behind the attacks is P.L.A. Unit 61398, whose main office is on Datong Road, outside Shanghai, but victims of its attacks call the unit the “Comment Crew” of “Shanghai Group,” the New York Times said.
Targets of Unit 61398 include agencies and companies whose databases contain vast and detailed information about critical U.S. infrastructure, including pipelines, power generation facilities and transmission lines.
The Obama Administration is supposed to unveil some type of actions and defenses against this activity  tomorrow.  In my view, it is time to get really tough with the Chinese especially if it is proven this is the work of the Chinese government.  What would our reaction be to a physical attack on our pipelines or power grid by the Chinese?   We might even have to tell them that we won't let them loan us any more money!  Therein, lies the problem.  We have let us ourselves become dangerously dependent on Chinese goods, money and materials.  In Proverbs 22:7 it is stated this way,

"The rich rule over the poor, and the borrower is servant to the lender."

The second war front appears to be going on with currencies.  There seems to be a determined effort by many of the world's governments to debase their currencies.  Those that attempt to weaken their currency think that by doing so they will increase their country's competitiveness in the world marketplace. They think that be debasing their currency that they will boost exports, create jobs and boost company profits.

However, like most things that government does, such a strategy is extremely short-sighted. It may provide a temporary benefit but it rarely will benefit the country over the long-term.

I had the good fortune to spend a day with Arthur Laffer 30 years ago. Laffer was the economist who was known for the "Laffer Curve" and was considered by many to be the intellectual force behind Reagonomics in the 1980's.  In the period between 1980-1985 the U.S. dollar was very strong relative to other currencies and there were many who decried its advance and argued that government policies should be taken to weaken it.  I remember Laffer telling me, "Why would anyone want to be weaker rather than stronger?  A strong dollar provides enormous benefits to Americans.  You can buy more.  You can travel more cheaply.  You have greater incentives for productivity and innovation."  I have always remembered that thinking whenever I hear about the "advantages" of weakening our currency.

Axel Merk of Merk Investments reminded me of my conversation with Laffer in a recent article he wrote entitled "Currency Wars Are Evil".   Merk does not mince any words right at the top of the article.

Real people may die when countries engage in “currency wars.” Countries debasing their currencies risk, amongst others:
  • Loss of competitiveness
  • Social unrest
  • War

A few of Merk's comments on each of these points.

Loss of Competitiveness
Importantly, when a country subsidizes one’s exports with an artificially weak currency, businesses lack an incentive to innovate. Japan is the best example: Japan’s problem is not that of a strong currency, but a lack of innovation. By weakening the yen, companies are given a free ride, taking an incentive away to engage in reform. Advanced economies, in our humble opinion, cannot compete on price, but must compete on value. European companies have long learned this, as there are rather few low-end consumer goods being exported from Germany. The Chinese have also heeded this lesson, allowing low-end industries to fail and relocate to Vietnam or other lower cost countries: China is rapidly moving up the value chain in goods and services produced. Incidentally, Vietnam has repeatedly engaged in currency devaluation, as the country mostly competes on price; in the absence of a strong consumer recovery in the U.S., we see further currency debasements in Vietnam.

In summary, market pressure to innovate is the most powerful motivation. Governments subsidizing ailing industries through currency debasement do long-term harm to their economies.

Social Unrest 
Currency debasement is not just bad for the corporate world: it’s particularly painful for citizens. Just ask citizens of Venezuela where the government just announced a 32 percent devaluation in the bolĂ­var’s official exchange rate to the dollar. An overnight move of that magnitude is immediately noticeable, as are the negative effects on consumers, whereas gradual debasement in currencies of advanced economies are less noticeable, but ultimately have the same effect. The natural consequence of currency debasement is inflation, i.e., loss of real purchasing power; the two forces meet at the gas pump: as a currency loses value, commodities – all else equal – become pricier when valued in that currency.
Stagnant real wages in the U.S. over the past decade may in large part be attributed to the gradual debasement of the greenback, courtesy of fiscal and monetary policy. Folks whose real wages didn’t go anywhere for a decade feel cheated and are more likely to vote for populist politicians promising change. Currency debasement fosters growing income and wealth inequality and diverging political reactions, e.g., the Tea Party movement on the political right and the Occupy WallStreet movement on the political left. The rise of populism can be seen in the rise of Twitter: we sometimes quip that politicians that can distill their political message into a tweet have a better chance of being elected these days. Except that we are wrong: it’s not a joke.
In the Middle East, similar trends cause revolutions. People can be suppressed for a long time, but if they can’t feed themselves, they revolt. In the U.S., we are told food and energy are to be excluded from measuring inflation, as our economy is less and less dependent on food and energy (although curious that a record number of Americans used food stamps last year). However, in countries where large segments of the population cannot earn enough to feed themselves, currency debasement contributes to revolutions, not just the rise of populism.
When told by Fed Chairman Bernanke that the gold standard prolonged the Great Depression, many feel as if monetary activism were a blessing rather than a curse. In our assessment, Ivory Tower economists are particularly apt at confusing cause and effect. The root causes of a depression are excessive debt, not currencies that are too strong. Currency debasement and expansionary monetary policies are attempts to socialize such debt, bailing out those that have taken on irresponsible debt burdens. But because governments tend to be in the group of those taking on excessive debt burdens, we are made to believe that such policy is for the greater good.
We respectfully disagree: currency wars destroy wealth. Currency wars have a disproportionate impact on the poor, as they don’t hold assets whose value is inflated in nominal terms and that could buffer some of the fallout. Central banks don’t cause real wars. But monetary policy has a profound impact on the social fabric. Abstract theories about how aggressive monetary action are the remedy to depressions ignores the heavy social toll currency wars have on people. For those that argue that the social toll of a depression is greater, we respond that the best short-term policy to address economic ills is a good long-term policy. We cannot see how currency wars can be good long-term policy.
We often hear from "noted" economists like Paul Krugman that debt does not matter.  I have not won a Nobel Prize in Economics like Krugman or a Nobel Prize in Peace like Obama.  However, what I know about economics tells me that debt does matter.  It has to be repaid at some point.  And compound interest is a killer in the interim.  If it is not paid, it still carries a cost-to the borrower who bears the loss of default. A price will be paid by someone.

I also know something about peace.  And there will be no peace of mind for anyone if there are currency and cyber wars going on around us.  Perhaps President Obama can really do something to earn a Nobel Peace Prize the next time by getting our economic house in order.  How about starting by seeing if he can find somewhere to shave a few dollars off of our budget deficit without it being considered a national calamity?  And doing it without raising taxes! And reaching across the aisle and working with Republicans!  I think that just might earn him another trip to Oslo.

Sunday, February 17, 2013

It's All About Growth

I attended an investment symposium a couple of weeks ago and had the opportunity to see several of the leading academics in the field of economics and finance.  The speakers included Robert Merton, Professor of Finance at MIT and winner of the 1997 Nobel Prize in Economics and Eugene Fama, Professor of Finance at the University of Chicago.

Another speaker at the seminar that I was not familiar with before the event was Kevin Murphy who is a Professor of Economics at the University of Chicago.  Murphy puts most of his focus on microeconomics doing research in the areas of economic growth, unemployment, relative wages and  medical research.  His speech at the conference was "Investments in People: Education, Health and Growth.

I am a chart guy and I thought several charts in his speech were very interesting and insightful as were his comments on what are the necessary elements for a growing economy in the future.

The first is a chart of the growth in real U.S. per capita GDP.  The red line indicates the growth trend over the years 1889-2012 and the blue line is actual growth.

As you can see, over the last 100+ years we have enjoyed an inexorable increase in our GDP and wealth.  This growth has given us a standard of living that is the envy of the world.

What is fascinating in looking at this visual is even though we hear so much about our recent economic downturn it barely shows up as a blip on the chart.  Compare the current downturn with the 1930's.

The challenge for the future is to keep the blue line moving onwards and upwards with the red line.  If we do that we will continue to prosper.  If we fail to do that, we have a lot of trouble ahead.

Murphy stated that improvements in life expectancy have contributed about as much overall to our overall welfare as as have improvements in our material wealth.  In fact, improvements in longevity from 1970 to 2000 were worth roughly an extra $95 trillion (or $3.2 trillion per year) to U.S. citizens.  That is why health is such an important factor in our growth and is really an investment in human capital over the long term.

Murphy displayed the cumulative value of longevity gains since 1900 in this chart.

You might ask what happened in 1918-1919 to set us back so far?  Those were the years of the so-called Spanish Flu pandemic that claimed over 500,000 lives in the United States most of which were healthy, young adults.  Worldwide the flu killed 50-100 million.  The cost of these deaths carried a very high economic cost. Who knows what might have been produced or invented by this young talent over their lifetimes?   There is no greater loss than that of unrealized potential.

The deaths from this pandemic are also a cautionary tale for the future.  Are prepared for dealing with something like this again?  It is something we need to be planning for.

So how do we keep growing our economy?  Murphy points to three primary sources for increased productivity and wealth.

  • Investment in physical capital
  • Investment in human capital
  • Improvement in technology (knowledge)
Productivity grows as new technologies are introduced and widely adopted.  This is not limited to just high tech.  The same applies for manufacturing, agriculture, rail transportation etc.

However, new technologies will inevitably displace low skilled workers, require higher skilled workers and require increased and new varieties of physical capital.  Continued progress depends on getting a balance of all three inputs: technology, physical capital and human capital.

Murphy spent most of the time in his speech focusing on the effects of how the growth in technology has played out in the labor market.  The increasing demand for highly skilled workers has resulted in an increasing wage premium for college graduates over the last 40 years.  This trend is even more pronounced for graduate school degrees.

The reality of the situation is that real incomes for those with high school education and below have been essentially flat in real terms for a number of years. This has resulted in a disproportionate amount of the wealth produced by the productivity gains going to the higher educated and skilled in the workforce.  

These trends can be seen in this chart of the overall rise in wage inequality for men where those in the 90th percentile (the top 10% of wage earners) have seen increasing wage growth that began in the early 1980's (introduction of the personal computer) and accelerated in the mid-1990's (internet revolution).

From these charts you can also see the effects of supply and demand on the labor market.  During the late 1960's and early 1970's college enrollments rose substantially with the first wave of Baby Boomers going to college.  The result was a tremendous increase in the supply of those that were college-educated that actually depressed relative wages for those with college degrees.  This began to change in the early 1980's with technology advancements. 

I have written before about how I believe technology has had a big impact on the growth of income inequality.  This is what I wrote almost one year ago in my post "1% + 99% Should Be Greater Than 100%".

The technology industry began to take off in the mid-1980's.  We entered the information age from a manufacturing age.  Manufacturing spreads income in a much broader swath in an economy.  You need to pay a lot of workers to build an automobile.  You only need a couple of computer programmers to develop a video game that might sell millions.  For example, the Call of Duty: Modern Warfare 3 game that was released last year grossed $1 billion in the first 16 days it was for sale. 
No where was this more apparent in the last year than the Instagram story in which a 20-something age kid and 12 others developed a photo sharing program that netted them over $1 billion when Facebook bought them out 18 months after it was developed.  I wrote about this as well in this post last April.

The Instagram story underscores the point.  In the manufacturing age you would need millions of invested capital in plant and equipment and thousands of workers to build a business worth $1 billion.  It is unlikely that it could be done in 18 months no matter what the resources were.  There is little doubt the world has changed.
Two final charts in the Murphy presentation show education premiums by gender and race.  In case you are wondering, supply and demand also does matter here.  Women and blacks with college degrees both do better than whites compared to their non-college counterparts when it comes to relative wages.

What should our primary policy goals be to insure that growth continues according to Murphy?

  • We must maintain the incentive for physical investment
  • We must provide an environment that fosters that growth of human capital
  • We must provide rewards to innovation
I hope President Obama is paying attention and our policymakers are paying attention.  We are not going to continue to prosper by penalizing and punishing those who have succeeded.  We need these people to innovate and invest.  We need to continue to make the pie bigger and see that more people have the skills needed to compete in the 21st Century workplace.  

We need to get more people interested in their own personal growth if we are to get future growth in our economy.  That will not happen if  40% of those entering high school do not graduate and men make up less than 40% of recent college graduates.  These should both be national priorities as should passing an immigration reform policy that allows more highly educated immigrants with technical talents in science, technology, engineering and math to get expedited paths to work in this country and become citizens.

Wednesday, February 13, 2013

Obama Dissonance

Cognitive dissonance is the term used in psychology to describe the conflict that exists when there is discrepancy between the beliefs and behaviors of an individual.  Many times the discrepancies seem to be driven by the differences in our brains.  Our brains operate in two spheres-an emotional or reflexive mode and an analytical or reflective mode.

Most decisions are made reflexively as this is the part of the brain that insures survival.  It is focused more on the here and now without careful thinking and analysis.  After all, if a wild boar started chasing your ancestor as he left his cave in the morning, he didn't stop and analyze the situation before starting to run for the nearest tree.  This is reflexive thinking.  There just wasn't a whole lot of reflective thinking done in those caveman days when surviving each day was a major accomplishment.  Your ancestor may have thought he needed to plan for winter by storing up food but it you are hungry right now it is unlikely you are going to let that reflective thought get in the way of tonight's meal.

We see cognitive dissonance all of the time.  The middle age man who knows he needs to save for retirement but spends all his savings on a new big screen tv.  The high school girl who needs to lose twenty pounds before the prom but eats ice cream every night.  The college guy who needs a good grade on his final in psychology to avoid flunking out but goes drinking with his buddies instead.  The woman who says it is important to her to be financially secure but who keeps dating men who are all financial losers.  You get the idea.  It really amounts to a disconnect between belief and behavior.  Knowing what you should do but doing the opposite.

All of this struck a chord with me over the last few days as I watched the State of the Union address last  night and saw several other articles about President Obama in the news.  If there was ever a case of cognitive dissonance, it is readily apparent in looking at the American people's attitudes regarding President Obama.

A few examples.

These are President Obama's job approval ratings on nine key national issues according to a recent Gallup poll .  He is below 50% approval on eight of the nine issues.  60% disapprove of his handling of the economy.  He only has a 31% approval rating on the federal budget deficit.

However, the Gallup survey points to a World Affairs poll conducted in the same timeframe that shows President Obama's overall job approval to be 51%.  How can this be?  I call this Obama Dissonance.  In your head you know he is wrong.  However, in your heart, you just want to believe he is right.

Another example is this article in that profiles the dire warnings of Boston University economics professor Laurence Kotlikoff on the urgent need for entitlement reform.  (Note: the emphasis below are mine).

Social Security and Medicare are bankrupting the economy, and the payroll tax needs to be raised four percentage points to keep Social Security solvent, says Boston University economics professor and author Laurence Kotlikoff. 
“The entire country is probably broke,” he tells Newsmax TV in an exclusive interview. “It’s in much worse long-term fiscal shape than any politician is revealing to the public. I’m not even sure they understand the truth. Certainly the president doesn’t sound like he understands.”
Social Security is 31 percent underfinanced, and Medicare “by itself can probably run the country broke,” Kotlikoff says.
 “Generationally this is a zero-sum game,” he says. The president doesn’t seem to understand that.”
Asked his reaction to President Barack Obama’s opposition to an increase in the Medicare eligibility age, Kotlikoff says, I think he’s a person who doesn’t care about the future of the country.”

It sounds as if Professor Kotlikoff has really thought this through with very precise analytical reasoning.  As I am reading this I am wondering how the good Professor voted in last November's election.  After all, he lives right in Mitt Romney's neighborhood.  What do I find but another case of Obama Dissonance as I read on.

Kotlikoff hastens to add that he voted for Obama. But, “I can’t think a responsible adult who gives a damn about his children would look at this situation and come up with that kind of a statement,” he says.
He voted for Obama and yet this is the way he thinks?  It gets even better.

So what happens if we continue to do nothing about these problems?
As the budget deficit remains huge and the Federal Reserve keeps printing money, inflation “takes off,” Kotlikoff says. China and others sell our bonds, and interest rates go up.
“Then we become like Greece,” he says. “We have to cut benefits or raise taxes dramatically.” 
And it’s young people who will suffer the worst of that, Kotlikoff says. “This is fiscal child abuse. The president is the country’s leading fiscal child abuser."
That's right, Professor Kotlikoff admits that he voted for the country's leading fiscal child abuser.  What is he thinking?  He is thinking right.  However, his behavior belies his beliefs.

The final example occurred during last night's State of the Union address that I watched on the Fox News Channel.  Fox partnered with Bing to develop a pulse poll to monitor real-time reactions to the President's speech.  It allowed viewers to register their approval of the speech second-by-second from a positive score of +100 to a negative score of -100.  A neutral score would be 0.  Obama's overall score for the entire speech was -54 out of 12.9 million votes cast when I checked the results on Bing last night.

I watched the entire speech and I only saw the pulse line hit 0 once all night.  That is when he spoke about bringing the troops. When he spoke about climate change legislation and gun control legislation, the pulse line almost hit the -100 bottom.  This clearly could be a skewed sample as the people participating in the pulse pol most likely had smartphones, iPads and other devices fired up at the same time they were watching the SOTU.  However, I think it is instructive nevertheless.

I also found it interesting that when I went back to pull the data in writing this post that the overall score of -54 was no longer on that site.  The graphs shown above were also altered to make it appear that "Positive" above was a Score of 100 when in reality it is a "Neutral".   In effect, the graphs above are just showing various shades of negative.  I guess it might have been a little too much for the Microsoft staff in Bellevue to realize that there were no positives when people were viewing President Obama second-by-second.  Yet another example of Obama Dissonance.

What does this all mean?  It simply means that most human beings are driven more by style than substance.  Cool over competent.  Today over tomorrow.  Heart over head.  Easy over hard.

However, style changes, cool turns cold, tomorrow does comes and you need to start using your head to survive.  Hard today will look easy tomorrow when that day comes.  We all need to start reflecting on that.  It is time to start overcoming Obama Dissonance before it is too late.

Monday, February 4, 2013

Yen and Yield

Two trends have been occurring in the last three months that have not gotten a lot of attention by the popular press but you need to be aware of to protect your investment portfolio.

First, the yield on 30-Year Treasury Bonds has increased from 2.72% shortly after the November election to 3.21% on Friday.

Second, the Japanese yen has lost substantial value against the US Dollar over the same period.  In November, a dollar would get you 79 yen.  As of Friday, it provides you with almost 93 yen-that is a 18% decrease in the value of the yen in just three months.  The loss compared to the Euro has been even larger-about 20%.

Let's consider the practical implications of this currency movement as viewed by Bruce Krasting.  Krasting points out that three months ago if you were comparing a Lexus LS 460 and an Audi A8 they both would have set you back about 80k.

Three months ago... the relative value of these cars was equal. If you assume that 80% of the cost of the car was the imported value, then you were “paying” 50,394 Euros for the Audi and 5,120,000 Yen for the Lexus. At the exchange rates in early November, the Euro component of the Audi was $64,000 (80,000 X 80% X EURUSD 1.27). The Yen cost was also $64,000 (80,000 X 80% /80.00). The EURJPY exchange rate was 102. 
Today the EURJPY FX rate is 1.2650. The dollar cost of those Euros and Yen have changed substantially. $68,900 is now the Euro component of the Audi (+3,900). The dollar cost of the imported Lexus has fallen to $55,350 (-$8,649). Looking at just the FX rate changes, the cost of the Lexus is down to $71,350, the Audi is up to $84,910. In three months there is a $13,560 price gap. Now which one do you choose?
I bring this up to make the point about how very rapidly the terms of trade have turned against Germany (all of the EU) and in favor of Japan.
Of course, the sticker price on the Lexus will not change immediately, but you can see where this is going.  And it is not good for the Europeans who are already struggling to get their economy going.

However, Krasting also sees potential trouble in the equity markets as a result of this foreign exchange volatility.

What we are witnessing is Yen weakness (yes, coupled with Euro strength vs the $). The rate of change has been very substantial, arguably, this is the most volatile period in FX over the past 15 years.
Compare the prior periods of FX upheaval to today. In many ways, what has happened of late with the Yen versus the major currencies is unique to history. What is also amazing (to me) is that this FX violence is happening at a time when equity markets are soaring.
From 1999 – 2003 NASDAQ fell 70%, the S&P got clipped for 40%. 2008 – 2009 was a horror show. Today, the equity markets are thriving on the FX instability.
Are we in one of those “New Paradigm” things with markets again? A financial world that can go through a very turbulent period in FX, while there is no fallout anywhere else?

Let's return to the increasing yield on the long bond.

3.21% is still an incredibly miniscule yield for loaning anybody money for 30 years.  Consider the fact that the average 30-year yield since the Treasury started issuing these bonds in 1977 has been 7.25%.

Increasing interest rates have historically not been favorable for equity returns. This is due to the fact that the bond market is much, much bigger than equity markets.  It is usually at least four times the size of the equity markets globally. Therefore, as the yield on bonds goes up, it results in bonds attracting capital away from stocks.  Conversely, as interest rates fall, equities become relatively more attractive to investors.

The charts below give you a perspective on the relative sizes of the equity and bond markets and how they have grown over time.  Due to the size difference it does not take a lot of movement in or out of the bond markets to have a significant impact on flows in and out of the equity markets.

Source: QVM Group, Inc as of August, 2011

Considering all of the above raises questions in my mind about the sustainability of the S&P 500 rally that has seen stock prices rise 12% over the last three months.  Looking at history, you would not expect to see equity prices increasing in a time of foreign currency volatility and rising interest rates.

Has the world changed such that trends like this don't matter any more?  We are in uncharted waters but I would be surprised if the financial currents are not just as strong as they have ever been in situations like this.  My advice is to keep your hands firmly on the wheel guiding your wealth.  As always, be more focused on the return of your capital than the return on your capital.