Friday, March 27, 2009

Latest South Park episode is on the money

Ironically, this is one of the clearest expositions of what ails the economy. The private sector -- particularly the consumer -- is overleveraged. The government has simply not been running large enough budget deficits to sustain sufficient private sector net financial wealth commensurate with the level of aggregate demand we had grown accustomed to. Aggregate demand was sustained instead through financial engineering and excessive leverage.

Now we are in the inevitable deleveraging stage, which is extremely disruptive and painful. The best and most effective way to shorten this stage is for the owner of the money printing press to fire it up and to disburse money as fast and as equitably as possible to the private sector. In the South Park episode, the owner of the printing press is Kyle with his no spending limit American Express platinum card. In the real world, it is the Federal government.

I am more optimistic about the economy in the intermediate term because of the automatic stabilizers built into the Federal budget. As the economy weakens, the budget deficit grows, and this works to correct the problem. So far, though, the government has done too little on the fiscal side. The stimulus in 2008 was done in a timely fashion, and it was the right idea, but it was far too small. The actions of the Obama administration so far have been a waste. They are more focused on seizing an opportunity to enact a long-term liberal agenda than they are in getting the economy going again.

Still, the economy will be well on its way to recovery in 12-18 months. The recovery could be faster and stronger if the right fiscal policies were enacted, but it appears we can never count on the government to do the right thing.

Thursday, March 26, 2009

Money Market Fund Regulation

There is some talk of an overhaul of the regulatory scheme for our financial system. Quite frankly, that's wholly unnecessary, and I suspect it will turn out to be counterproductive. As I will discuss in future posts, the government is primarily responsible for the unfolding economic disaster -- both because its interference in the housing market inflated the bubble and because it has failed to inject sufficient money into the private sector in a timely manner to mitigate the bubble's collapse.

The near meltdown of money market funds after Lehman's bankruptcy last September did underscore a vulnerability in this area of the market. There is only one change that is needed, however, an obvious one that addresses one of my long-term pet peeves.

Money market funds should not be allowed to fix their NAV per share at $1. The NAV per share should accurately reflect the market value of the portfolio. It's insane that it has been otherwise for as long as money funds have been existence. I suppose it is a vestige of a time when mathematicians hadn't worked out long division to more than 3 decimal places.

Using a market value NAV is important for two reasons:

First, not using a fair NAV for redemptions and purchases allows arbitrageurs to take advantage of existing shareholders. To see this, consider a sudden drop in the short-term interest rate of 200bps (this has actually happened twice in the past year). An arbitrageur can invest the next day at $1/share and earn the legacy interest rate for several weeks or months (i.e. a rate 200bps higher than the prevailing rate) at the expense of existing shareholders, who will earn less interest than they would have. The reverse works as well. An invested arbitrageur can redeem at $1/share if short-term interest rates were to rise suddenly. The arbitrageur takes his money out and earns the higher prevailing rate, once again at the expense of shareholders who will earn the lower legacy interest rate (and even less than they would have thanks to the arbitrageur).

Second, and more importantly, runs on money market funds are less likely to get started and less likely to grow. The NAV problem is one of the reasons runs start. The smartest investors see the underlying assets going down in value and take their money out while the NAV is still $1/share and the getting is good. Once a run begins, however, the fair NAV method helps to nip it in the bud. The manager of the fund starts selling assets to meet the redemption requests. This lowers the price of the assets, leading to a lower NAV per share and a higher implied fund yield. By the basic law of supply and demand, a lower price discourages current investors from redeeming and encourages new investors to purchase shares. Stability.

Unfortunately, I doubt that the Feds are going to figure this out.

Thursday, March 19, 2009

The AIG Bonus Outrage

The outrage here is that people are outraged. The government response is particularly outrageous.

I don't know the details of whether these bonuses were deserved in some moral sense, but the fact is these bonuses are contractually obligated and should be paid. If the government had a problem with paying large amounts of compensation to employees in order for them to stay and clean up the mess they created, it should have raised the issue when AIG was teetering on the edge of bankruptcy. After all, the bonuses would not be paid in the event of bankruptcy, so the government had some leverage to demand that employees take a pay cut. But it is too late for that now.

Personally, I don't even have a problem with paying smart, hard-working people a lot of money to try to mitigate the damage. It seems rational to pay them to stay if they can do a better job than their potential replacements. The fact that these same employees were responsible for losing a lot of money is irrelevant. I think the administration was getting a bad rap for this, and its initial instincts were correct.

Now, though, the administration and congress (and I include Republicans here) are acting like tyrants. It is completely unacceptable -- morally and constitutionally -- for them to try to pressure people to give up their contractual rights based on popular outrage, or worse, to pass taxes aimed at punishing them. The tax bill just passed by the House is essentially a bill of attainder, which is specifically proscribed by Article I of the constitution.

Any congressman who voted for this bill is guilty of a violation of his sacred oath to uphold and defend the constitution. We'll soon see if Obama also violates the oath he took just two short months ago.

Monday, March 16, 2009

The Employee Free Choice Act should be stopped

Once upon a time, perhaps 100 years ago, unions may have made sense. When the economy was industrialized and dominated by a handful of monopolies, when labor mobility was restricted, when communications were inefficient, labor might have been at such a large negotiating disadvantage that perhaps unions were needed to counter exploitation from the so-called "owners of capital."

But unions are an anachronism today. At any given time, even during a deep recession, there are millions of job opportunities, offered by hundreds of thousands of companies throughout the United States. Indeed, with the growth of the internet, it is possible to take a job on the other side of the country (or even outside the country) without having to move. Furthermore, the US government has zealously applied antitrust law to break up monopolies and prevent any one sector of the economy from becoming dominated by a single corporate entity.

From an economic perspective unions are bad for at least three reasons.

First, the union bureaucracy is a dead weight loss to the economy. That is, the time and effort spent operating unions, regulating them, defending them, and fighting them could be better spent producing real goods and services which improve our aggregate standard of living.

Second, unions extract higher compensation for low-productivity jobs, which (a) is an unfair transfer of wealth to union members, which inevitably comes at the expense of non-union workers in the form of uncompensated higher prices for goods and services; and (b) causes a misallocation of labor. For example, an auto worker producing $50/hour in value but being paid $45/hour will not do a different job in which he is capable of producing $60/hour in value but is paid only $40/hour.

Finally, unionized workers are not properly incentivized to work hard and do a good job because both their upside and their downside is limited. No matter how good an employee is, his compensation will be constrained by the union contract. No matter how bad an employee is, his firing will be fought by the union. In my view, the main problem we have with public education is that the powerful teachers' unions strip the teaching profession of any traces of a meritocracy.

As for the Employee Free Choice Act (EFCA), it is hard to overstate the deceit of its proponents.

Under current law, workplace union organization starts with a card check process, in which employees are asked by organizers to sign a card requesting representation by a union. If at least 30% of workers sign the cards, then the organizers can hold a secret ballot election which determines by majority vote whether or not a union will be formed. If at least 50% of workers sign the cards, the organizers generally will just present the cards to the National Labor Relations Board (NLRB) for union certification, but then the company can insist on a secret ballot election. Either way, there will almost always be a secret ballot election in which the will of the majority is expressed. If a majority votes against unionization, then a union will not be formed.

One of the changes the EFCA would make is the following: if more than 50% of the employees sign the authorization card, the union will be certified automatically. There will be no secret ballot election.

It's pretty obvious that the EFCA does the exact opposite of its name. Workers will have to decide out in the open, possibly under duress, whether or not to sign an authorization card. And if 1 out of 2 of their fellow workers sign the card, they won't be able to retract their decision to sign (i.e. their decision to support unionization publicly) in a secret ballot election.

I can't sugarcoat this. The EFCA is a desperate measure created to fight declining union membership by trying to force unionization on reluctant workers through intimidation. Its proponents who argue otherwise are malicious liars.

Monday, March 9, 2009

Paul Krugman award for Intellectual Dishonesty

Paul Krugman is a smart guy, and presumably he understands economics, having been a John Bates Clark Medal winner and a Nobel Prize winner. But he clearly lets his leftish political views shape his economic commentary.

The Economist has written the following: "... his past columns reveal[s] a growing tendency to attribute all the world's ills to George Bush ... Overall, the effect is to give lay readers the illusion that Mr. Krugman's ... personal political beliefs can somehow be derived empirically from economic theory."

If anything, this understates Krugman's bias. For shamelessly and dishonestly using his stature as a world-class economist to justify and promote his personal political beliefs, Krugman is, in my opinion, the most intellectually dishonest economic commentator alive today.

I have decided to shine some light on intellectually dishonest commentary from time to time by copying an idea that other bloggers have used, which is to offer an award dedicated to the most well-known offender.

The inaugural winner is Dorothy Brown, a professor of tax law at Emory University, for her op-ed in the NY Times today about the unfairness of the preferential tax rate on stock dividends and capital gains (p. A23 of Mar 9, 2009 print edition).

Dorothy writes nine paragraphs explaining that the tax rate on dividends and capital gains is only 15%, -- in contrast to the maximum rate of 35% on ordinary income -- and that this is some crazy aberration which benefits rich people and penalizes poor people. The reader is led to believe that there is simply no rational basis for a preferential capital gains tax rate and furthermore that there would be no negative consequences to equalizing the rate at the ordinary income tax rate.

Given that Dorothy is a professor of tax law, we can assume that she knows the real reason behind the preferential capital gains rate. To wit, the earnings on C corporations are already taxed at the corporate level (35% rate) before they are distributed. Until either the corporate level tax is repealed, a corporate tax deduction is allowed for dividends, or a tax credit (a.k.a franking credit) is passed along to stockholders, the United States will remain virtually the only country in the developed world that taxes stock investors twice. I figure the least our friendly, neighborhood tax collector can do is give a small discount when he comes around for the second time.

Ironically, the real aberration in our tax code was that stock dividends were taxed at a higher rate than capital gains, which fortunately the Bush administration remedied in 2003. The aberration was causing corporations to hoard excess cash, or at best use it for stock buybacks (which strikes me as rather inefficient and less than transparent) instead of paying it out to shareholders.

I am looking forward to Dorothy's next op-ed in which I expect she will decry the unfairness of municipal bonds. After all, the rich are paying zero tax on the interest! I'm sure that she can come up with a good solution, something along the lines of having an alternative minimum tax framework for people who have too much municipal bond interest income. Yeah, that's the ticket...

Thursday, March 5, 2009

The Economic Hole -- What's the fastest way out?

I continue to believe that the fastest and best way out of the current economic crisis is for the government to put about $1.5T into the private sector immediately.

Government spending is NOT the right way to do it. It is extremely wasteful of human and natural resources. Resource allocation (i.e. spending) by politicians, lobbyists, and government bureaucrats is an economic evil. Sometimes a necessary evil, but an evil nonetheless. If it can be avoided, it should be avoided. In this case, most economists agree the goal is to put money into the private sector. Additional government spending is not necessary to do this -- all you need are net government transfers, which can be accomplished by cutting taxes or giving people checks.

I agree with Warren Mosler ( that the most efficient way to stimulate aggregate demand is to have a wage tax holiday. I think an income tax holiday may also be necessary to get enough money into the private sector. Cutting taxes on economic activity is obviously a good thing in general because it removes impediments to economic activity. Cutting taxes on wages and income is best of all because it incentivizes that very activity (i.e. production) which makes us all wealthier (in the standard of living sense).

Democrats won't accept an income tax cut, let alone an income tax holiday. For them it is a "giveaway" to the rich, as Democrats believe in redistribution of wealth as a desirable goal. I don't agree with them, but there is no right or wrong on the issue. It is an axiomatic difference between Republicans and Democrats, and right now the Democrats are in control.

The next best thing is to give every (and I mean "every") permanent American resident a check -- a big check. A check for $5,000. Bill Gates gets a check for $5,000. So does his wife and each of his kids. The President gets a check, as well as every member of congress. The CEO of GM gets a check and the CEO of Citigroup too. But also the elementary school teacher and every one of the kids in her class. The woman on welfare who hasn't worked in 5 years gets a check. The 100 year old great, great grandmother who has been on social security for 40 years. The newborn baby of illegal immigrants, as well as every newborn in the maternity ward in the poorest hospital in Alabama. Everybody serving in the armed forces, every college student, everybody. Even members of the Al Qaeda sleeper cell who have been here 5 years and have already earned their green cards.

Democrats should love this because it is redistribution of wealth in purest form. There is no so-called "taxpayer" who is paying for this. Whether or not you paid taxes in the past has nothing to do with whether this is on balance good or bad for you personally. In theory, this is on balance bad for people who have substantial net financial wealth (which includes foreign central banks holding lots of Treasuries) and good for people who have zero or negative net financial wealth. It diminishes the value of each dollar by creating more of them. It directly stokes inflation by driving aggregate demand higher while not directly increasing the capacity of the economy to produce goods and services. In normal times, it would be unfair and perhaps destabilizing to do this.

However, the problem we have today is deleveraging, deflation and falling aggregate demand. It is a vicious cycle that weakens creditworthiness and discourages investment and consumption, leading to more deleveraging and deflation. On balance, wealthy people too will benefit from an injection of money to fight deflation, spur aggregate demand and stabilize creditworthiness.

The beautiful thing about giving money directly back to the people is that there is no waste of resources whatsoever. No politician or lobbyist is directing thousands of workers to build schools in Milwaukee which nobody will use. No government bureaucrat is going to direct thousands of workers to toil away building a zero-emissions coal plant before the technology is ready. Those resources will be available to be allocated by the private sector -- by hundreds of millions of people making billions of economic decisions each year. This sounds like a novel idea, but it is called capitalism, and it is a distinctly more efficient economic system than what the Soviet Union created in the 20th century.

You may wonder, and the talking heads on CNBC will certainly ask, "How can the government pay for this huge handout? How can the government sell enough debt? Will the Chinese keep buying it? How can our children pay it back?"

The short answer is that the government owns a dollar printing press and doesn't need to borrow money from anybody. In fact, the bonds the government issues are no more debts than the dollars in which they are denominated. Government bonds are best thought of as liquidity sponges that soak up excess dollars and create a positive interest rate floor on savings. And if the Chinese want to hold their dollars, they have a choice between interest bearing Treasuries and non-interest bearing dollars at the Federal Reserve. If they don't want to hold their dollars, then they have to sell them to somebody else who will now have them.

Wednesday, March 4, 2009

Does taxing high incomes mean taxing the rich?

Politicians (particularly Democrats) and the media talk about high income and wealth as if they were the same thing. In fact, they aren't as correlated as you might think. Many rich people have low incomes (at least low taxable income), and many high earners are not yet rich.

A reasonable definition of rich is that level of wealth where you feel comfortable enough financially to quit your job. You can provide for all of your family's needs, live comfortably, and cover plausible emergencies or catastrophic events, just from the nest egg you have accumulated and the investment returns on that nest egg.

How much do you need to be rich? Most financially savvy people who have thought about the issue think that $3MM is a bare minimum. In today's low interest rate environment, you probably need more, but let's use $3MM as our benchmark.

Obama's tax plan says that households making over $250K are rich. Well, let's take a look at a household that's well into that "rich" bracket -- a 35-year old couple where both husband and wife work and are doing very well. Combined, they make $400K per year. They recently started making that kind of money and up until the present haven't been able to save much. They used to have $150K in retirement savings, which is now down to $100K, and they used to have $100K of equity in their house, but which is now basically nothing.

They have two kids in pre-school, a $400K mortgage, two 5-yr old cars and the usual assortment of modern amenities (groceries from Whole Foods, utilities, cell phones, broadband internet, cable tv, once a week housekeeper, landscaper, once a week babysitter, 2 vacations a year, etc).

I estimate that a fairly tight family budget would total at least $100K/yr outside of mortgage interest and taxes. This includes maintenance and insurance on the house and the cars (plus depreciation on the cars since they need to be replaced every ten years). Their current taxes are as follows:

Federal Income tax: $95K
FICA tax: $20K
State Income tax: $20K
Property tax: $5K
Mortgage interest $24K

At the end of the year, they get to save about $136K, and that's by being pretty frugal. So at that rate of saving, this couple won't be rich for over 15 years (this includes investment earnings on their savings), by which time the definition of rich will have moved from $3MM to $5MM.

Don't get me wrong, this family is quite affluent. They are living in a nice house and can easily afford the basic necessities of life. Their spending each year exceeds the total annual income of the vast majority of US households. But these people have very hectic lives, do not feel financially secure, and they are very worried about losing their incomes.

It is also important to recognize that much of the spending that seems extravagant is not really discretionary, but rather necessary to support a two-earner household. Pre-school ($15/yr), babysitters ($3K/yr), housekeeping ($5K/yr), maintaining more than one car ($3K/yr) -- these are items that a one-earner family can do without. So hiking taxes on income but not allowing deductions for these types of expenses definitely penalizes two-income families.

Anyway, my overall point is that income is a poor metric to use to decide who is rich. Income, at least wage income, is a better measure for determining how productive you are, although certainly far from perfect.

I would argue even further that wealth is not the right metric to use to determine who deserves to pay more for the burden of government. If you're rich, but you don't consume, then your wealth doesn't hurt anybody. You are not hogging finite resources for your own enjoyment.

A perfect example is Warren Buffett. He is worth tens of billions of dollars, but the guy probably hasn't spent more than $10MM for himself and his family in his entire lifetime. His vast accumulation of dollars doesn't do me any harm as long as he's not going to use it to consume (i.e. spend it), thereby raising the cost of resources (human, man-made, or natural) for everybody else.

So perhaps the people who deserve to pay the most are those who consume the most. By the way, even poor people can consume quite a great deal. My guess is that the inequality in rates of consumption in the US is far smaller than it is for net worth or income. Consumption should be the true measure of an individual's burden on society and his moral responsibility to pay.

Tuesday, March 3, 2009

Earmarks -- Why are they really bad?

Obama has claimed before (and will soon claim again) that earmarks are a miniscule portion of the budget and therefore not that big an issue. But he's missing the point, probably intentionally.

The reason the earmark process is so bad is that it is a form of bribery. If congressman Blue Dog Democrat in Alabama doesn't want to go along with a 12% increase in the State Department budget or a 10% increase in Amtrak subsidies, well, maybe his vote can be bought by funding an $819K catfish genetics research project in his district. We're seeing this with the new 2009 Omnibus Budget bill. A lot of congressmen have qualms about the vastly increased spending in this bill, but the 8,500 different earmark projects (worth about $7.7B) embedded in it make its likelihood of passage very high.

Everybody knows an earmark is bad in and of itself because it is far more likely to be an inefficient allocation of money. It wouldn't be an earmark if it could survive scrutiny from the full congress, so it had to be tucked away in a bill where nobody could see it or remove it.

But the really bad thing about earmarks is never discussed. The earmark process corrupts the law-making function of congress. In essence, it is a legal form of bribery. It leads to a far less representative democracy and a far more inefficient government than we would otherwise have.

Monday, March 2, 2009

Is the Government Spending Taxpayer Money?

Who loses when the government wastes money?

Certainly not the past taxpayers or current taxpayers -- that money is a sunk cost. Maybe future taxpayers lose (nobody knows for sure who these people will be) if government officials try to remedy unhealthy deficits with future tax rate hikes.

But unhealthy deficits can instead cause future government spending and transfer payments to fall, or if government policies remain unchanged, cause the value of the dollar to drop. In the former case, beneficiaries of government spending and transfers (e.g. retired people, low-income people, or industries with powerful lobbies) will suffer. In the latter case, holders of finanical wealth in dollars will lose out. The big holders of dollar financial wealth, by the way, include large foreign holders of treasuries like foreign central banks and sovereign wealth funds.

I am not arguing that government waste doesn't have negative consequences -- it does, and waste should be avoided. But the losers include everyone except the direct beneficiaries of that waste. Past and current taxpayers do not have any special direct exposure to the negative consequences of waste, and probably not future taxpayers either. Given the tremendous political pressure not to reduce spending or to raise taxes significantly, it can be argued that the biggest direct losers of unhealthy deficits are entities with significant net wealth exposed to the value of the dollar. That is, wealthy people, who do not necessarily have a lot of taxable income, and foreign governments, who do not pay US income taxes at all. The winners are government employees, those entities with Washington connections, and people and companies which have negative financial net worth.