Friday, November 30, 2012

Buffett Math

Warren Buffett, New York Times on November 25th 2012:
Suppose that an investor you admire and trust comes to you with an investment idea. “This is a good one,” he says enthusiastically. “I’m in it, and I think you should be, too.”

Would your reply possibly be this? “Well, it all depends on what my tax rate will be on the gain you’re saying we’re going to make. If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1 percent.” Only in Grover Norquist’s imagination does such a response exist.
MBA final exam question: Explain the mistake in this paragraph.

How do we decide whether to invest in a project?  Discounted cash flow.

For example, suppose you’re thinking of building a factory (or starting a business). Once built, your best guess is that the factory will produce $10 profit every year. Discounting at a 5% required return, typical of stock market investments, the value of that profit stream is 1/.05=20 times the yearly profit, or $200. If the factory costs $150 to build, it’s a good deal and will return more than its costs. You build it. If the factory costs $250 to build, you walk away.

Did you forget to put in after-tax cash flows? Whoops, that's a B- now at best. For example, if the tax rate is 50%, then your after-tax profits are only $5 each year. Now the value of the profit stream is only $100. The factory still costs $150 to build however, so now you’d be a fool to do it. It truly is better to leave your money in the bank earning a quarter of a percent.

Mr. Buffett made an elementary accounting mistake. How did he get it wrong? Implicitly, he is thinking that he pays $100, then gets back $100 for sure, and only the profit is taxed. He's thinking that a 5% rate of return gets cut to 2.5%, which is still better than 0.025%. But when you build a factory or start a business, you are not guaranteed return of principal. You only get the profits, if any. If the government taxes half the profits, that’s like taking half the initial investment away.

This is perhaps an understandable mistake for a financial investor such as Mr. Buffett. In my example, the market value of the factory was $200, and falls to $100 when the tax is imposed. Mr. Buffett doesn't build factories or start businesses, he buys them.  Now, Mr. Buffett -- ever the "value" investor -- can swoop in, buy the factory for $100, and a $5 per year after-tax cashflow generates the same 5% rate of return. But nobody will build new factories, and that’s the economic damage.

Ok, now you get an A. Let's go for the A+.

Mr Buffett ignored risk. If somebody offers you a 5% rate of return, risk free, when Treasury bills offer you a quarter of 1 percent, his name is Madoff, not Buffett-Buddy.

Mr. Buffett wants you to think his investments are arbitrage opportunities, and a 2.5% arbitrage is as attractive as a 5% arbitrage. That's false. Investments involve bearing risk, and taxes make those investments directly worse.

Now, the effect of taxes here is subtle. Yes, a 50% tax rate cuts a 5% expected return down to 2.5%. But it also cuts volatility too. Isn't this just like deleveraging? Answer: no, because unless you're investing in green energy boodoggles only available to Administration cronies, the government takes your profits, but does not reimburse your losses.

If the investment makes 10%, you get 5%. If it makes 5%, you get 2.5%. But if it loses 10%, you lose 10%. It's a strictly worse investment when taxed. (Yes, you might be able to sell the losses if the IRS doesn't notice what you're up to... but now you know why Buffett is a "master of tax avoidance.")

And there is always another margin: If rates of return on investment look lousy, just stop investing at all and go on a consumption binge. The estate tax is a big subsidy to the round-the-world cruise and private jet industries. 

I am really amazed by how this argument has evolved. Only a few months ago, supporters of the Administration's plans for higher tax rates admitted the plain fact that higher tax rates on investment are bad for growth. But, they argued that higher taxes would be good for other goals, like "fairness," redistribution, or winning elections important for other policies they like such as ACA. (These taxes are not going to put a dent in the deficit.)  And we had a sensible argument about how bad the growth effects would be, and how long it would take for them to kick in.

Now they're trying to argue that taxes aren't bad for the economy at all.  Some are suggesting higher investment tax rates are actually good for the economy.  All in the face of the natural experiment playing out in front of us across the Atlantic. The contortions needed to make this argument are just embarrassing. As above.

It seems clear to me that the Administration wants to raise the tax rate on high income people for political reasons, whether or not they raise tax revenues from such people; witness the deafening silence about reforming the chaotic tax code. The Buffetts of the world who can exploit the loopholes in the tax code and lobby for more will do fine in the new world. But they shouldn't stoop to such obvious silliness to try to fool the rest of us that pain don't hurt.

(Thanks to Cliff Asness who brought this to my attention and suggested some of the arguments.)

Thursday, November 29, 2012

Truth stranger than fiction?

From the New York Times. I checked, it really is not from the Onion
WASHINGTON — House Republicans said on Thursday that Treasury Secretary Timothy F. Geithner presented the House speaker, John A. Boehner, a detailed proposal to avert the year-end fiscal crisis with $1.6 trillion in tax increases over 10 years, an immediate new round of stimulus spending, home mortgage refinancing and a permanent end to Congressional control over statutory borrowing limits.

...In exchange for locking in the $1.6 trillion in added revenues, President Obama embraced $400 billion in savings from Medicare and other entitlements, to be worked out next year, with no guarantees.

The upfront tax increases in the proposal go beyond what Senate Democrats were able to pass earlier this year. Tax rates would go up for higher-income earners, as in the Senate bill, but Mr. Obama wants their dividends to be taxed as ordinary income, something the Senate did not approve. He also wants the estate tax to be levied at 45 percent on inheritances over $3.5 million, a step several Democratic senators balked at. The Senate bill made no changes to the estate tax, which currently taxes inheritances over $5 million at 35 percent.
Meanwhile, Costco is in the news, for borrowing $3 billion dollars, and paying it out as a special dividend before dividend taxes rise.  Stock rose 6%. Tax arbitrage is so cool.

Wednesday, November 28, 2012

Experimental evidence on the effect of taxes

Much of our "fiscal cliff" debate revolves around the incentive effects of raising marginal taxes on high incomes. High tax advocates used to say that taxes won't hurt growth that much, and advocated them for other reasons.  Now they are advocating that even a 91% federal income tax rate, on top of state, sales, etc, as we had in the 1950s, (not counting all the loopholes!) will actually be good for the economy and also raise lots of revenue.

This seems to me like magical thinking, and a great testament to how people can persuade themselves of anything if it suits the partisan passion of the moment.  But wouldn't it be nice if someone would run an experiment for us?

Fortunately, Europe has been running a very useful set of experiments on what happens if you address yawning deficits with high income, wealth and property taxes. Which brings me to a report from the Telegraph
Almost two-thirds of the country’s million-pound earners disappeared from Britain after the introduction of the 50p (percent) top rate of tax, figures have disclosed.
In the 2009-10 tax year, more than 16,000 people declared an annual income of more than £1 million to HM Revenue and Customs.

This number fell to just 6,000 after Gordon Brown introduced the new 50p top rate of income tax shortly before the last general election....

It is believed that rich Britons moved abroad or took steps to avoid paying the new levy by reducing their taxable incomes.

George Osborne, the Chancellor, announced in the Budget earlier this year that the 50p top rate will be reduced to 45p from next April.

Since the announcement, the number of people declaring annual incomes of more than £1 million has risen to 10,000.

However, the number of million-pound earners is still far below the level recorded even at the height of the recession and financial crisis....

Far from raising funds, it actually cost the UK £7 billion in lost tax revenue
That's just one year. Usually, we think that it takes a while for high taxes to have effects. It takes a while for people to move, shelter income, close down businesses, not start businesses, not go to school, etc. Hitting the Laffer limit in one year is pretty impressive.

Update: Thanks to JM Pinder below I went back to the HMRC report which is indeed more detailed. Some highlights:
The 50 per cent additional rate of income tax was introduced on 6 April 2010. It was the first increase in the highest rate of tax in the UK for over 30 years, and was expected to yield around £2.5 billion...

This report provides the first comprehensive ex-post assessment of the additional rate yield using a range of evidence including the 2010-11 Self Assessment returns. The analysis shows that there was a considerable behavioural response to the rate change, including a substantial amount of forestalling: around £16 billion to £18 billion of income is estimated to have been brought forward to 2009-10 to avoid the introduction of the additional rate of tax. ...[This is a suggestion that it's a one time loss. We'll see]
The modelling suggests the underlying behavioural response was greater than estimated previously in Budget 2009 and in March Budget 2010, decreasing the pre-behavioural yield by at least 83 per cent. This result is also consistent with that contained in the Mirrlees review, and suggests the additional rate is a highly distortionary form of taxation.
Don't miss the bigger point here. The US discussion harks back to the great old 1950s, ignoring the much more relevant evidence right before us from Europe: Want to try cutting deficits (very slightly) with high marginal taxes, especially on investment, along with minor "cuts" (declines in growth rates) of spending, but no substantial change in the welfare state? Hey, they just tried it! Their economies sink, and they don't get much revenue.

Do You Need to Register? Foreign Investment Firms Fined By SEC

If you are doing business in the United States, you need to follow the US securities laws, regardless of where you are located. While there are exemptions from registration and other exceptions that may be available, all firms need to examine the issue and doing business in the US is very broadly interpreted. The costs of failing to comply with the state and federal securities laws can be very costly, as four foreign financial services firms just learned.
The SEC announced charges against four financial services firms based in India for providing brokerage services to institutional investors in the United States without being registered with the SEC as required under the federal securities laws. The four firms agreed to pay more than $1.8 million combined to settle the SEC’s charges.
According to the SEC’s orders against the firms, they engaged with U.S. investors in some of the following ways despite being unregistered broker-dealers: Sponsored conferences in the U.S. Had employees travel regularly to the U.S. to meet with investors. Traded securities of India-based issuers on behalf of U.S. investors Participated in securities offerings from India-based issuers to U.S. investors.
Almost two million dollars in fines for failing to register, a process that can be costly, but certainly not two million dollars worth of costly. Now add to that the possibility that their clients may have claims against the firms because they were not registered  and this becomes a very costly oversight.
The full details are at the Commission's website - SEC Charges Four India-Based Brokerage Firms with Violating U.S. Registration Requirements; If you have questions about the registration status or requirements for any financial services firm, foreign or domestic, give us a call or email me at We have been representing financial firms across the country in compliance and registration matters for decades.
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Sunday, November 25, 2012

Taxes and cliffs

(Update: John Batchelor show radio interview on this blog post)

The whole tax debate is supremely frustrating to anyone who survived econ 1.

The ill effects of taxation -- the "distortions" -- depend on the total, marginal rate including transfers. If I earn an extra dollar, how much more stuff do I get, or how much more of someone else's services can I receive? That calculation has to include all taxes, federal, payroll, state, local, sales, excise, etc. and phaseouts.

And, if you receive a benefit from the government that phases out with income, so every dollar of income above (say) $30,000 reduces your benefit by 50 cents, then you face a 50 percent marginal tax rate even if you pay no "taxes" at all. Taxes and benefits -- both in level and on the margin -- need to be considered together.
I've been looking for good calculations of marginal rates.  The CBO has just issued a nice report titled "Effective Marginal Tax Rates for Low- and Moderate-Income Workers" that begins (begins!) to shed some light on the right question.  Here's one important graph, titled "Marginal Tax Rates for a Hypothetical Single Parent with One Child, by Earnings, in 2012";

The CBO's headline (first page) says these low-income workers
face a marginal tax rate of 30 percent, on average, under the provisions of law in effect in 2012. ... Over the next two years, CBO estimates, various provisions of current law will cause marginal tax rates among this population to rise, on average, to 32 percent in 2013 and to 35 percent in 2014.
30% and rising to 35% is already news. (A lot of the rise reflects means-tested insurance subsidies under the ACA). But digging a bit deeper I see a more chilling story in the CBO report
...CBO also finds that under provisions of law in effect between 2012 and 2014, marginal tax rates vary greatly across earnings ranges and among individuals within the same earnings range.
Consider again the graph on the top. The marginal tax rate is not an even 30%. There are slices of income where the marginal rate approaches 100%. And, the graph is really misleading because it doesn't graph the "cliffs."  The figure caption says
The dotted lines indicate income limits for Medicaid and CHIP where taxpayers face “cliffs.” Similar spikes in marginal tax rates when the taxpayer loses eligibility for TANF and SNAP are not illustrated.
The CBO's artists apprently did not want to graph the vertical spikes in an honest solid line. (The CBO's "average" is, as far as I can tell, an average across taxpayers. No taxpayer reported income at exactly the cliff income, not one dollar more or less, otherwise the "average" would have been infinite. The CBO is not taking an "average" across income, which would include the cliffs.)

Another figure gets at the situation better, I think, though it takes more sophistication to digest

Now the "cliffs" show up. Overall, disposable income is very flat from $0 to $30,000 of income, and there are swaths where a discrete jump in income produces no increase in overall income.

Cliffs are particularly pernicious incentives. Even if people overlook marginal incentives for a while, "if you take this job you'll lose your health insurance" really focuses the mind.
And, this is only the start. Single parents with one child who are going to work need childcare, transportation, clothes, and so on. The calculation leaves out sales taxes and a range of additional means-tested programs and social services.  It  only represents marginal tax rates by people who actually do work and file taxes. The jump from out of the labor force, illegal work, or disability to employment is higher. (Box 3 p. 17 cites a 36% marginal tax rate for the jump to employment and 47 percent from part time to full time.)

Even within the same income group, there is a  tremendous variation in marginal tax rates.

 The CBO' introductory graph makes somewhat the same point. The huge spread in effective tax rates is as interesting as the average value

These estimates are also  understatements, as they only scratch the surface. The actual marginal tax + loss of benefit rates people face is very complex. A quick poll of faculty at the Booth lunch table showed the usual range of opinion but no serious calculations. Maybe it's deliberately complex so people will not make the obvious responses to big marginal tax rates!

And, in the name of simplicity, the CBO left out dozens if not hundreds of additional means-tested programs. As the CBO says (p. v) "Including additional programs would generally increase estimates of marginal tax rates." Yes, it would.

Why is there so much variation in tax rate across people of the same income? (p.v) The CBO here is looking at actual taxpayers, and
Survey data show that the majority of lower-income families do not receive means-tested transfers, either because they do not meet additional, nonfinancial eligibility requirements or because they are eligible but do not apply for benefits. Of those who receive transfers, the majority participate in only one program.  
This is both heartening and chilling. Written into law is a much larger welfare state than we actually have. Americans don't fully play the game. Yet. Witness the recent ad campaign to get more people to use food stamps. Once more people take more full advantage of the programs available to them, first the budget explodes. And second, they start to feel larger and larger marginal tax rates against growing out of the programs.

All of this  is official confirmation of the point Casey Mulligan has been making in his new book: Our system imposes huge disincentives for low-income people to move up. 
Greg Mankiw (H/T this is where I learned about the report) suggests
What struck me is how close these marginal tax rates are to the marginal tax rates at the top of the income distribution.  This means that we could repeal all these taxes and transfer programs, replace them with a flat tax along with a universal lump-sum grant, and achieve approximately the same overall degree of progressivity. 
The spread in tax rates means Greg is much more right than he knows. A $20,000 "universal lump sum grant"  and 30% flat tax rate would indeed be a better system -- not because it would approximate the current system more simply, as Greg implies, but  because it would dramatically lower marginal tax rates for so many low-income families.

The idea is worth pursuing. A "lump sum grant" means $20,000 voucher for food, housing, health insurance, and eliminating all the programs and their administering bureacracies. I didn't know Greg was such a radical!  However,  $20,000 x 100 million households = $2 trillion, on top of the military and all other federal spending. It's not clear a flat 30% even with no deductions at all is going to pay for it.

Perhaps we keep the $20,000 as provided benefits, as they now are, just lousy enough that rich people abandon them voluntarily as they bail out of public schools. That limits the budget impact a bit, though it will be pretty hard to explain to a $50,000 wage earner now paying next to nothing in Federal income taxes that they'll be writing a check for $15,000 next year, but don't feel bad because now they get to use food stamps and be on medicare.

We're going decidedly and inevitably in the other direction, which is the CBO's point in its gentle and understated  admonition that the "average" marginal rate is going to rise to 35%.

The response to our budget woes is more means-testing: Leaving deductions in place but capping them, adding to the phaseouts in the tax system,  more means-testing for Social Security, Medicare, and Medicaid, all of the low-income subsidies for the ACA which phase out with income of hours on the job.

It all sounds great if you don't understand margins.  Why should the government help rich people? But every time we do cap something or means-test it, we introduce another marginal tax. And some of the biggest marginal taxes hit the poor.

This is a deeply important point so let me reiterate it. If you means-test any benefit, you introduce a steep marginal tax rate at means-testing point. If you don't means-test a benefit, you blow out the budget. It's a hard nut, that you can't get around.

This is not a little problem. We worry about the distribution of income in the US, and how low-income people seem stuck. Well, faced with these barriers of course they're stuck. And the barriers are going to get worse. 

What to do?  To some extent this is why economics is called the dismal science. Draw the line any way you want, subject to the budget constraint that all redistributed money has to come from somewhere. If you make it high at the left end it has to have a low slope. Compassion breeds "dependency," a pejorative word for the simple fact that poor people are smart and respond to incentives.

But we can do a lot better!  At least we can measure and talk about total marginal tax rates including phaseouts and benefits -- and the CBO study is only a beginning -- rather than the silly Warren Buffet vs. his Secretary stories about average personal Federal income taxes in isolation.

And, we can avoid the big variation and the cliffs. We can avoid some people facing 100% or more margins and others facing no margin. We can  bring everyone closer to the "average" 30% rate.  The costs of a high rate are larger than the benefits of a low rate (and varying rates cause people to clump up on the high rates.)

Finally, perhaps more time limit as well as income limit will work as a sensible compromise. Unemployment benefits are limited in time, which is what has kept the US from developing the permanent underclass on the dole of some European countries.

Half-joke:  the Republican response to the Democrat's desire to raise the high bracket of  Federal income taxes to 39.5%, and raise the taxes on dividends and capital gains should be: Fine. You can have the Warren buffet lower limit. In return, we get the Greg Mankiw upper limit: (named after Greg's 90% marginal tax rate) If any taxpayer can show that his total marginal tax rate, including payroll, Federal, phaseout, state, local, excise, share of corporate, sales, property, and removal of benefits exceeds 75%, then his Federal income tax rate shall be reduced to that level. Well, maybe we should take this seriously on the low end of the income distribution.

Personal story: This is how I became an economist. Taking econ 1 as my humanities distribution requirement at MIT (pause for laugh), the professor showed the budget constraint for people on welfare, which at the time reduced benefits one for one with income, and kicked people out of public housing. For years I had felt at sea in the moral and cultural arguments about welfare dependency. In a flash, I saw it, there but for the grace of good fortune go I.

Next topic. In week 2 of econ 1 you learn that the distributional effects of taxation also are not read off the headline rates of the Federal income tax, but also depend on all taxation, all spending, and the burden of taxation through higher prices and wages, not who actually pays the taxes. That political argument is even sillier.


An excellent comment arrived by email:

Dear John... Regarding your post on marginal tax rates, the best paper I’ve seen on the subject is by Larry Kotlikoff and David Rapson, “Does it Pay, at the Margin, to Work and Save? Measuring Effective Marginal Taxes on Americans’ Labor and Saving.” This includes state programs (in Massachusetts, if I recall correctly), which add even more phaseouts. (Link to the NBER version). The chart on page 45 of the file is particularly striking. [reproduced below]

[Kotlikoff's abstract is great: 
The paper offers four main takeaways. First, thanks to the incredible complexity of the U.S. fiscal system, it's impossible for anyone to understand her incentive to work, save, or contribute to retirement accounts absent highly advanced computer technology and software. Second, the U.S. fiscal system provides most households with very strong reasons to limit their labor supply and saving. Third, the system offers very high-income young and middle aged households as well as most older households tremendous opportunities to arbitrage the tax system by contributing to retirement accounts. Fourth, the patterns by age and income of marginal net tax rates on earnings, marginal net tax rates on saving, and tax-arbitrage opportunities can be summarized with one word -- bizarre.]
 This anecdote from Jeff Liebman also illustrates the issue in a way that Kotlikoff’s charts might not:
Despite the EITC and child credit, the poverty trap is still very much a reality in the U.S. A woman called me out of the blue last week and told me her self-sufficiency counselor had suggested she get in touch with me. She had moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more. I told her I didn’t know what I could do for her, but agreed to meet with her. She showed me all her pay stubs etc. She really did come out behind by several hundred dollars a month. She lost free health insurance and instead had to pay $230 a month for her employer-provided health insurance. Her rent associated with her section 8 voucher went up by 30% of the income gain (which is the rule). She lost the ($280 a month) subsidized child care voucher she had for after-school care for her child. She lost around $1600 a year of the EITC. She paid payroll tax on the additional income. Finally, the new job was in Boston, and she lived in a suburb. So now she has $300 a month of additional gas and parking charges. She asked me if she should go back to earning $25,000.....
[Thanks! I also am not a specialist in this literature and am glad for pointers to good work.] 

Update 2: Another graph, thanks to MG.

Source, a great presentation by Gary D. AlexanderSecretary of Public Welfare Commonwealth of Pennsylvania at the AEI

Friday, November 23, 2012

Wednesday, November 21, 2012

SEC Insider Trading Cases

As our readers and followers are aware, part of our practice is the representation of targets, defendants and potential defendants in insider trading investigations and complaints. Since 1985 when I was part of the defense team for the first civil prosecution of insider trading under the misappropriation theory, this specific area of the law has been part of my practice.

In SEC vs. Materia, the trial court found that Mr. Material, a financial printing firm employee, misappropriated confidential information from his employer and traded on that information. The Second Circuit adopted that reasoning, paving the way for the Supreme Court's adoption of the misappropriation theory of insider trading some 13 years later.

That case, and the entire concept of the misappropriation theory has always struck me as being wrong and intellectually dishonest. The "fraud" is not connected to the purchase or sale of a security, and the misappropriation theory simply reads the "in connection with" requirement of 10b-5 out of the statute.

However, I can't change the law, and today, with my new association with former SEC Senior Enforcement Attorneys Jim Sallah and Jeff Cox, we continue to represent those accused of insider trading across the country, and have expanded that area of our practices.

In doing so, we have  noticed an increase in insider trading cases brought by the Commission, which was recently confirmed by the SEC. In the recap of recent insider trading cases posted at the SEC's website, the Commission provides information regarding the 57 insider trading cases that it has brought over the last two calendar years.

Many of these cases have been discussed here on our blog, but the SEC provides information on their cases brought since 2009.  As we have noted in the past, the types of individuals accused of insider trading is interesting, and includes an Investment Bank Analyst, a Public Relations Executive, Former Major League Baseball Players, a Pharmaceutical Company Executive, Five Physicians, the Founder of Equity Research Firm, a Yahoo Executive and Ameriprise Manager, a Movie Producer and Ring of Relatives and Associates, an Expert Consulting Firm  and a host of stock brokers, traders and hedge fund managers.

The entire list is at the Commission's web site, and although they do not trumpet the cases they lost, such as the one they lost in Florida last year, where Jim Sallah successfully defended a doctor in an insider trading case, the list is an interesting look at those recent enforcement cases.

SEC List of Recent Insider Trading Cases

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Tuesday, November 20, 2012

Health economics update

Russ Roberts did a podcast with me in his "EconTalk" series, on my "After the ACA'' article. Russ also put together a really nice list of readings with the podcast, at the same link.

I also found this very informative editorial "What the world doesn't know about health care in America" by Scott Atlas. It goes a good way to answering the persistent "What about how great health care is in Europe" comments. Some choice quotes:
Affirming 2005’s Chaoulli v. Quebec, in which [Canadian] Supreme Court justices famously concluded “access to a waiting list is not access to health care,” [my emphasis] countless studies document grave consequences from prolonged waits...
I love this little quote, because the deliberate confusion of "insurance" with "access" has long bugged me about the US debate.

Lots and lots of things are dysfunctional about US health care, but not the long waits that others endure
...“waiting lists are not a feature in the United States,” as stated in a 2007 study and separately underscored by the OECD .
They're talking months here, not 6 hours in the ER.
Americans would be stunned to hear the reality of nationalized insurance:

• In its latest “care guarantee,” Sweden found it necessary to stipulate that patients must be able to see a doctor within seven days; patients should not wait more than 90 days to see a specialist; and treatment should be scheduled within 90 days…six months from presentation;...

• England’s 2010 “NHS Constitution” declared that no patient should wait beyond 18 weeks for treatment (after GP referral). Even given this long leash, the number of patients not being treated within that time soared by 43% to almost 30,000 in January.
How about all those wellness visits, the idea that under socialized medicine, people will get lots of cost-effective preventive care so they don't  wind up at the ER with something expensive? It turns out that's better in the US despite our chaotic system:
...treatment of diagnosed high blood pressure, the focus of preventing heart failure and stroke, was highest in the US (53%), lowest in England (25%), then Sweden and Germany (26%), Spain (27%), Italy (32%), and Canada (36%). In 2010, drug treatment was higher in the US than all European countries, including Austria, Denmark, France, Germany, Greece, Italy, Netherlands, Spain, Sweden, and Switzerland. In 2011, nearly 70% of Britons with known hypertension were left untreated.
And when you do get something serious?
Waits for diagnosis and treatment of heart disease, the leading cause of death in the US and Europe, plague nationalized health systems. OECD reported delays of several weeks to months for treatment in Australia, Canada, Finland, England, Norway, and Spain – not including waiting for specialist appointments. In 2008-2009, the average wait for CABG (coronary artery bypass) in the UK was 57 days. Swedes waited a median of 55 days, even though 75% were “imperative” or “urgent.” Canada’s heart surgery patients wait more than 10 weeks after seeing the doctor, and two months for CABG even after cardiologist appointments. 
The obvious point: Of course, under the ACA, many new patients and "cost control" price caps, we are surely heading in the same direction: rationing by wait time.

The less obvious point: Remember all the critics I cited in "After the ACA'' painting the picture that sick people need treatment now, and can't possibly shop? That really is a misleading picture.

The bottom line
..gradually, Europeans are circumventing their systems. Half a million Swedes now use private insurance, up from 100,000 a decade ago. Almost two-thirds of Brits earning more than $78,700 have done the same. But what might really surprise those who assert the excellence of nationalized insurance systems is that throughout Europe, from Britain to Denmark to Sweden, when faced with their inability to deliver timely access, the government’s solution is increasingly to enable access to private health care.
I don't know enough about European "private health insurance" to know how it works. Individual, private health insurance is so screwed up in this country that it's not clear we will have this option.  And, the point of After the ACA, paying with your own money doesn't do much good if there is not a competitive market supplying health services.

Monday, November 19, 2012

Penny Wise?

A new financial advisory firm just retained us to review and revise their agreements BEFORE a regulator finds a problem. While I didn't ask, it sounds like they used a non-attorney group to create their registration documents and agreements, and are now looking for some additional advice.

Using a filing service to prepare boilerplate forms and agreements fine. In fact, we often send our smaller new clients to a third party service for the initial preparation of Form ADV and the related materials. Those firms can put together basic documents in a much less expensive manner than we can.

But we need to review those documents before they are used. If boilerplate were sufficient, there would be no need for filing of anything - every firm and practice would be the same, and the regulators would not need to know about the particulars of your business - everyone's business would be the same.

But advisory practices are not boilerplate, and each individual entity needs to have its ADV, its operating agreement, it codes and procedures, and its agreements with clients and vendors individually drafted. 

Unfortunately, too many firms and professionals do not take that next step and retain our firm, or someone like us, to review their agreements, preferring to wait until there is a problem before spending the money and being proactive in their own practices.

We have been representing financial professionals and firms for decades. A few hours of our time, reviewing and revising agreements and procedures can save a firm hundreds of thousands of dollars. A review and negotiation of an employment agreement can do the same for individual advisors.

Why aren't financial professionals and firms more proactive, like our new client? It doesn't make sense. If you need a consultation with us, send me an email - I won't charge you to read your email and respond.

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Friday, November 16, 2012

Debt Maturity

Another essay, a bit shorter this time, on maturity structure of  US debt. I was asked to give comments on a paper by Robin Greenwood, Sam Hanson, and Jeremy Stein *at a conference at the Treasury. It's a really nice paper, and (unusually) I didn't have much incisive to say about it, except to say it didn't go far enough. And, I only had 10 minutes. So I gave a speech instead. (The pdf version on my webpage may be better reading, and will be updated if I ever do anything with this.) 

Having your cake and eating it too: The maturity structure of US debt
John H. Cochrane 1
November 15 2012

Robin Greenwood, Sam Hanson, and Jeremy Stein 2 nicely model two important considerations for the maturity structure of government debt: Long–term debt insulates government finances from interest-rate increases. Short-term debt is highly valued as a “liquid” asset, providing many “money-like” services, and potentially displacing run-prone financial intermediaries as suppliers of “liquidity.” Long-term debt also provides some liquidity and collateral services, (Krishnamurthy and Vissing-Jorgensen3 (2012)) but not as effectively as short-term debt. How do we think about this tradeoff?

Posing the question this way is already a pretty radical departure. The maturity structure of U.S. debt is traditionally perceived as a relatively technical job, to finance a given deficit stream at lowest long-run cost, as Colin Kim eloquently explained in the panel. Greenwood, Hanson and Stein, along with the other papers at this conference, are asking the Treasury’s Office of Debt Management to consider large economic issues far beyond this traditional question. For example, saying the Treasury should provide liquid debt because it helps the financial system and can substitute for banking regulation, whether or not that saves the Treasury money, asks the Treasury to think about its operations a lot more as the Fed does. Well, times have changed; the maturity structure of US debt does have important broader implications. And getting it right or wrong could make a huge difference in the difficult times ahead.

Go Long!

As I think about the choice between long and short term debt, I feel like screaming4 “Go Long. Now!” Bond markets are offering the US an incredible deal. The 30 year Treasury rate as I write is 2.77%. The government can lock in a nominal rate of 2.77% for the next 30 years, and even that can be paid back in inflated dollars! (Comments at the conference suggested that term structure models impute a negative risk premium to these low rates: They are below expected future short rates, so markets are paying us for the privilege of writing interest-rate insurance!)

Our Government has taken the opposite tack. When you include the Fed (The Fed has bought up most of the recent long-term Treasury issues, in a deliberate move to shorten the maturity structure) the US rolls over about half its debt every two years5.

Here’s the nightmare scenario: Suppose that four years from now, interest rates rise 5 percent, i.e. back to normal, and the US has $20 trillion outstanding. Interest costs alone will rise $1 trillion (5% of $20 trillion6 ) – doubling already unsustainable deficits! This is what happened to Italy, Spain, and Portugal. Don’t think it can’t happen to us. It’s even more likely, because fear of inflation – which did not hit them, since they are on the Euro – can hit us.

Moreover, the habit of rolling over debt every two years leaves us vulnerable to a rollover crisis. Each year our Treasury does not have to just borrow $1 trillion to fund that year’s deficits. It has to borrow about $4 trillion more to pay off maturing debt. If bond markets say no, we have a crisis on our hands.

Going long buys us insurance against all these events. And bond markets are begging us to do it! Most large companies are issuing as much long-term debt as they can.

I emphasize “insurance.” Long rates are low, and interest rate volatility is low. This isn’t about the forecast (you can’t buy insurance against something expected) and it’s not about volatility. It’s about a big left tail. What if the 4% growth underlying our already depressing deficit forecasts turns into another 4 years of sclerotic 1.5% growth, the CBOs static revenue forecasts from higher tax rates fail to materialize, inflation picks up, budget chaos raises the risk premium of US debt, and China7 stops buying?

The world has changed. In the past, the Treasury could adjust maturity structure thinking only about liquidity or term premiums. The fiscal risks were small, since the overall amount of debt was small. With debts above GDP, and 5 times Federal revenues, the old rules go out the window.

Fix the accounting

Why not go long? I suspect the Treasury is reluctant to go long because, under current accounting, moving $10 trillion of debt to long-term would add $277 billion to interest costs, which makes the current deficit look much worse.

But this accounting makes no economic sense. Yield to maturity is not the same thing as the annual cost of borrowing, which includes capital gains and losses. Confusing yield and one-year return is a classic fallacy. (It makes even less sense given that the Fed is buying all the long term debt, so that the maturity hasn’t really changed at all!)

If this consideration is holding the Treasury back, we should fix the accounting. Politically difficult you say. We’ll get accused of cooking the books, you say. OK, but is it really worth running the country into a fiscal crisis because we can’t fix the accounting? In simple ways that every business follows?

Simply marking to market capital gains and losses, and including that in the budget would be a good start. Then, we need to calculate and report expected capital gains and losses during the next year.

According to the expectations hypothesis, which holds well at well at the relevant multiple-year horizons, and perfectly if we are willing to footnote “expectation” with “risk-neutral,” the expected cost is independent of the maturity structure. An upward sloping yield curve means that the government expects to make capital gains on long-term bond issues that just offset their higher yields. I expect that the Treasury would use a more sophisticated term structure model, to isolate risk premia and liquidity premia as well as expectations effects. That would be all well and good, but the overwhelming effect would still be to remove the confusion of yield with return. You might see 20 or 30 basis point cost of going long, but not 2.77%.

Now, accounting is not miraculous. Interest costs don’t disappear. Higher long-term yields correspond to higher future interest rates, and thus higher interest costs in future years. But here, the calculation would correctly show that the US will pay these higher future expected interest costs independently of the maturity structure. Today’s 2.77% 30 year yield is not “paid” today, in any meaningful sense. It is paid when interest rates actually do rise. And rolled-over short term debt would pay the same costs, at the same time.

Go even longer, and more liquid

Why stop at 30 years? The Treasury should issue perpetuities – bonds with no principal repayment date. When the government wants to pay down the debt, it simply buys them back at market value.

Perpetuities pay a set coupon – say $1 – forever. Their price varies as interest rates rise and fall. It would be better for the Treasury to sell only one coupon amount – say $1 – rather than adjust the coupon amount so that the bond sells at par. After all, a $2 coupon is just two perpetuities, unlike the case of coupon bonds. (If it really matters to sell bonds at “par,” then the Treasury can simply bundle the perpertuities. At a 1% yield, one $1 perpetuity costs $100, so sells at par. If yields rise to 2%, so the price of a single perpetuity falls to $50, the Treasury can issue them in bundles of 2, at “par.” Or maybe people can figure this out on their own.)

Perpetuities do not age, so perpetuities issued at different times are identical securities. There will be no more on-the-run / off-the-run spreads, no more liquidity premiums, no more arbitrages between economically-equivalent bonds because one can’t be delivered when the other has been shorted. And there will be no need to roll over of maturing debt, ever.

This standardization would also sharply increase the liquidity of long-term debt. In turn, raising that liquidity should lower the overall rate the government pays. It’s a win-win all around.

(While we’re at it, the Treasury should also issue an inflation-protected perpetuity, with a fixed real coupon, and adjust that coupon downwards for deflation symmetrically with upwards adjustments for inflation. The coupon pays $1 2012 dollars, forever. That would be a better and more liquid version of its current TIPS. Finally, the Treasury should issue variable-coupon debt. The coupon on this debt would act like corporate dividends, and variable-coupon debt would function like an equity source of government financing. By cutting the dividend in bad times, the government could reduce its debts without the calamities of default or inflation. By raising the coupon in good times, the government would establish a reputation that makes the bonds saleable, and convince investors to hold on through coupon reductions. Coupon adjustments should be made by Congress, of course.)

Go modern

If we go long, what about the liquidity advantages of short-term debt? Just a little financial engineering could avoid the apparent tradeoff between long and short term debt, allow the Treasury to quickly go longer without having to dramatically reform the maturity structure of government securities, which will take far more time than we have, and it could help to get around faulty accounting.

In modern finance, exposure is no longer tied to investment amounts. With aggressive use of interest rate swaps, (and, potentially, futures, interest-rate options, or CPI swaps,) the Treasury could buy the interest rate protection the government urgently needs, supply as much short-term debt as liquidity demands, and satisfy the political demands of budget accounting. There need be no tradeoff at all. We can have our cake and eat it too.

For example, suppose the Treasury issues only one-month debt, but then swaps it all to fixed rate. The Treasury agrees to pay to swap counterparties the fixed (2.77%) rate and receive the floating one-year rate. Now, it has issued $16 trillion of one-month debt, surely satisfying any liquidity demand to the utmost. But the Treasury is fully protected against interest rate rises just as if it had issued the entire amount in 30 year bonds. The investment amount is one month, the risk exposure is 30 years. Every bank routinely uses swaps to adjust its interest-rate exposure without touching its low-cost source of funds (sticky liabilities) or its profitable but illiquid assets (loans). The Treasury should do the same!

(I don’t know enough about deficit accounting to know where swap payments go, but I’ll leave it as an article of faith that the sharpies at Goldman Sachs who made Greek debt disappear in 2006 can get around that one too.

Yes, we need to make sure that swap counterparties are not too-big-to-fail banks, of course! But swap contracts are collateralized, so counterparty credit risk is not really that big an issue. The lower posts enough collateral that the winner can replace the contract in the event the loser defaults And if Dodd-Frank is good for anything, it ought to be good for keeping plain-vanilla interest rate risk off the balance sheets of “systemically important” banks.

Finally, I say “Treasury,” but what matters of course is the consolidated government. If it makes more sense for the Treasury to issue and pass on government interest-rate risk management to the Fed, so be it. The Fed can more explicitly be the Treasury’s asset management service.)

The bigger point: The Treasury should enlarge its “maturity” selection beyond the 18th century choice of maturity among coupon bonds, to include at least 20th century plain-vanilla modern fixed income instruments.

Go long, again

I don’t know if I’ve pounded my fists on the table enough. Historically normal interest rate rises will send the US into a fiscal tailspin, with interest costs doubling our deficit, and thus forcing a true fiscal crisis. The markets are offering to take this risk from us for next to nothing. For a while.

I don’t exaggerate much when I say, the fate of the Republic is in your hands!

Go Short

On the other side, Greenwood, Hanson, and Stein remind us of the liquidity value of short-term US Treasury debt. For example, it is the most widely accepted form of collateral, even in crises. Owning a one-month Treasury always allows you to borrow. Many accounting rules treat short-term Treasury debt as equal to cash. More of that too seems a good idea. Again, though, we can do better, and we can avoid the tradeoff.

Why stop at traditional Treasury bills? These have awkward properties: They are only issued in large denominations, and they are rolled over frequently. The Treasury should go beyond bills, and issue floating-rate debt, held in electronic book-entry form. Either the Treasury can directly allow small denomination, or it can encourage money-market funds to intermediate for retail clients.

The most “liquid” floating-rate debt has a constant principal value of $1.00, always. It’s like a money-market fund, where each share is always worth $1, and interest is paid on top of that. That can be achieved by a daily auction, as overnight repo rates were set in a market each day. However, a daily auction is not necessary, if the Treasury simply guarantees the value at 1.00 like a money market fund. Then the rate can then be indexed or simply adjusted at a periodic auction to adjust the quantity outstanding. (The Treasury maintains an account at the Fed, and uses that buffer to freely trade bonds for reserves at 1.00 between interest-rate reset periods.)

Yes, this is interest-paying money, issued by the Treasury. Every collateral, liquidity, or money-like feature of one-month Treasury debt I can think of works better with such fixed-value floating rate debt. Why bother “money-like” monthly Treasuries, when we can have money itself, without suffering any interest cost?

Overnight, floating-rate, electronic-entry Federal debt already exists. It’s called bank reserves. However, bank reserves are only available to banks, so have to be intermediated again to be available to the rest of the financial system. Also the Fed’s current “exit strategy” involves reestablishing a spread between reserves and market rates, which means reducing the quantity of reserves and sending the financial system off to other sources of “liquidity.”

Fixed-value, floating-rate, Treasury debt -- interest on reserves for everyone -- allows us to live the “optimum quantity of money” described by Milton Friedman. With an interest cost, people unnecessarily economize on money balances by spending more time and effort economizing on money balances. Without an interest cost, they voluntarily hold huge money balances and save all that time, effort, and cash-conserving financial engineering.

The advantages for our modern financial system are much deeper. With abundant floating-rate, fixed-value government debt, there is simply no need for all the complicated and run-prone “liquidity creation” that engulfed the financial system. Special purpose vehicles holding mortgage tranches funded by short-term debt, overnight repo, money market funds holding Lehman Brothers debt and promising fixed value, even bank deposits funding mortgages all become unnecessary for the purpose of creating liquid assets. Rather than allow all this intermediation and then hope that regulation can stop the next run, why not fully satisfy the demand for such assets directly? Then we need not fear requiring that anyone who wants to hold risky or illiquid liabilities match those liabilities with similar assets, eliminating runs and the need for extensive risk regulation. Greenwood, Hanson and Stein call it “crowding out,” and a partial substitute for regulation. Yes, but let’s crowd out entirely and substitute for a lot more regulation!

No theory of inflation says there is any problem with the creation of such “money-like” assets, any more than the liquidity value of one-month bonds causes a problem for price-level control. Keynesian and new-Keynesian models say that the level of interest rates, which the Fed still controls by announcing the rate on reserves and discount window lending, controls inflation. An artificial interest spread between classes of Fed liabilities doesn’t matter. The Fiscal theory of the price level says that fiscal solvency gives price level control, not a scarcity of “liquid” vs. “illiquid” government debt. Monetarists thinks of reserves that pay full interest as bonds, not money, so arbitrary amounts are not inflationary. Milton Friedman himself called for interest on reserves.

Bottom line

As a policy priority, buying insurance against interest rate spikes at our current extremely low interest rates is the first priority. This has to be accomplished before long-term interest rates rise. The left-tail danger of a run on US Treasury debt, and an interest-cost death spiral, is real.

Providing abundant liquidity with floating-rate debt, which will discourage the reconstruction of a run-prone shadow banking system, is only a slightly longer term priority. An ideal maturity structure of government debt is perpetual. Long-term debt has a fixed $1 coupon, and a floating price. Short-term debt has a fixed $1 price debt and a floating coupon. Then there is never rollover risk, or rollover transactions cost. Making all Treasury debt even more liquid, by standardizing the long issues and allowing low-cost electronic transactions of the short issues, greases the financial system and lowers the rates the Treasury will pay.

By opening up to swap and other derivative transactions, the Treasury can dissociate the amount of interest-rate insurance it purchases or sells on behalf of taxpayers from the task of supplying the amount of these fundamental securities that private-sector “liquidity” demands require, and that provide the least-cost source of funding.

Obviously, these moves need to be coordinated with the Fed. There is no point in lengthening if the Fed just twists it away. I notice a tendency of the two institutions to follow parochial concerns and to forget that there is a single budget constraint uniting them!

Enjoy your cake.


1 Professor of Finance, University of Chicago Booth School of Business, Research Associate, NBER, Senior Fellow, Hoover Institution, and Adjunct Scholar, Cato institution., These are comments prepared for the Second Annual Roundtable on Treasury Markets and Debt Management, Department of the Treasury, November 15, 2012.
2 Robin Greenwood, Samuel Hanson, and Jeremy Stein, 2012, “A Comparative-Advantage Approach to Government Debt Maturity” Manuscript, Harvard University.
3 Krishnamurthy, Arvind and Annette Vissing-Jorgensen, 2012, “The Aggregate Demand for Treasury Debt. Journal of Political Economy. (Aril 2012)
4 Actually, I’ve been screaming “go long” for a while now. In particular, see “Inflation and Debt,” National Affairs 9 (Fall 2011), and “Understanding fiscal and monetary policy in the great recession: Some unpleasant fiscal arithmetic,” European Economic Review 55 (2011), 2-30.
5 I got this from Hamilton, James D. and Cynthia Wu, 2011, “The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment,” Manuscript, UCSD and University of Chicago. They put all debt on a zero coupon equivalent basis. Beware the average maturity numbers, as this ignores coupons and weights long maturities too heavily. What we want of course is the duration of US debt – change in market value in response to interest rate changes – which I don’t have handy.
6 I use the total debt, including that held by government agencies, as these are the claims on the Federal income tax. Using debt held by the public does not generate a much prettier picture.
7 Daniel Beltran’s paper presented at the conference, said China alone is worth 2%! (Beltran, Daniel, Maxwell Kretchmer, Jaime Marquez, Charles P. Thomas (2012) “Foreign Holdings of U.S. Treasuries and U.S. Treasury Yields” Federal Reserve Board.

Thursday, November 15, 2012

SEC Charges Miami-Based Adviser with Hiding Trading Losses and Diverting Client Funds

In a complaint filed last week, the SEC charged a Miami-based investment adviser for defrauding his clients by concealing trading losses and diverting investor funds for personal use.

The SEC alleges that Anand Sekaran and his firm Wasson Capital Advisors Ltd. fabricated documents showing illusory profits after his trading strategy became unprofitable in 2008 and produced substantial losses for clients. The Commission also alleges that Sekaran also misused client funds to pay various personal and business expenses, and he collected fees in excess of what he was due under the arrangements he had with clients.

 According to the press release from the SEC, Sekaran and Wasson agreed to resolve the SEC’s charges as well as a parallel criminal action announced today by the U.S. Attorney’s Office for the Southern District of New York.

“An investment adviser’s fiduciary duty applies equally in good times and bad,” said Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit. “Sekaran breached that duty when he concealed trading losses and misled clients rather than simply admitting that his investment strategy was unsuccessful.”

In settling the SEC’s charges, Sekaran and Wasson consented to a final judgment imposing permanent injunctions from future violations of the anti-fraud provisions of the federal securities laws. Sekaran separately consented to an SEC order barring him from the securities industry and penny stock industry. Sekaran is required to pay $2.3 million to satisfy restitution and forfeiture orders in the criminal matter.

For more details see the SEC's complaint and press release. If you believe you have been defrauded in a securities related matter, our attorneys, located in New York, New Jersey and Boca Raton, Florida, are available for a free consultation by phone. Email our office at and we will connect you with the appropriate attorney. You can visit our web site - Securities Enforcement Attorneys and - The Securities Law Home Page, for more information about our firm, and the securities laws in general.
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Tuesday, November 13, 2012

Bloomberg TV interview

A short interview with Bloomberg TV's Betty Liu on the fiscal cliff.  No big news for readers of this blog, but maybe fun anyway.

We were just getting going when it ended. I was ready to say, if you didn't buy stimulus from spending increases, you shouldn't fear lack of stimulus from spending reductions; all government (federal, state, local) and all taxes matter; you need to include taxes and benefits, and then see the huge marginal taxes faced by poor people, and how cutting subsidies that go to rich people counts in the distributional calculus;the growth of regulation and tax chaos matters more than tax rates, Europe just showed us what happens when you try to balance the budget with sharp hikes in marginal rates....Next time.

Monday, November 12, 2012

Gas price contest

As all of you know, New York and New Jersey are having huge gas lines in the wake (still) of hurricane Sandy. Both are enforcing laws against "gouging," and New Jersey's attorney general, apparently having time on his hands, is going after people who listed gas for resale on Craigslist.

Let's start a little comments essay contest. If New York and New Jersey let people charge whatever they wanted for gas, and prices went up to $25 per gallon then...

Here are some ideas to get you started

  • People would voluntarily stay home.
  • Rather than allocating gas to people with time on their hands to wait in line, gas would go to people who are really busy. 
  • People would voluntarily form carpools. Better, they would advertise for paying carpool mates on Craigslist, and the minivan owner running it would be able to get gas. 
  • People who have emergencies, like wife needing to go to the hospital to deliver a baby, could get gas to do so. 
  • Ditto emergency services, fire, ambulances, cops
  • Gas stations would have bought generators, so they could pump and sell gas at a big profit when the power goes out.
  • Gas stations would buy said generators now. (We need to get rid of gouging laws on the generators too, so that gas stations needing generators can pay through the nose to get them, instead of someone who wants to recharge his iphone.)
  • People who don't have to go anywhere would siphon their gas and sell it neighbors. Or second-car gas. 
  • They'd siphon their lawnmowers too.
  • People would rent tanker trucks, drive around the northeast, buy gas and resell it in NY.
  • Actually, people might get a bunch of gas cans and drive the gas in from rural areas in the back of pickups. Not sure if this is a good idea, especially for smokers, but it would improve gas supplies.  
  • Exxon would have spent the money for more storage tanks in NJ, ready to sell gas at high prices in an emergency. 
OK, you get the idea. I took the low hanging fruit, but you've got time on your hands, obviously, you're reading a blog. Let's see some creativity here. 

Interactions between gas and New York's reported prohibitions on home made food for shelter, tree clearance without permits, restrictive taxi and limo licensing laws, taxi prices, etc. are especially welcome. 

Stories of market adaptation to rationing rules are also welcome.  I gather that with AG prosecution for gas pricing in the air, Craigslist ads now ask $5 for gallon of gas. $100 for container. Are local teenagers yet starting little businesses to go get gas for neighbors? --"For $25 I'll go wait in line and fill up your car?" Are people swapping plates yet? 

Diversity in academia

99 percent of donors from Princeton gave to Obama, reports the Daily Princetonian, 157 to 2.  Princeton's one-percenters are a visiting lecturer and a custodian.

As a colleague pointed out, it may be little wonder that Republican politicians distrust academic "studies," whether about the effects of taxes on growth or carbon on the climate.

The story talks about the reasons for current faculty's opinions. But that misses the issue, which is how faculty are hired. Certain Opinions need not apply.

The faculty opinions are interesting anyway.
Goldston, a former director of the Princeton Plasma Physics Laboratory, ...said he believes the large divide between faculty who donate to Obama and to Romney can in part be attributed to Obama’s effectiveness in supporting higher education.
The ethanol farmers of Iowa cheer this patriotic attitude.
“A lot of my own work is on stereotyping and prejudice and diversity issues, and I think the Democrats are just hands-down better in that,” she [Psychology professor Susan Fiske] said.
You just can't make this stuff up. Diversity? Stereotyping? Prejudice?
“Now, this is a big generalization, so there are many educated conservatives, but on average, my understanding is that education tends to make people more progressive,” she added.
With an education like that, no wonder.

(BTW my rough guess is that the Booth school is about 2/3 Democrat, at least judging from lunchroom discussions.)  

Update: Commenter JB McMunn below pointed out the comments at the daily Princetonian website, which I had not seen. I thought I had an acid tongue! A critical spirit is alive and well among Princeton students, it seems.

Update 2: Many commenters, and many of the much more venemous comments that I've been deleting, are missing the point. It's perfectly ok to vote for democrats. I vote for democrats (and libertarians) often as well. I find the republican social conservatives' positions as noxious as much dirigiste democratic economic policy. Take your pick which is more dangerous to the country at a given moment.

The point is diversity. If you never hear from the other side, if nobody where you live and work has anything remotely like their views, you become insular, and your own opinions, never challenged, can harden on serious mistakes.

Academia especially profits when lots of widely different views contest, not when it becomes a claque of uniformity. The thing I enjoy most about being an academic is when I'm proven wrong, or at least challenged -- when Dick Thaler or Austan Goolsbee hammers me in the lunchroom, and I say, whoa, I need to think about that. Princeton, according to the Daily Princetonian, and most of the University of Chicago as well, never hears from religious conservatives, members of the armed forces, neoconservative hawks, or even middle of the road Bush I republicans, to say nothing of free market economists and libertarians. These people are not stupid, and an academic institution devoted to intellectual diversity needs to hear from them, and occasionally hire them.

Saturday, November 10, 2012

Dodd-Frank and Stigler's Ghost

The New York Times finally published  Gretchen Morgenson's article, pointing out that Dodd-Frank enshrines rather than eliminates "too big to fail," though systemic "designation" of "financial utilities" such as the exchanges has been underway since the bill's beginning. Needless to say, this has been my opinion all along.

Today let's move on. I'll label the bigger problem, "too big to fail means too big to compete." TBTF=TBTC. There, we can put that on bumper stickers.

As the Ms. Morgenson figured out, the Chicago Mercantile Exchange is now too big to fail, and will be able to borrow from the Fed and get a bailout. But that's not the big issue. The CME is now too big to compete. Who can now start a new exchange, maybe offering more protection against high frequency traders or other conveniences to customers, and threatening the CME's customer base? Not against a protected "financial utility."

George Stigler taught us that regulators are prone to "capture." Over the years, regulators start to sympathize with the industry they're regulating. Next thing you know, the regulations end up being used to protect the industry from competition. Luigi Zingales' great new book calls it "crony capitalism," emphasizing that it, not too much benevolent government or too much ufettered market competition, is the main characteristic of our society.

This is not an aspersion on the morals of the people involved, who are usually very well meaning. But if you spend most of  your days talking to industry people, not consumers, for your entire career, it's pretty natural to soon get the view that your job is to help industry. And all the "jobs" it provides. You get the idea. If you're living on a government salary, and ties to the regulator will be worth huge amounts in industry when you quit, it's even more natural.

Stigler would tell us that simple, clear regulations, and situations where the regulator doesn't see the same people over and over again, are less amenable to capture. Huge, complex regulations, whose wording gives regulators great discretion, and regulators who see the same people again and again, pose the most danger for capture.  Inviting regulators to spend thousands of hours sitting down with the regulated firms to write detailed complex rules, which deeply affect what those firms and their competitors can do is asking for trouble on a cosmic scale. I don't have to tell you where Dodd-Frank lies on this spectrum.

Worst of all, the main point of Dodd-Frank "regulation" is to make sure that regulated financial companies don't lose money. If the regulators are imposing big costs on the banks and other institutions, but are charged with making sure they don't lose money, how will they possibly avoid structuring regulations to help subsidize the industry and avoid "wasteful" competition, or upstart competitors siphoning away profitable lines of business? TBTF=TBTC.

The "stress tests" are a good example. Will the Fed publish rules for the stress tests, so that banks can know what's coming? No. The Fed staffers know that if they write rules, then the banks will game around them and the tests will always pass.  So, the Fed comes up with something new and interesting for each stress test. The  fact that financial institutions will game their way around rules is what leads to the huge regulatory discretion under Dodd-Frank.

This would be fine..except that billions of dollars are hanging on the outcome. Like whether B of A gets to pay dividends. Really, how long can a small group of Fed staffers stay uncaptured playing a game like that? A regulator with great discretion is the easiest to bend to industry's wishes.

Capture does not happen right away. Zealous young regulators wade in to write rules and fix the world. Capture happens over years of haggling, people moving in and out of industry and regulatory body, networks of friendships and personal relationships springing up. That hasn't happened yet. But if the system is ripe for capture, it would be amazing if this one time in all of history the capture did not result.

I recently toured the Fed's website on financial reform. The Fed is remarkably transparent about all the things it's doing to "implement" Dodd Frank. (Is this a plea, "this is not our idea, don't make us do all this crazy stuff?")  2/3 of the Dodd-Frank regulations have yet to be written.  So grab Stigler's ghost, and let's  read what the Fed is up to.  As you read, think, "How much money is at stake in this rule-making?" and  "could this process possibly get captured?" Also ask, "Just how much of this is absolutely necessary to stop another financial crisis?"
 The Board .. is working on a final rule that….

..defines when a nonbank company is "predominantly engaged" in financial activities; and the terms "significant nonbank financial company" and "significant bank holding company."

..would implement the enhanced prudential standards..

..implementing Volcker Rule requirements that restrict the ability of banking entities to engage in proprietary trading and to invest in or sponsor private equity funds and hedge funds.

...establish margin requirements for swap dealers,… major swap participants,.. …permitting entities supervised by the Federal Reserve to engage in retail foreign exchange futures and options.

…establishes risk-management standards for designated FMUs supervised by the Federal Reserve

…implement the credit risk retention requirements applicable in connection with the issuance of asset-backed securities.

…prescribe regulations or guidelines that prohibit incentive-based compensation arrangements..
I wonder what the CEOs think of that one.
The Board expects to request comment on a proposed rule….

…to apply the Depository Institution Management Interlocks Act to a nonbank financial company designated for consolidated supervision by the Federal Reserve.

…to impose fees on bank holding companies… that are sufficient to cover the cost of supervising and regulating these organizations.
(Stop and read that jaw-dropper again.)
… prohibits a financial company from making an acquisition if the liabilities of the combined company would exceed 10 percent of the liabilities of all financial companies.
… establish minimum requirements for registration and reporting of appraisal management companies.

…implement quality controls for real estate appraisal automated valuation models. 
(Wait. to stop another financial crisis we need to regulate "appraisal management companies?" "Minimum requirements" is clear Stigler-speak for "keep out competitors)
The Board issued rules 
... on stress testing requirements for certain bank holding companies…

…[that] establishes risk-management standards for designated FMUs supervised by the Federal Reserve

…that permit a debit card issuer subject to the interchange fee standards to receive a fraud-prevention adjustment.

,… to implement changes to the market risk capital rule, which requires banking organizations with significant trading activities to adjust their capital requirements … The final rule includes alternative standards of creditworthiness for determining specific risk capital requirements for certain debt and securitization positions,
(There's a whopper of negotiating who gets to make how much money)
..issued reports to Congress on their implementation of OMWI [Office of Minority and Women Inclusion]offices.
If this rule-making is all starchy for you, thanks to the Fed's excellent transparency, we can see what Fed staff actually do all day and who they talk to. These are the first two I picked off the website, honest, no cherry picking:

A Random Sample of a Fed Staffer’s day:
Meeting Between Federal Reserve Bank of New York (FRBNY) Staff and Representatives from Tullett Prebon July 23, 2012

Participants: (deleted)  
Summary: Tullett Prebon and FRBNY staff held a call to discuss bulk risk mitigation services in the interest rate derivative market. Tullett Prebon staff discussed the role such services play in the market and the potential impact of CFTC and SEC proposed rules for trading and reporting OTC derivatives on Tullett’s tpMatch service.
Well, I'm glad the Fed is listening closely to how its rules affect the profitability of specific companies.
Meeting between Federal Reserve Board Staff and Representatives of Citigroup Inc. June 11, 2012

Participants: (deleted)

Summary: Staff of the Federal Reserve Board met with representatives of Citigroup, Inc. (“Citigroup”) to discuss issues related to the proposed rule of the Board and other prudential regulators on margin and capital requirements for covered swap entities and to discuss issues related to implementation of other requirements under Title VII of the Dodd-Frank Act.

The Citigroup representatives discussed their views and concerns regarding the manner in which the requirements under Title VII would apply to overseas branches of U.S. banks, including non- U.S. clients of such branches, as well as related issues regarding implementation, timing and harmonization of global rules. A copy of the meeting agenda provided by Citigroup is attached below.
Again, the point here is not to accuse the Fed and its staffers of malfeasance. All of this rule-writing is required by the Dodd-Frank act, and the Fed website almost apologetically shows the section of Dodd-Frank requiring every measure. All the Fed staff I know are dedicated well-meaning people. Stuck in an impossible system.

Wednesday, November 7, 2012


I did a short spot on NPR's Marketplace this morning (also here). The announced topic was what I thought would happen to economic policy after the election. Jeff Horwich, the interviewer wanted to stitch together a story about everyone is going to get together and play nice now, which seemed like a fairly pointless line to pursue. What "I would do" is now off the table, and I didn't think it worth arguing with Jared Bernstein's repetition of Obama campaign nostrums.

But it gave me a chance to put some thoughts together. I usually don't predict anything, because I (like everyone else) am usually wrong. But I'll make an exception today

Forecast in three parts: The sound and fury will be over big fights on taxes and spending. They will look like replays of the last four years and not end up accomplishing much. The big changes to our economy will be the metastatic expansion of regulation, let by ACA, Dodd-Frank, and EPA.  There will be no change on our long run problems: entitlements, deficits or fundamental reform of our chaotic tax system.  4 more years, $4 trillion more debt.

Why? I think this follows inevitably from the situation: normal (AFU). Nothing has changed. The President is a Democrat, now lame duck. The congress is Republican. The Senate is asleep. Congressional Republicans think the President is a socialist. The President thinks Congressional Republicans are neanderthals. The President cannot compromise on the centerpieces of his campaign.

Result: we certainly are not going to see big legislation. Anything new will happen by executive order or by regulation.

1. Taxes and spending

The tax negotiations fell apart last summer. Why should exactly the same deal revive now? The President will not give in on raising taxes on  "the rich," and go for a revenue-neutral reform, especially after campaigning on it. The house will not give in: They will note that even the President's rosy revenue forecast of $1 trillion in 10 years is $100 billion a year, 1/10 of our deficit. They will look across the ocean and see that every European country that has tried to balance its books by raising (marginal) taxes, especially on investment, is raising pathetic amounts of revenue and creating a double dip recession.

If you have the same situation, you have the same outcome: every January a free-for-all chaos to plug the holes for one more year. Every lobbyist comes to Washington to get his piece renewed. Occasional debt ceiling fights. No budget for 4 more years.

2. Regulation:

With no big legislation coming, the unfolding of regulation will be the big story. It is news to most Americans, but the ACA and Dodd-Frank are not regulations written in law. They are mostly authorization to write regulations. They are full of "the secretary shall write rules governing xyz" with a timetable. Most of that timetable starts today, November 7 2012. You don't have to think the administration is a bunch of willy nilly regulators to foresee a metastatic expansion of regulation. You just have to look at the time-table of regulations already legally mandated and pending.

I fished around a little on the net. The EPA has regulations under development that by its own estimates will cost hundreds of billions of dollars a year.  I'm all for clean air, but there is a question of just how clean and at how much cost. A few small examples, picked for their obviously intrusive nature, questionable cost/benefit or humorous values

  • Greenhouse gases. Detailed industry controls focusing on greenhouse gas emissions.  They're even going to regulate cow farts. Sorry, Farm Methane Emissions. It's funny unless you're a dairy farmer.  Hundreds of billions
  • Between greenouse gases, much tighter mercury limits, and  designating coal ash a "hazardous substance" like nuclear waste (I'm exaggerating, but that's the idea), the end of coal.
  • Tight fracking regulations.
  • Much tigher ozone standards. Many cities are now way over the limit.
  • Cut sulfur in gas from 30 ppm to 10 ppm. EPA: $90 billion a year
  • Temperature standards to protect fish in powerplant cooling ponds
  • Tighter standards for farm dust. Farms have to submit mediation plans.
  • Water quality control for every body of water in the country.  
  • Strict regulation of industrial boilers ($10-20 billion)
  • Formaldehyde emissions from plywood. I didn't know Home Depot was a dangerous place to hang out. 

ACA/Obamacare. The big parts are all coming in the next four years.  Medicaid expansion, Exchanges, the mandate to buy insurance, the ban on charging people different amounts based on preexisting conditions, “accountable care organizations,”  and most of the regulatory bodies are all coming.

Dodd Frank. For number of rules that a law commands be written this takes the cake. If you want to scare your libertarian kids on Halloween, just read from the Fed's admirably transparent regulatory reform website. Just for fun here is a sampling of Final Rules Due in one three day period,  Dec 31 – Jan 2

  • Expiration date for CEA exemption for swaps 
  • Broadened leverage and risk based capital requirements 
  • FDIC Investment grade definition 
  • Final rule OCC credit rating alterinatives 
  • Joint final rule Market risk capital 
  • OCC lending limit rule compliance 
  • Supervision of consumer debt collectors 
  • Incorporating swaps 
  • Clearing agency standards

I have no idea what any of this means either. I do know that hundreds of billions of dollars are at stake, and the involved industries, their lawyers and lobbyists, are furiously "helping" to write all these rules.

This is the real news. It's baked in. Any new regulatory agendas come on top of this. And it will remake the American economy in the next four years.

The point here is not good or bad. I'm just forecasting what is going to happen -- and it seems clear to me that writing, haggling over, implementing, challenging, and repairing all this regulation is going to be the main story about actual economic policy for the next four years.

With no legislation forthcoming, any new initiatives will be by new regulations, or by executive orders.

3. Deficits, entitlements, reform

I see no chance that the new government, a repeat of the old government, will make any substantial progress. I wish they would, but hope is not a forecast.  Deficits will be $1 trillion per year, plus or minus due to the usual effects of any economic growth or lack of it on taxes and spending, so long as some chumbolones somewhere are willing to lend our government the money at negative real interest rates.  4 more years, $4 trillion more debt.  Entitlement bomb 4 years closer.

4. Economic forecast

Slow growth. Recovery is a bit natural, no matter how much sand the government puts in the gears. So, sclerotic but positive growth is the baseline. That's all conditional on my forecast that not much new comes out of Washington. With big tax hikes, slower growth or a double dip recession. With (in my dreams) a revenue-neutral, marginal-rate cutting dramatic simplification, or a miracle of sanity hitting our regulators, we get much more growth.

We're still sitting on a debt bomb. Remember 2004, when a few chicken-littles were saying "there is trouble brewing, there is a huge amount of debt (mortgages) that is in danger of defaulting, and the banks are stuffed with it?" And how everyone made fun of them? That is our situation now, but it's sovereign debt. (There's an interesting tidbit in today's news that Exxon and Johnson and Johnson bonds are trading with prices above / yields below US Treasuries)

Advice? If you run a business, get a lot of lawyers and lobbysists. He who writes the regulations will make a lot of money. He who does not will lose.  Make sure you make the right political contributions and don't say anything critical of those in power. You will need a discretionary waiver of something, and these rules are so huge and so vague, the regulators can do what they want with you. Don't be the one to get "crucified" (EPA). We live in the crony-capitalist system that Luigi Zingales describes so well. Live with it. Political freedom requires economic freedom, taught us Milton Friedman. You don't have the latter, don't expect the former.

If you're an investor, get out of long term nominal government debt. I have no idea who is holding 10 or 30 year treasuries at slightly negative real rates of interest, and bearing the risk of inflation and interest rate rises. Not me.

I hope I'm wrong. I really, really hope I'm wrong.

OK, no more grumpy, and no more forecasting.