"Misapplying the theory I mislearned in college."
By James Kwak
Last week, the Wall Street Journal highlighted a Federal Reserve report on total household net worth. Surprise! Americans are richer than ever before, both in nominal and real terms.
At the same time, though, wealth inequality is increasing from its already Gilded Era levels. The main factor behind increasing household net worth over the past year was the rising stock market (followed far behind by rising housing prices). These obviously only help you if you own stocks—not if, say, you never had enough money to buy stocks, or you had to cash out your 401(k) in 2009 because you were laid off. Put another way, rising asset values help you if you are a supplier of capital more than a supplier of labor.
Is there anything we can do about this? The conventional wisdom from the political center all the way out to the right fringe is that we shouldn’t tinker too much with the wealth distribution—otherwise people won’t work as hard, which is bad for everyone. But perhaps it isn’t true.
In a new paper (Vox summary; hat tip Mark Thoma), three IMF economists look at the relationship between redistribution—measured by differences between the pre-tax-and-transfer income distribution and the post-tax-and-transfer income distribution—and overall economic growth over five-year periods, across countries and across time. They find (from the summary) “remarkably little evidence in the historical data used in our paper of adverse effects of fiscal redistribution on growth.” In general, that is, average levels of redistribution tend to be associated with higher levels of growth that are sustained for longer.
Why would this be? One reason is that inequality, in and of itself, seems to be associated with lower levels of growth. So if you redistribute income in order to reduce inequality, even if it is true that this hurts incentives to work hard, the reduced inequality has a countervailing (and, in most cases, stronger) effect.
Indeed, there’s a strong argument to be made that a capitalist society needs systematic redistribution to survive. Thomas Piketty’s new book—which I plan to read the next time I have time to read a 700-page economics book—free markets generally produce higher returns on capital than on labor, which means, to a first approximation, that people with capital will get richer faster than people with only labor. In a world where the political system is open to money, this means that the capitalists will also accumulate a disproportionate share of political power, leading to the type of extractive society described by Acemoglu and Robinson in Why Nations Fail. Which is not a world that most of us would want to live in.
By James Kwak
In White House Burning, there is a section on the rise and political influence of the conservative media. At one point, I looked up the top ten talk radio shows by audience. Nine of them were unabashedly right-wing, politically oriented shows. The tenth was Dave Ramsey. Ramsey has plenty of conservative elements: religion, moralism, glorification of wealth. But his show isn’t about conservative politics. It’s about personal finance.
Ramsey is a huge success because—in addition to his charisma and marketing skills—he is peddling one of the huge but popular illusions of American culture: that people can become rich by making better financial decisions. He’s also one of the characters skewered by Helaine Olen in her recent book, Pound Foolish, which describes the fallacies, hypocrisies, and borderline-corrupt schemes of personal finance gurus like Ramsey and Suze Orman. It’s a fun read—a bit repetitive, but that’s largely because all personal finance “experts” are pushing a small handful of myths.*
The “sham” of the financial literacy movement—the idea that all of our financial problems would be solved if Americans were better educated about money—is the subject of Olen’s article in Pacific Standard. More than a dozen states require personal finance classes in high school, even though the evidence is that they have no impact. In short, people who consume financial education behave no differently from people who don’t.
There is a whole hierarchy of reasons for this. One is that people tend to forget what they learn in class—no matter what class you’re talking about. One is that at the moment of making the financial decision—say, to take out the subprime mortgage—anything they may remember from class is overwhelmed by the sales pitch of the mortgage broker sitting in front of them. One is that people make financial decisions on irrational grounds.
There are a couple of structural reasons, as well. Financial education content has to come from somewhere—and overwhelmingly it comes from the asset management industry itself, which has the incentive to teach people many of the wrong things. Financial education courses are often designed by financial institutions themselves; financial “education” available on the Internet is even more likely to be a type of marketing above all else.
Beyond that, it’s not even clear—to me, at least—that there is a scientific basis of agreement on how people should make financial decisions. Sure, there are some obvious things that any informed expert should know: buy index funds (for liquid, near-efficient markets) and minimize fees, for example. But when it comes to asset allocation, for example, there are reputable people like Ian Ayres who say that young people should invest more than 100% of their assets in the stock market, and reputable people like Zvi Bodie who say that the minimum amount of money you need for retirement should be invested in inflation-indexed Treasuries. Similarly, you could get a spectrum of reasonable opinions on the wisdom of taking out loans to go to college. (Up to a point, most of the opinion would be in favor because of the expected earnings boost you get from education, but it depends on a lot of factors like where you go to college, what you study, etc.).
Olen’s book shows in entertaining detail that the way most financial education is done is a joke. (Ramsey, for example, advises people to pay down their debt in increasing order by principal amount—not descending order by interest rate, which is obviously better from an, um, financial perspective.) But it’s not clear to me how much of it could even be done right. The bottom line is that it’s no panacea—not for poor financial decision-making, let alone for the income inequality and threadbare safety net that are the underlying cause of most serious personal financial problems.
* I’m about a third of the way through at this point. I only read it during Tuesday morning “family reading” with my daughter at school. She sits next to me and reads historical fiction.
By James Kwak
President Obama’s 2015 budget proposes a number of tax increases that will mainly affect the rich. They include:
- Limiting the tax savings on deductions to 28 percent of the deduction amount (and applying this limit to exclusions as well, such as the one for employer-provided health benefits)
- Requiring a minimum 30% income tax on income less charitable contributions, which is intended to limit the benefit of tax preferences on capital gains and qualified dividends
- Reducing the estate tax exemption from $5.34 million to $3.5 million and raising the estate tax rate from 40% to 45%
- Eliminating tax preferences for retirement accounts once someone’s account balance is enough to fund a $200,000 annuity in retirement (simplifying slightly)
These are all good things, given the size of the projected national debt and the urgent needs elsewhere in society. But, of course, they have no chance of actually happening.
If President Obama really wanted these outcomes, there was a way to get them. He could have let the Bush tax cuts expire for good a year ago, making high taxes on the rich a reality. Then, a year later, he could have proposed a middle-class tax cut and dared the Republicans to block it in an election year. (He could also have traded a reduction in the top marginal rate—from the 39.6% that would have resulted, not counting the 3.8% Medicare tax—for the reforms he is now proposing.)
But no. Instead, he locked in low marginal rates, including low rates on dividends, that cannot be budged so long as Republicans have 41 votes in the Senate. And today he’s left waving a “roadmap” that has no chance of becoming reality.
By James Kwak
James Poterba wrote up a very useful overview of the retirement security challenge in a new NBER white paper. (I think it’s not paywalled, but I’m not sure.) He provides overviews of much of the recent research and data on life expectancies, macroeconomic implications of a changing age structure, income and assets of people at or near retirement, and shifts in types of retirement assets.
In the past, I’ve used the Federal Reserve’s Survey of Consumer Finances as my source for data about the inadequacy of many households’ retirement savings. Poterba has a new, perhaps even more stark snapshot:
You have to read down the columns, not across the rows. That is, the first row doesn’t give you the financial picture of the 10th-percentile household. Instead, it gives you the net worth of the 10th-percentile household by net worth, the present value of Social Security benefits for the 10th-percentile household by Social Security benefits, and so on.
Still, it’s eye-opening. It says that 50% of households have personal retirement accounts worth $5,000 or less; 50% of households have other financial assets of $15,000 or less; and 50% of households have no defined benefit pensions. 30% of households have total wealth, not counting annuitized pensions, of $72,000 or less. As of late last year, a 65-year-old woman buying a life annuity with a 3% annual escalation clause would get 3.7% of her up-front payment per year (Table 15), so $72,000 in wealth would generate just $2,664 per year—and that’s assuming she finds a way to liquidate her home equity (often the main source of wealth for people in the low-to-medium wealth tiers). And these data are from the 2008 Health and Retirement Survey, so they are only partway down from the housing market peak of late 2006.
These figures might not be so worrying if defined benefit and defined contribution plans turned out to be substitutes for each other—that is, if households without DC plans tended to have DB plans and vice versa. But that doesn’t seem to be the case. First, 26% of households headed by individuals aged 55–64 have no retirement plan at all, and 37% have only one plan (DC, DB, or IRA). Second, it turns out that the more retirement plans you have, the more you tend to have in each one; for example, people who have IRAs, DC plans, and DB plans have higher balances in their DB plans than people who have fewer plans (Table 13).
The overall picture is that the combination of income inequality and a retirement system that largely caters to high-income workers (for example, through tax preferences that disproportionately benefit people in high tax brackets who can afford large retirement contributions) has created vast inequality in retirement preparedness. Poterba does some back-of-the-envelope calculations indicating that people will most likely have to save a lot more than most people are saving today if they want to enjoy decent replacement rates in retirement.
This is true as an arithmetic point, but of course your ability to save depends more than anything else on your income. Absent some form of lifetime income risk sharing (like Social Security), it’s not clear there is a solution for people near the bottom of the income distribution.
By Peter Boone and Simon Johnson
U.S. Secretary of State John Kerry arrived in Kiev on Tuesday. The Obama administration is feeling real pressure from across the political spectrum to “do something”, but the US has no military options and little by way of meaningful financial assistance it can offer to Ukraine. The $1 billion in loan guarantees offered today by Mr. Kerry means very little.
Millions of people have a great deal to lose if the situation gets out of control, and the Russian leadership is behaving in an unpredictable manner. The sharp drop in the Russian stock market index on Monday morning, alongside an emergency hike in interest rates by the Central Bank, demonstrates that Russia’s financial elite was also caught completely off guard.
Mr. Kerry can and has made threats, but it would be better to join the Europeans in helping to calm the situation. There is a completely reasonable and peaceful path to a solution available, but only if everyone wants to avoid a major conflict.
The alternative to peace will be ugly. Many Russians believe that the Maidan uprising will negatively the rights of ethnic Russians in Ukraine. The fact that the new authorities in Kiev quickly sought to repeal Russian as an official second language inflamed these fears (the interim president, Oleksandr Turchynov, vetoed the proposed law on Sunday). Russian President Vladimir Putin will not stand by quietly if ethnic Russians protest and such protests lead to violence. The borders of Ukraine may be redrawn, and the ensuing conflict would be painful for all involved.
Russia will pay a high cost for its unilateral intervention in Crimea. Many in western Ukraine have been further alienated, while some Russian-speaking Ukrainians and ethnic Russians in Eastern Ukraine will not like the bullying tactics. But the big Russian choice lies ahead: Putin can heed “calls” to bring his military further into Eastern Ukraine (a threat articulated in public by one of his aides in September), or he can work with the EU, the US, and all Ukrainians to seek out a more democratic outcome.
Which way this situation develops will depend on three factors.
First, Ukraine’s established politicians have spent the last two decades playing off the US and Russia, and extracting resources from both sides. Corruption among this group is pervasive; in no sense have they managed Ukraine for its people.
The genuine Ukrainian street revolution is against the political elite most closely aligned with Yanukovych. But do not get too starry eyed about new democrats already taking over – the people now holding the reins of power have been prominent before.
Second, the Russians have what they see as legitimate security concerns. They are Ukraine’s largest trading partner, they transport a lot of natural gas across Ukraine through soviet-built pipelines, and their Black Sea Fleet – based in Crimea – is seen as a major strategic asset. The Russians sell their gas cheaply to Ukraine. They have repeatedly forgiven large arrears on payments and ignored gas gone missing in transit. It is naïve to think Russian interests can now be ignored in a “winner take all” victory for the opposition.
Third, with the ouster of President Viktor Yanukovych, pro-Russian forces lost a big round. But the current pro-western forces are unlikely to remain strong and undivided. The pro-Western 2004 “Orange Revolution” rapidly collapsed with accusations of corruption and betrayal amongst partners – leading ultimately to Yanukovych’s election in 2010.
The appointment in recent days of three rich Ukrainian businessmen to the Ministry of the Interior and to key gubernatorial positions suggests the fight against corruption will be uphill.
Mr. Kerry should push for more representative government in Ukraine. There need to be elections, including for the presidency (currently scheduled for May) and for parliament. And there needs to be a negotiation – involving Europe, the U.S., and Russia, as well as Ukrainians – over how these elections will be managed so they are fair and can ensure all ethnic groups in Ukraine are represented in future government. This could involve constitutional reform, to be approved by a national referendum.
Some Europeans and Ukrainian officials are suggesting the EU association agreement (EUAA) should be signed immediately. Rapid accession prior to establishing a more representative political process would be a mistake. Implementing the EUAA demands years of legislative work that will bring Ukraine’s laws closer to Europe’s legal framework. Such long-term reforms can’t be managed or promised by a government lacking a broad mandate, and one that only recently toppled an elected President.
Mr. Kerry is not in a position to provide generous loans, and money will not be forthcoming from Europe, but large funds are not needed. The International Monetary Fund can lend the amounts needed to refinance its own debts and to build some foreign exchange reserves as a way to build confidence. Domestic bonds are largely held by domestic banks, and those can be rolled over and refinanced if the authorities work with the banks on a plan.
Most importantly, the Ukrainians should end their dependence on cheap Russian gas by agreeing to pay market prices going forward. They need to pass these prices on to local customers, effectively ending subsidies and reducing the budget deficit. Ukraine needs to stop running budget deficits that can’t be safely financed at home. For now, that means balancing the budget.
All this is not enough to create a more dynamic and prosperous Ukraine, but at least the benefits to corrupt Ukrainian politicians from playing off East and West will have been reduced, and a new representative, elected regime will be in place.
By James Kwak
I don’t often go to academic conferences. My general opinion is that at their best, sitting in a windowless room all day listening to people talk about their papers is mildly boring—even when the papers themselves are good. And it takes a lot to justify my spending a night away from my family.
Despite that, a little over a year ago I attended a conference at George Washington University on The Political Economy of Financial Regulation. I went partly because my school’s Insurance Law Center was one of the organizers, partly because there was a star-studded lineup (Staney Sporkin, Frank Partnoy, Michael Barr, Anat Admati, Robert Jenkins, Robert Frank, Joe Stiglitz (who ended up not showing), James Cox, and others, not to mention Simon), and partly because I have friends in family in DC whom I could see. It was one of the best conferences I’ve been to, both for the quality of the ideas and the relatively non-soporific nature of the proceedings.
Many of the papers and presentations from the conference are now available in an issue of the North Carolina Banking Institute Journal (not yet on their website), which should be of interest to financial regulation junkies. My own modest contribution was a paper on the issue of corporate political activity. (In a moment of unwarranted self-confidence, I told one of the organizers I could be on any of three different panels, and they put me on the panel on “political accountability, campaign finance, and regulatory reform.”)
In the wake of Citizens United (and, more to the point, SpeechNow.org), there is plenty of discussion of how campaign finance law might be changed to limit political participation by corporations. My paper takes another approach, asking whether existing corporate law already places limits on the ability of a corporation’s directors and managers to dedicate corporate resources (which, according to the commonly accepted doctrine, belong in some sense to shareholders) to political purposes. (This question was raised by John Coates, among others, who has studied whether corporations can claim to be getting economic benefits for their political contributions.) Courts so far have not placed many limits on the ability of corporations to contribute to super PACs, 501(c)(6) organizations like the Chamber of Commerce, 501(c)(4) “social welfare” organizations like Karl Rove’s Crossroads GPS or President Obama’s Priorities USA (both of which have affiliated super PACs), or 501(c)(3) charitable organizations like the Congressional Sportsmen’s Foundation.
I argue in my paper that courts could, at least theoretically, scrutinize political contributions as potential violations of insiders’ duty of loyalty (to the corporation and to shareholders). That is, if the CEO of a company makes a contribution in the expectation of some personal benefit (like lower individual income taxes), even if the contribution might also benefit the corporation, the courts should apply a higher standard of review.
The paper also winds its way into a discussion of corporate contributions to charities in general. Although such contributions are generally unquestioned, they rest (at least in some states) on a relatively thin and dodgy set of precedents. The line of cases begins with a Cold War case (A.P. Smith Manufacturing Co.) in which a corporate contribution to Princeton University was justified essentially as a way of protecting democracy from the communist threat. It culminates in Kahn v. Sullivan, in which the judge reluctantly signed off on a massive gift by Occidental Petroleum to build a monument to its CEO, Armand Hammer—in part because of the unusual posture of the case, in which one set of plaintiffs was contesting a settlement negotiated by a different plaintiff. The result is that today CEOs can give away (shareholder) money to “charities” (and take the attendant board seats and social status for themselves) without even having to claim that the contribution will provide a net benefit to the corporation.
At the end of the day, the importance of corporations in both realms—electoral politics and charitable giving—is probably overstated. Less than 5 percent of charitable contributions are made by contributions; all the blockbuster gifts you read about are by individuals or their private foundations. On the political side, it is a fact that super PACs were overwhelmingly financed by individuals; but because we don’t know who is contributing to (c)(4) and (c)(3) organizations, it’s possible that corporations are playing a significant role there. We just don’t know (which is one reason why we need greater disclosure of political spending, as argued by Lucian Bebchuk and others.) Regardless of the volume of corporate political spending relative to spending by Sheldon Adelson and his ilk, however, corporate insiders shouldn’t be allowed to waste shareholder money on their own pet political beliefs.
By James Kwak
I’m not qualified to comment on the internals of Bitcoin; I’m neither a programmer (OK, Alex, not much of a programmer) nor a computer scientist. But I do know that Bitcoin exists because of software that people wrote, and every means by which we use Bitcoin also operates because of software that people wrote. The problem here is the “people” part—people make mistakes under the best of circumstances, and especially when they have an economic incentive to rush out products. That’s why, while we love what software can do for us, we also like having a safety net—like, say, the human pilots who can take over a plane if its computers crash. This is the subject of my latest column over at The Atlantic. Enjoy.
By James Kwak
Mixed in with blogging about this, that, and the other thing, it’s nice to occasionally write on a topic I actually know something about. 401(k) plans and the law surrounding them were the subject of my first law review article (blog post). They have also been in the crosshairs of Ian Ayres (who simultaneously works on something like nineteen different topics) and Quinn Curtis, who have written two papers based on their empirical analysis of 401(k) plan investment choices. The first, which I discussed here, analyzed the losses that 401(k) plans—or, rather, their administrators and managers—impose on plan participants by inflicting high-cost mutual funds on them. The second, “Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans,” discusses what we should do about this problem. To recap, the empirical results are eye-opening. This table shows that 401(k) plan participants lose about 1.56 percentage points in risk-adjusted annual returns relative to the after-fee performance available from low-cost, well-diversified plans. The first line indicates that participants only lost 6 basis points because their employers failed to allow them to diversify their investments sufficiently. The big losses are in the other three categories:
- Employers forcing participants to invest in high-cost funds by not making low-cost alternatives available
- Investors failing to diversify their investments, even when the plan makes it possible
- Investors choosing high-cost funds when lower-cost alternatives are available
Now you could say that the latter two sources of losses are the fault of individual plan participants, but that is cutting the employers (and the plan administrators they hire) too much slack. In particular, administrators should know that, if you offer both an S&P 500 index fund and an actively managed fund that closet-indexes the S&P 500 for 120 basis points more, some people will put their money in the latter.
The conclusion that Ayres and Curtis draw, which I also drew based on a different line of argument, is that many 401(k) plan fiduciaries—roughly speaking, employers and other parties with a management role in a 401(k) plan—are not meeting their legal obligations to protect the interests of plan participants. The key legal problem is the existence of the section 404(c) safe harbor, which exempts employers from liability for losses that are due to participants’ investment decisions. As currently interpreted by most courts, the safe harbor protects employers from liability for negligently constructing menus of investment options, so long as the resulting menu meets certain criteria met by the Department of Labor—criteria that allow plans to be stuffed with high-fee, actively managed mutual funds.
Ayres and Curtis argue that, although these legal standards could be modified, relying on participant lawsuits is a haphazard and at best partial solution to the problem. Instead, they propose a new regulatory scheme in which participants are defaulted into low-cost funds and must overcome some kind of barrier in order to switch into more expensive investment choices. In addition, participants would be allowed to roll their money out of 401(k) plans that do not offer low-cost investment options. This would be a vast improvement over the current system, to the tune of billions or even tens of billions of dollars a year.
There is a host of known problems with 401(k) plans as retirement savings vehicles. Ultimately, several of those problems stem from a faulty statutory and regulatory scheme—one that is based on a statute, ERISA, which was originally designed for defined benefit rather than defined contribution plans. Unfortunately, the current system has its ardent defenders—most notably the asset management industry, which likes the ability to charge high fees to captive customers, and the protection they receive from current judicial interpretations of the statute. Ordinary workers, as always, don’t have much of a lobby.
By James Kwak
It seems obvious. Yet it’s often lost, both by the scolds who lecture Americans for not saving enough and by the self-appointed personal finance gurus who claim that anyone can become rich simply ye saving more (and following their dodgy investment advice). Saving is sometimes seen as some kind of moral virtue, but from another perspective it’s just the ultimate consumption good: saving now buys you a sense of security, insurance against misfortune, and free time in the future, which are all things that ordinary people don’t have enough of.
Real Time Economics (WSJ) links to a new survey being pushed by America Saves (which appears to be a marketing campaign run by the Consumer Federation of America, which seems not to be evil*). According to the survey, there are significant differences in savings rates and accumulated savings between lower-middle- and middle-income households. And that’s treating all households in the same income bracket as being alike, leaving aside differences in family structure, cost of living, etc.
I’m all for living within your means and saving for retirement and all that. But it’s a myth to say, as America Saves does on its home page, “Once you start saving, it gets easier and easier and before you know it, you’re on your way to making your dreams a reality.” The underlying problems are stagnant real incomes for most people, rising costs (in real terms) for education and health care, increasing financial risk due to the withdrawal of the safety net, and increased longevity (good in some ways, but bad if incomes aren’t rising and you want to retire at 65). That’s why households are showing up at age 64 with less in retirement savings than they had just last decade. And why, if you feel like you’re not saving enough, it’s probably not your fault.
* But America Saves itself is supported by a bunch of financial institutions and trade associations like the Investment Company Institute, which have a vested interest in getting people to entrust more money to them.
By James Kwak
Before 2006, people used to talk about the Greenspan put: the idea that, should the going get rough in the markets, Chairman Al would bail everybody out. But there’s something even better than having the Federal Reserve watching your back. It’s the résumé put.
The Wall Street Journal reported that Vikram Pandit, former CEO of Citigroup, is starting a new firm called TGG which will . . . well, it’s not entirely clear. In one email, they claim “a novel approach to address the challenges that large complex organizations face in compliance, fraud, corruption, and culture and reputation.” (That’s the standard marketing tactic of describing what benefits you will provide without mentioning what you actually do.) Now, Pandit certainly has experience in a large, complex organization with compliance, fraud, corruption, culture, and reputation problems. Citigroup checks pretty much every box. But is it experience you would want to pay for?
Pandit hardly covered himself in glory as CEO of Citigroup. Basically, he took over a bank that was already heading into an iceberg, rammed it head-on into the iceberg, and then called in the Coast Guard to rescue him. He doesn’t deserve all the blame for the fact that Citi was the shakiest of the big four commercial banks in 2008, but he certainly doesn’t deserve the credit for keeping it afloat: that goes to one Timothy Geithner.
Pandit got into Citi when the bank bought the hedge fund he co-founded, Old Lane, for $800 million. Old Lane earned 3 percent in 2007, lost money in 2008, and was shut down that very summer. Hardly a performance that would merit a CEO position, but there it is. Pandit did have a successful career at Morgan Stanley before starting Old Lane, but that just seems like more evidence for the theory that working at Morgan Stanley (or Goldman Sachs) makes you seem smarter than you actually are.
So why would anyone hire Pandit to do anything—let alone “use insights into human behavior, economics and so-called big data . . . to help large, complex companies analyze employee behavior, management decision-making, business models and strategy”? (Presumably, having made something like $160 million on the sale of Old Lane, he isn’t going to work for peanuts.) To be clear, no one has hired him yet. But in general, if you become CEO of a big company, you’re pretty much guaranteed lucrative employment for as long as you want it, regardless of your performance. This is the résumé put: you have downside protection because you can always go and get another job.
The other big question is why Steven Levitt and Daniel Kahneman would want to have anything to do with Pandit. It probably isn’t the money—Levitt must be worth a gazillion dollars with the Freakonomics franchise, and I doubt Kahneman is hurting. And if they really want to bring behavioral economics and instrumental variables to big corporations, they don’t need a mediocre washout as CEO of America’s laughingstock bank.
At the end of the day, it all probably comes down to our culture’s fascination with money. Make enough of it, and people will always assume you must have deserved it one way or another. And you will always get another shot (see Spears, Britney).
By James Kwak
Over on Twitter, Matt O’Brien wrote:
“Why are people mad at Wall Street, & not Silicon Valley, pay?” is a piece that doesn’t include the word “bailout” http://t.co/kqmWH276Gi
— Matt O’Brien (@ObsoleteDogma) February 19, 2014
That inspired me to take a look at the article O’Brien referred to: a column by Steven Davidoff asking why JPMorgan gets pilloried for giving CEO Jamie Dimon $20 million while Google can give Chairman Eric Schmidt $106 million without incurring the wrath of the public.
I went into it thinking I would agree with O’Brien—that there is something worse about lavish Wall Street pay packages than lavish Silicon Valley pay packages. Part of that was home team bias: I spent most of my business career working for companies based in Mountain View, Sunnyvale, Menlo Park, San Mateo, and Foster City (that’s two companies and five office moves). But I ended up mainly agreeing with Davidoff.
I think O’Brien is right on the narrow question of why people are mad: JPMorgan has done a lot of bad things in recent years, while Google’s role in the world is more ambiguous. But at the end of the day, voting the chairman of the board enough money to buy a Gulfstream 650 and an entourage of 550s is not a good use of shareholder money. And it’s shockingly tone-deaf in this age of rising inequality and cuts to food stamps. That’s the topic of my latest Atlantic column.
By James Kwak
As I previously wrote on this blog, one of my professors at Yale, Ian Ayres, asked his class on empirical law and economics if we could think of any issue on which we had changed our mind because of an empirical study. For most people, it’s hard. We like to think that we form our views based on evidence, but in fact we view the evidence selectively to confirm our preexisting views.
I used to believe that no one could beat the market: in other words, that anyone who did beat the market was solely the beneficiary of random variation (a winner in Burton Malkiel’s coin-tossing tournament). I no longer believe this. I’ve seen too many studies that indicate that the distribution of risk-adjusted returns cannot be explained by dumb luck alone; most of the unexplained outcomes are at the negative end of the distribution, but there are also too many at the positive end. Besides, it makes sense: the idea that markets perfectly incorporate all available information sounds too much like magic to be true.
But that doesn’t mean that everyone who beats the market is actually good at what he does, even if that person gets a $100 million annual bonus. That person would be Andy Hall, the commodities trader who stirred up controversy when he apparently earned a $100 million bonus at Citigroup—in 2008, of all years. (That was a year with huge volatility in the commodities markets.)
The latest news is that Occidental Petroleum, which bought Phibro, Hall’s trading operation, from Citigroup in 2009, is now considering jettisoning its proprietary trading activities. That isn’t to say it was a bad investment; Phibro was profitable for several years after the purchase by Occidental. At the same time, though, Hall’s hedge fund, Astenbeck Capital, has posted mediocre returns—an annualized return of 5 percent since January 2008 (about the same as the total return on the S&P 500), with a drop of 8 percent in 2013.
It’s quite possible that Andy Hall is the real deal: someone whose ex ante, risk-adjusted expected returns are better than those of the markets in which he deals. But that doesn’t mean that his performance spikes, like in 2008, aren’t largely the product of random variation. This is why it’s never a good idea to buy a free agent right after he had a huge year, whether he plays baseball or commodities.
It’s also why it’s not a good idea to buy stock in a company whose revenues look like this—especially when that company has been around since 2002.
That’s not a startup that is enjoying meteoric growth: that’s a company that enjoyed some massive random variation last year. They may be better than the average mobile games company, but 2013 is not a base that they are reliably going to grow from in future years. Which means that coming up with a reasonable valuation is next to impossible.
By James Kwak
That’s what Jesse Litvak’s lawyer said at the start of his trial earlier today. And technically speaking, it’s true. If you’re trying to sell a bond to a client, and during the course of the conversation you say you can bench press 250 pounds when you can only bench 150, that’s not a federal crime. But if you lie about a material aspect of the bond and the client relies on your lie in buying the bond, that’s another story.
Litvak’s case is (barely) in the news because it has a financial crisis connection; some of the buy-side clients he is alleged to have defrauded were investment funds financed by the infamous Public-Private Investment Program (PPIP) set up in 2009 using TARP money, and hence one of the counts against Litvak is TARP-related fraud. But it bears on a much more widespread, and much more important feature of over-the-counter (OTC) securities markets.
Litvak was trading mortgage-backed securities for Jefferies when the alleged behavior occurred. The key feature of OTC markets is that there is no way to look up the prices at which securities are trading, as opposed to, say, on the New York Stock Exchange. If you are a buy-side investor and you want pricing information, you depend largely on the securities dealers themselves to tell you what the current prices are.
Litvak’s thing was that he lied to his clients about the prices of other transactions that he made up. For example, first Jefferies bought an MBS at $51.25. (SEC complaint, beginning on page 20.) Litvak then approached a potential buyer and claimed that a seller was offering him that bond at $55. The buyer offered $50.50. Litvak then lied three more times about the price that his phantom seller was offering: first $54, then $53.50, then finally $53, after which the buyer agreed to pay $53.25. Who would fall for this? Well, in this case it was Magnetar, the hedge fund renowned for destroying the U.S. economy (exaggeration). The complaint has dozens of similar examples, replete with ungrammatical emails detailing fictional negotiations.
The legal issues are whether Litvak violated Section 17(a) of the Securities Act or Securities Exchange Act Rule 10b-5, for which the lie has to be material and the buyer must have been harmed by it, among other things. Litvak’s defense is the usual one: his clients were sophisticated investors who could have read the documents themselves and analyzed the value of the securities independently. This might work with a jury, but it’s just wrong as an economic matter. If you’re an investor, you know that your analysis of a bond’s expected cash flows is just one opinion. What other people think the bond is worth is also valuable data—especially if you’re thinking you might want to unload the bond to another investor. If Litvak says that one investor expects to sell for $55 and only reluctantly parted with it at $53, that’s different from the fact that the investor sold it at $51.25—more than 3 percent different.
The broader issue is that this is the way OTC markets work. Dealers match buyers and sellers, or sometimes trade out of their own inventory, and everyone knows that they make money by taking a spread on each trade. But it’s impossible, or very difficult, to tell from the outside what the spread is. So even if the majority of bond dealers are upstanding model citizens, the system depends on them being upstanding model citizens—probably not what we want in a cutthroat, aggressive, money-driven culture. But the dealers want to preserve OTC markets precisely because it lets them charge large spreads, whether through deceit or not.
But why does the buy side put up with it? Partially because they don’t realize the extent to which they are being lied to. Litvak’s clients knew that he was buying low and selling high, but they had no idea how low he was buying because he lied about it. Had they known, they would have demanded lower prices or taken their business elsewhere.
But partially because everyone in this casino is playing with other people’s money, as described at length by Zero Hedge when the SEC first filed its complaint. Bond trading is a world of mutual back-scratching in which traders, who are paid a percentage of their profits, charge inflated spreads, and clients go along with it because they are paid a percentage of assets under management—and they get kickbacks in the form of gifts and entertainment from the traders. Everyone is better off except the investors at the end of the line. Which is the big reason why OTC markets are bad for ordinary people.
By James Kwak
Nicholas Kristof’s ill-conceived diatribe against the supposed self-marginalization of academics has come in for a fair amount of criticism, notably from Corey Robin. The most obvious problem with Kristof’s argument assertion is that anywhere you look in the policy sphere, you can’t help stumbling over academics left and right. Macroeconomics is an obvious one, but there many others. Take education, for example, where anyone pushing for any conceivable policy change can wave a fistful of academic papers in your face.
It’s easy to multiply examples of academics doing policy work or even occupying policy positions. The bigger question, and the less obvious problem with Kristof’s opinion, is whether more of us would do any good for the world.
Consider climate change. Here, academics have hit the ball out of the park. We know the world is getting hotter, and we know why, because of hard, painstaking academic research. There are two main reasons why we’re not doing anything about it, and neither is a shortage of op-eds by professors.
The first is a well-funded campaign by fossil fuel companies and anti-government ideologues to spread misinformation. That’s just politics, given the state of American campaign finance law.
But the second is a media that refuses to call out people for simply lying about science, relying on the formula of “expert A says X and expert B says Y” instead. And a media that compounds the problem by giving prime real estate to the unqualified climate change-denying drivel of people like George Will. In other words, the journalists–Kristof’s profession–are a big part of the problem.
On most policy questions of any importance, there are enough academics doing work to generate far more policy ideas than can seriously considered by our political system. When it comes to systemic risk, we have all the ideas we need–size caps or higher capital requirements–and we have academics behind both of those. The rest is politics. What we really need is for the people with the big megaphones to be smarter about the ideas that they cover.
By James Kwak
It’s been more than five years since the peak of the financial crisis, and it seems clear (to me, at least) that not much has changed when it comes to the structure of the financial sector, the existence of too-big-to-fail banks, and the types of activities that they engage in. It’s also clear that the Dodd-Frank Act and its ensuing rulemakings have embodied a technocratic perspective according to which important decisions should be left to experts and made on the grounds of economic efficiency. Even the Consumer Financial Protection Bureau, the Dodd-Frank achievement most beloved of reformers, is essentially dedicated to correcting market failures, which means attempting to achieve the outcomes that would be generated by a perfect market.
The big question is why we went down this route. The traditional explanation, and one that I’ve tended to assume in the past, is that it was a question of political power. Wall Street banks and their lawyers simply want less regulation of their industry, and they feel more comfortable granting actual rulemaking power to regulatory agencies that they feel confident they can dominate through the usual mix of congressional pressure, lobbying, and the revolving door. Given that the Obama administration also wanted to avoid structural reforms and preferred to rely on supposedly expert regulators, the outcome was foreordained.
In a recent (draft) paper, Sabeel Rahman puts forward a different, though not necessarily incompatible explanation. He draws a contrast between a managerial approach to financial regulation, which relies on supposedly depoliticized, expert regulators, and a structural approach, which imposes hard constraints on financial firms. Examples of the latter include the size caps that Simon and I argued for in 13 Bankers and the strict ban on proprietary trading that has been repeatedly watered down in what is now the Volcker Rule.
Rahman’s historical argument is that the managerial approach is actually a relatively recent creation. Among the Populists and Progressives (think of Louis Brandeis, for example), financial regulation was a political and even moral issue, and questions of the social utility of finance were paramount. In one sense, they finally won in the New Deal reforms of the 1930s. But the regulatory agencies created by those reforms became the new locus of technocratic expertise, and over time their objective became macroeconomic management rather than social progress. This trend only accelerated later in the twentieth century, bolstered by the general rise of economism and the fetishization of free markets, to the point where some (e.g., Greenspan) opposed any regulation and others defended regulation narrowly as a way of correcting for market failures.
What is missing, Rahman argues, is any actual consideration of the social value of finance in general and financial innovation in particular. In its absence, we are left with the judgment of the expert technocrats, which has predictably led us to where we are today. If we do open up the scope of financial regulation to take questions of social value into account, we might end up in a very different place.
By James Kwak
If I write about a legal matter on this blog, it usually involves battalions of attorneys on each side, months of motions, briefs, and hearings, and legal fees easily mounting into the millions of dollars. That’s how our legal system works if, say, you lie to your investors about a synthetic CDO and the SEC decides to go after you—even if it’s a civil, not a criminal matter.
But most legal matters in this country don’t operate that way, even if you face the threat of prison time (or juvenile detention), and all the collateral consequences that entails (ineligibility for public housing, student loans, and many public sector jobs, to name a few). Theoretically, the Constitution guarantees you the services of an attorney if you are accused of a felony (Gideon v. Wainwright), misdemeanor that creates the risk of jail time (Argersinger v. Hamlin), or a juvenile offense that could result in confinement (In re Gault). The problem is that this requires state and counties to pay for attorneys for poor defendants, which is just about the lowest priority for many state legislatures, especially those controlled by conservatives.
In Crisp County, Georgia, home of the Cordele Judicial Circuit, this just doesn’t happen. In 2012, for example, there were 681 juvenile delinquency and unruly behavior cases. The public defenders handled only 52 of those cases, and we know that most of the defendants couldn’t have afforded private attorneys. The result is hundreds of guilty pleas resulting in detention by children who have no idea what their rights are.
We know this because of a lawsuit (complaint; summary by Andrew Cohen) brought by the Southern Center for Human Rights. (I am a member of the SCHR’s board of directors.) This is not an isolated case. The SCHR alone has repeatedly sued the state of Georgia for underfunding its public defender system to the point where defendants lack any reasonable semblance of representation. This problem is not confined to less-serious cases (which are, of course, still extremely serious to the person facing time in prison). In Alabama, for example, state law limits the amount that can be spent on a court-appointed lawyer to $1,500—for death penalty appeals. (That’s $1,500 total, not $1,500 per hour, for those of you who work on Wall Street.)
At one end of our legal system, it’s too hard to hold anyone responsible for blowing up our financial system and costing 8 million Americans their jobs. At the other end, we are shuttling thousands of young people into detention and prison (and forcing them to pay fees for the public defenders who don’t show up at their hearings) because we can’t be bothered to pay decent lawyers. Something is wrong here?
By James Kwak
Floyd Norris says some sensible things in his column from last week on the retirement savings problem: Defined benefit pensions are dying out, killed by tighter accounting rules and the stock market crashes of the 2000s. Many Americans have no retirement savings plan (other than Social Security). And the plans that they do have tend to be 401(k) plans that impose fees, market risk, and usually a whole host of other risks on participants.
But even his cautious optimism about some new policy proposals is too optimistic. One is the MyRA announced by President Obama a couple of weeks ago. This is basically a government-administered, no-fee Roth IRA that is invested in a basket of Treasury notes and bonds, effectively providing low returns at close to zero risk. The other is a proposal by Senator Tom Harkin to create privately-managed, multi-employer pension plans that employers could opt into. The multi-employer structure would reduce the risk that employees would lose their pension benefits if their employer went bankrupt.
These are steps in the right direction, but modest ones. The underlying problem with private sector defined benefit plans is that the employee takes on counterparty risk, where the employer is the counterparty. In this case, the pension plan is insulated from the risk that a company will fail, which is an improvement, but not from the risk that the plan itself will fail due to a market downturn (of the kind we have recently seen). There is language about allowing the plan to reduce benefits in such a scenario, but this of course undermines the benefit of a defined benefit pension in the first place.
The underlying problem with individual retirement savings vehicles (in addition to all the usual problems like fees, bad investment choices, leakage, etc.) is that many people just don’t make enough money to save for retirement. In this country we like to think of the ability to save as some kind of moral virtue, but in reality it’s primarily a function of your income. There is no comparison between saving 10 percent of a $250,000 annual income and 10 percent of a $15,000 annual income. What’s more, the MyRA caps out at $15,000, after which point you’re on your own in the Wild West of asset management predators firms.
MyRAs could get people in the retirement savings habit, which is useful if they start making upper-middle incomes, but not enough if they are stuck in the lower middle class. At the end of the day, the only way to ensure some degree of decent retirement income for low earners is to have a partially redistributive pension system (or a much higher minimum wage), and the only way to avoid the solvency risks of defined benefit plans is to have a federal government guarantee. (It should be no surprise that Social Security has both.) MyRAs and Harkin’s plan can help at the margins, but they won’t solve those fundamental problems.
By James Kwak
. . . (source), and Medicaid is more than one-third of Alabama’s budget (same source), what is Alabama doing with all the Medicaid money it gets from the federal government?
By James Kwak
The Wall Street Journal reports that the federal financial regulators may yet again carve a loophole in the Volcker Rule. This time, the issue is whether banks subject to the rule’s proprietary trading prohibitions can hold collateralized loan obligations (CLOs)—structured products engineered out of commercial loans, just like good old collateralized debt obligations were engineered out of residential mortgage-backed securities during the last boom.
The reason to prohibit positions in CLOs obvious: it was portfolios of similarly complex, opaque, risky, and illiquid securities that torpedoed Bear Stearns, Lehman, Citigroup, and other megabanks during the financial crisis. The counterargument is one we’ve heard many times before: If banks are forced to sell their CLOs, they will have to do so at a discount, which will “have a material negative impact to our capital base,” in the words of one banker.
But think about it for a second. Why would selling CLO tranches reduce a bank’s capital? Capital is defined as assets minus liabilities; if you sell a CLO and get its value in cash, you have just exchanged one asset for another, and your capital is unchanged. The dirty not-so-secret is that the banks are afraid of having to sell their CLOs for less than the values at which they are carrying them on their balance sheets, which will reduce their capital (and, more importantly to their executives, their current-year accounting profits).
But this is one of the things that everyone should have learned back in 2008. If you sell something for less than its stated book value, it’s not the sale that’s making you economically worse off; it’s the fact that the thing is already worth less than you paid for it. If a bank is carrying a CLO at 100 cents on the dollar, and no hedge fund out there is willing to pay more than 90 cents, then it’s only worth 90 cents. The bank’s capital is already impaired; it’s just lying about it using accounting rules to avoid admitting it. If forcing banks to sell their CLOs is the only way to get them to recognize their actual value, then that’s a feature, not a bug.
Then the other argument is, you guessed it: prohibiting banks from holding CLOs tranches will reduce demand for the underlying loans, making it harder for companies to get credit. But again, that’s a good thing. Right now, banks are willing to overpay for CLOs (or, rather, they are unwilling to sell them for their actual market value, which amounts to the same thing in economic terms) because of accounting reasons. That means that we have too much demand for CLOs, which means we have too much credit. As we again should have learned in 2008, too much credit can be just as bad as—or sometimes much, much worse than—too little credit. It’s a distortion, and as any free market economist should tell you, getting rid of it is a good thing.
If CLO issuance is down, you can blame it, as Morgan Stanley does, on “regulatory uncertainty.” But what it really means is that the investors who only care about making money—such as hedge funds—don’t want to fund these loans, at least not at the terms on offer. That means that the economy will be better off if the loans do not happen. This is all the way things are supposed to be—except in that twisted fantasyland of bank lobbyists.
By James Kwak
So, we have eleven aircraft carrier groups. No other country in the world has more than one. Everyone who has looked at the issue has agreed that we could do with fewer than eleven while still achieving our national security goals: Bush/Obama Defense Secretary Robert Gates, Obama Defense Secretary Chuck Hagel, and think tanks on the left and the right.
But apparently we can’t retire even one–even though we would save not just the annual operating costs, but most of the $4.7 billion it will cost to refurbish over the next five years. Instead, the Obama Administration has promised the Pentagon that it can simply have more money and not comply with the spending limits set in the 2011 debt ceiling agreement (and modified by Murray-Ryan).
Why? Well, legislators from states with Navy bases don’t want to reduce the Navy’s budget. More important, though, few people want to be for a smaller military–even when our military is irrationally large, given our other national priorities (healthcare, education, infrastructure, etc.). Instead of asking whether we need eleven times as many aircraft carriers as any other country, defenders insist that any reduction is a sign of weakness–conveniently overlooking the fact that we used to have fifteen carriers, and the world hasn’t ended.
The obvious underlying problem is that every line item in the budget has an interest group that wants it in there. The slightly less obvious underlying problem is that every budgetary debate is fought on its own, without regard to the tradeoffs it entails. Who is going to be against more and in favor of less? (Actually, when it comes to the military, I would, given the problems that having a super-strong military has caused us–think of Iraq, for starters–but that’s not a viable political position.)
The inability to keep more than one thing in mind at a time is a natural human limitation. How many times have you seen a meeting’s outcome be determined by the last idea that someone had, regardless of how it compared to all the ideas that came before? But it’s no way to run a country.