"Misapplying the theory I mislearned in college."

Baseline Scenario

Syndicate content The Baseline Scenario
What happened to the global economy and what we can do about it
Updated: 49 min 52 sec ago

Rumsfeldian Journalism

Wed, 04/16/2014 - 06:30

By James Kwak

I still have Nate Silver in my Twitter feed, and I used to be a pretty avid basketball fan, so when I saw this I had to click through:

Just how bad were the @DetroitPistons‘ Bad Boys? http://t.co/q7A05JunDn#Detroitpic.twitter.com/SOOkfzCqq4

— FiveThirtyEight (@FiveThirtyEight) April 15, 2014

In the article, Benjamin Morris tries to analyze how “bad”* the Detroit Pistons of the late 1980s and early 1990s (Bill Laimbeer, Rick Mahorn, Dennis Rodman, etc.) were, with full 538 gusto: “That seems like just the kind of thing a data-driven operation might want to quantify.” But the attempt falls short in some telling ways.

First, Morris has to find a quantitative proxy for “badness.” He selects technical fouls. Huh?

Morris’s own sources define “badness” this way:

  • “physical, defense-oriented style of play” (Wikipedia)
  • “on-court mayhem” (Sports Illustrated, although in the original that’s in the same sentence as “class” and “smothering defense”)
  • “gritty, hard-nosed players who didn’t back down from anyone . . . the willingness to do seemingly anything to win (ESPN)

Morris runs with that last phrase and questionably defines it as unsportsmanlike conduct (even though most people associate the will to win with, say, Michael Jordan). From there, he uses technical fouls as a measure of unsportsmanlike conduct, concluding, “this stat is the closest we have to an official determination of ‘bad’ behavior.” (Foreshadowing: sometimes close isn’t good enough.)

That’s really weak. Any basketball fan old enough will tell you that the Pistons were known for physical play, for pushing and shoving under the basket and fouling rather than giving up layups, but none of this has anything to do with technical fouls. At the end of the day, Morris uses technical fouls because he doesn’t have anything else to use. This is called looking for your keys under the lamppost, and it’s generally considered a bad empirical method.

Morris then makes his argument even more tortured by saying that unsportsmanlike conduct alone does not constitute “badness”—it has to be unsportsmanlike conduct in the pursuit of winning: “For a team to earn a nickname prominently declaring how ‘bad’ it is, the players should be using their badness to make them better.” Now, it is true that the Pistons combined a high technical foul rate with a high winning percentage. But I’m mystified at what the point is here. We already knew that the Pistons were a very, very good team—we wouldn’t be talking about them otherwise. So I’m not sure how it adds anything to the analysis at this point.

Anyway, let’s stipulate for the point of argument that unsportsmanlike conduct constitutes “badness.” Morris makes the rather dodgy assumption that technical fouls accurately measure unsportsmanlike conduct. But there are other reasons why the Pistons might have gotten a lot of technical fouls. For one, once they acquired a reputation for being “bad,” referees almost certainly looked at them differently. Players’ reputations affect the calls that referees make against them; Larry Bird could complain about a call without getting a technical, while Dennis Rodman would get one for far less. In other words, technical fouls are partially measuring perceptions of badness. This means they are pretty unreliable as a vehicle for measuring the actual badness of a team that had a reputation for it.

This is pretty basic stuff when it comes to statistics. You have to think about whether a variable is an accurate measure of some underlying characteristic. But when technical fouls are all you have to deal with, you end up ignoring this kind of issue.

Finally, there is if not the worst chart of all time, certainly the worst chart produced by an outfit that claims to specialize in analyzing and presenting data:

The observations are individual team-years. The Y axis is the team’s technical fouls divided by the league average for that year. What’s the X axis? It says “More technical fouls relative to the average,” but that could just as well be the label for the Y axis.

I’m pretty sure that all the team-years are just arranged sequentially from left to right, from fewest relative technicals to most relative technicals. Which is a pretty unhelpful way to display this information. If you only have one dimension (number of technicals), you don’t need a chart: just say the Pistons had 7 out of the top X seasons, including the top 2, and save the ink. If you want to show the extent to which the Pistons were outliers, use a frequency distribution so we can see the mode around 1 and the Pistons out in the tail. Don’t use two dimensions to tell a one-dimensional story.

Donald Rumsfeld famously said, “You go to war with the army you have.” Well, this is what happens when you try to answer a vague and complicated question but you only have one data series—and not a particularly appropriate one.

Morris triumphantly concludes, “For once, a harder look at the data seemingly confirms rather than undermines a popular sports narrative.” I think XKCD (see the previous link) still has the last word.

* “Not bad meaning bad but bad meaning good,” that is.

Defending Kickbacks

Tue, 04/15/2014 - 13:39

By James Kwak

The Wall Street Journal reports that the SEC will soon decide (well, sometime this year) whether brokers should be subject to a fiduciary standard in their dealings with clients, as registered financial advisers are today. At present, brokers only need to show that investments they recognize are “suitable” for their clients—roughly speaking, that they are in an appropriate asset class.

Not surprisingly, the brokerage industry is up in arms. They want to be able to push clients into the products for which they receive the highest commissions—a practice that (they say) could be more difficult under a fiduciary standard. According to one lobbyist,

“a universal fiduciary standard could end up hurting many investors. Lower- and middle-income investors often turn to brokers who are compensated through product commissions, he says, because such clients are less attractive to financial advisers who are compensated based on a percentage of assets under management. Higher costs could prompt some brokers to drop commission-based accounts in favor of more-lucrative accounts that charge a percentage of assets under management, leaving many lower- and middle-income investors without anyone to turn to for investment advice.”

(That’s a paraphrase by the Journal writer, not a direct quotation.)

First of all, note the underlying chutzpah here. The SEC is thinking of requiring brokers to act in the interests of their clients. The defense is, “We’ll have to change the way we do business.” How is that not an admission that they aren’t currently acting in the interests of their clients?

Second, let’s dig into the supposed benefits of commissions. Another word for “commissions” is “kickbacks.” Basically what’s going on is that some mutual fund company is charging a, say, 5 percent load, and then it’s paying some of that back to the broker who steered you into the fund. In other words, the only reason the fund company is paying a kickback to the broker is that it is making an even higher profit from the customer.

With the sales load, it’s obvious. But it’s also the case for a “no-load fund” with a high expense ratio. Brokerage commissions are not supposed to be included in fund expense ratios. But expense ratios do include 12b-1 fees, which are used to pay kickbacks to brokers.* Again, the kickback is just a way for the fund company to share with the broker the excess profits it earns from the customer who buys that fund—as opposed to, say, the index fund with an expense ratio of 10 basis points or less.

Now, sales commissions can make sense in some markets. For example, say there are two products in the market. A is worth $100 and costs $100 to make; B is worth $110 and costs $100 to make. But only professionals know which is worth more. In that case, if B is priced at $108 and $4 of the profits go to the broker as a commission, then your broker is more likely to steer you into B, and everyone is better off. (Of course, on these facts, the broker would still steer you into B even with the fiduciary duty, so a fiduciary duty rule would do no harm.) Or there can be a market in which ordinary customers have to go through brokers—that is, every product has a sales charge, one way or another.

But that’s not the case with mutual funds in liquid asset classes, which you can buy directly from Vanguard, Fidelity, and many others. There’s no reason to believe that, on an expected basis, a higher-priced product (in expense ratio terms) will have higher returns than a lower-priced product. Higher-fee funds are a combination of higher expenses on pointless things (“research,” trading costs) and higher profits for the fund company, which they are willing to share with brokers as a cost of doing business.

In other words, the sole reason the broker gets a commission is that he is selling you a worse product than the low-fee index fund. The excess profits and the kickback go together; you can’t have one without the other. If brokers choose to drop lower-income clients, then said clients are better off for not getting bad advice. If they need advice, then they should consult a fee-only adviser; the amount they spend in fees will be more than made up in avoiding poor investments recommended by brokers with hidden agendas.

* The Investment Company Institute, apparently in all seriousness, says, “Rule 12b-1 plans have provided an important addition to the choices investors have in how to pay for their fund shares.” Like, you could pay less, but now you can choose to pay more!

What Might Have Been . . .

Fri, 04/11/2014 - 14:23

By James Kwak

I was reading the plea deal in the SAC case, which was approved by the judge yesterday, and then I started reading the criminal indictment filed by the U.S. Attorney’s Office. What I noticed was how relatively simple it was for the prosecutors to convict SAC Capital for the insider trading committed by its employees. In short, because the firm enabled and benefited from the employees’ crimes, the firm was itself criminally liable.

Looking back at the enormous amount of effort the Southern District has put into Preet Bharara’s crusade against insider trading, you have to wonder what they might have accomplished had they instead targeted, say, fraud committed by Wall Street banks that contributed to the financial crisis. That’s the topic of my new column in The Atlantic. One of the frustrations of post-crisis legal proceedings is that it’s so hard to show that any senior executives themselves committed fraud, since they can usually plead some combination of ignorance and incompetence instead. Failing that, though, the government could have put more resources into flipping lower-level employees and then filing criminal indictments against their banks. Yesterday Bharara claimed, “when institutions flout the law in such a colossal way, they will pay a heavy price.” But only if the Department of Justice chooses to go after them.

The Absurdity of Fifth Third

Wed, 04/09/2014 - 11:53

By James Kwak

No, I’m not talking about the fact that a major bank is named Fifth Third Bank. (As a friend said, why would you trust your money to a bank that seems not to understand fractions?) I’m talking about Fifth Third Bancorp. v. Dudenhoeffer, which was heard by the Supreme Court last week.

The plaintiffs in Fifth Third were former employees who were participants in the company’s defined contribution retirement plan. One of the plan’s investment options was company stock, and the employees put some of their money in company stock. (Most important lesson here: don’t invest a significant portion of your retirement assets in your company’s stock. Remember Enron? Anyway, back to our story.) As you probably guessed, Fifth Third’s stock price fell by 74% from 2007 to 2009—this is a bank, you know—so the plaintiffs lost money in their retirement accounts.

The claim (I’m looking at the 6th Circuit opinion)  is that the people running the retirement plan knew or should have known that Fifth Third stock was overvalued in 2007, and they breached their fiduciary duty to plan participants by continuing to offer company stock as an investment option and by failing to sell the company stock that was owned by the plan. The suit was dismissed in the district court for failure to state a claim, so on review the courts are supposed to accept all the plaintiffs’ allegations as correct.

The serious legal issue in this case has to do with the duty of retirement plan fiduciaries to manage the plan’s assets prudently and for the exclusive benefit of plan participants and beneficiaries (ERISA § 404(a)(1)) and how that applies to an individual account plan that is invested in employer stock, to which the usual diversification requirement does not apply (ERISA § 404(a)(2)). More specifically, it has to do with a “presumption of prudence” that some courts apply in this situation—that is, a presumption that it is prudent for an employer stock ownership plan (ESOP) to continuing investing in company stock.

When you are down in the legal minutiae, this is not a crazy idea; after all, the participant chose the company stock option. But at a higher level, this borders on absurd. If you work at a company, you are already heavily invested in that company. Besides having skills that are particularly useful to that company, there’s the little problem that if the company does badly, you could lose your job. Doubling down by putting your retirement assets in the company is just increasing your risk. (This applies less to retirees, unless you’re drawing other retirement benefits from the company, but then the usual rules about investment diversification still apply.) How could the word “prudent” have anything to do with this practice?

At a higher level, you also have to wonder whether simply having a company stock option counts as prudent management of a retirement plan. ERISA exempts the company stock option itself from the diversification rules, but it doesn’t exempt you from the general duty to manage the plan prudently and for the benefit of participants. Given that diversification is the first rule of investing, it seems to me that the existence of an ESOP within a retirement plan is imprudent to begin with. There is a debate (which I’ve written about here) about whether having a stupid investment menu is exempt from the usual fiduciary duties under ERISA § 404(c), but it certainly shouldn’t be.

In short, if retirement plan fiduciaries actually behaved like fiduciaries, we wouldn’t have ESOPs within retirement plans to begin with. That’s what’s absurd about Fifth Third.

Disability Insurance Basics

Tue, 04/08/2014 - 13:30

By James Kwak

A while back I wrote a post critical of a Planet Money/This American Life episode on disability insurance. Among other things, I thought that the episode made too much of the fact that the number of people on federal disability insurance (SSDI or SSI) has gone up since the financial crisis.

The book I’m currently reading with my daughter at family reading time (she just finished a fictional book about a Polish immigrant girl in a mining community in the late nineteenth century) is Social Insurance: America’s Neglected Heritage and Contested Future, by Theodore Marmor, Jerry Mashaw, and John Pakutka. It’s a pretty good overview of the programs that are typically thought of (at least by the left and center-left) as social insurance in this country. Here’s what they say about recent trends in disability insurance (pp. 166–67):

“It has long been understood by those who study disability insurance that during times of economic distress, the incidence of claimed disability increases. Impairments that might have been overcome during times of economic growth and high rates of employment become the basis for claims of disability. . . . As a recession drags on and jobs are not plentiful, many no doubt make the choice to see if a musculoskeletal malady or a mood disorder qualifies them for disability insurance benefits.”

In the longer term—meaning before the financial crisis—disability rates have been creeping upward. The main reasons are: (1) an aging population; (2) the slow increase in the full retirement age for Social Security, which keeps people on SSDI (as opposed to OASI) longer; and (3) the increasing frequency of musculoskeletal and mood disorder claims (e.g., depression). These are all completely normal things, unless you want to go back to the bad old days when mental illnesses like depression were not considered on pair with physical illnesses. At the margin, there is certainly fraud in the system, but in fact it’s quite hard to get disability benefits, and the standards aren’t getting any more lenient.

Sometimes the real story isn’t all that mysterious.

The Too Big To Fail Subsidy Debate Is Over

Sat, 04/05/2014 - 00:15

By Simon Johnson

No doubt there is still a lot of shouting to come, but this week a team at the International Monetary Fund completely nailed the issue of whether large global banks receive an implicit subsidy courtesy of the American government.   Is there a subsidy, is it large, and how much damage could it end up causing to the broader economy?

The answers, in order, are: yes, there is an implicit subsidy that lowers the funding costs for very large banks; the subsidy is big, with costs of borrowing for these banks lowered by as much as 100 basis points, i.e., 1 percentage point; and yet this large scale of implicit support is small relative to the macroeconomic damage that is likely to be caused by the high leverage and incautious risk-taking that the subsidy encourages.

If anything the IMF’s work provides a conservative (i.e., low) set of estimates.

Still, as I explain in my NYT.com Economix column, I’m a big fan of this work because the Fund’s report is very good on how to handle and reconcile the main alternative methodologies for getting at the issue.

The Fund offers an entirely reasonable approach that sets a very high quality bar. The Government Accountability Office (G.A.O.) is expected to produce a report on TBTF subsidies in the summer; their work now needs to be at least as careful and as comprehensive as that of the IMF. The same applies to the Federal Reserve and anyone in the private sector who attempts to dispute these numbers.

More Pseudo-Contrarianism

Fri, 04/04/2014 - 11:11

By James Kwak

I accidentally glanced at the link to David Brooks’s recent column and—oh my god, is it stupid. You may want to stop reading right here to avoid being exposed to it.

Basically, Brooks says that the Supreme Court’s decision in McCutcheon is pro-democratic because it strengthens political parties relative to “donors and super PACs.” In case you weren’t aware, McCutcheon eliminates the aggregate limits on direct contributions to candidates, parties, and PACs (not super PACs–no such limits exist) but the individual contribution limits still stand—so now you can max out to more candidates and parties than you could before.

First of all, let’s be clear about the practical impact here. In the 2012 cycle, 644 people hit the aggregate limits, and they donated $93 million (to entities governed by aggregate limits). That’s nothing. Sheldon Adelson alone contributed close to $150 million. And the limits on what you can donate to either party’s national committee, or either party’s Senate committee or House committee, still stand.

So basically we’re talking about those very few people who, when asked to contribute to (say) the DCCC, said, “Sorry, I’m maxed out.” At the margin, now some of those people can write the check to the DCCC rather than to some super PAC—although they can also write the check to some candidate, or that candidate’s PAC, and that money isn’t under party control.

In Brooks’s world, this is good because weaker parties make it harder for challengers to unseat incumbents. Huh? Has he seen what is going on over in Republican land? The rise of super PACs is a major reason why extreme right wing candidates, funded by the Club for Growth and FreedomWorks, can threaten far right candidates preferred by the Republican Party.

The big money is in super PACs and 501(c)(4)s not because the super-donors wanted to give money to the parties but couldn’t. It’s there because the super-donors like it that way. They like the anonymity of giving to a 501(c)(4). They like the ability to dictate what a super PAC does, rather than having to compete with other people trying to influence a national party.

Brooks also thinks that the current emphasis on fundraising is a consequence of weak parties: “With the parties weakened, lawmakers have to do many campaign tasks on their own. They have to do their own fundraising and their own kissing up to special interests.”

Correlation, causality. The reason candidates have to raise more money is that they need more money. The reason they need more money is that there is a lot more money in politics. The reasons there is a lot more money is politics are (a) rich people have vastly more money than they did a few decades ago and (b) campaign finance laws now allow those rich people to spend a lot more money on politics. That’s why Barack Obama and Mitt Romney both spent time not just soliciting checks made out to their campaigns, but also appearing at events for their “uncoordinated” coordinated super PACs.

McCutcheon isn’t quite the end of the world, because its immediate practical impact is not as big as that of Citizens United and SpeechNow.org. It is significant as a precedent, since it shows that a majority of the Court is perilously close to tossing out contribution limits altogether, going further down the Citizens United rabbit hole in which corruption doesn’t exist. If justices think that a multi-million-dollar donation to a politician’s uncoordinated super PAC isn’t corruption or the appearance of corruption, then there’s no amount of stupidity they aren’t capable of.


Fri, 04/04/2014 - 09:37

By James Kwak

One of the criticism’s of Michael Lewis’s book is that he gets his moral wrong. High-frequency trading doesn’t hurt the little guy, as Lewis claims; instead, it hurts the big guy. The explanation is this: people sitting at their desks buying 100 shares of Apple are getting the current ask, so mainly they care about volume and tight bid-ask spreads. Institutional investors, buy contrast, want to buy and sell huge blocks of shares, and they don’t want the price to move in the process; they are the ones being front-run by the HFTs. Felix Salmon pointed this out, and it’s the subject of an op-ed by Philip Delves Broughton today.

What this leaves out is the question of who ends up being harmed. To figure that out, you have to ask whose money we’re talking about when we say “institutional investor.” If it’s SAC Capital, meaning Steven Cohen’s money, then who cares? But most ordinary people invest—if they are lucky enough to have money to invest—through mutual funds (401(k) plans, for example, are largely invested in mutual funds), and those funds are among the “institutional investors” losing money to HFTs. Another big chunk of institutional money belongs to pension funds. In this case, if the pension fund does poorly, the money may come out of its corporate sponsor in the form of increased contributions—or it may come out of beneficiaries and taxpayers in the form of a bankrupt plan shifting its obligations to the PBGC. Then there are insurance companies: in that case, losses from trading affect shareholders, but if they are systemic across the industry they end up as higher premiums for consumers.

This is not to say that the institutional investors are warm and cuddly and are just passive victims in all of this. I’ve spilled enough ink inveighing against active asset managers, and Salmon points out that the buy side bears its share of blame for being careless with other people’s money. At the end of the day, if HFT harms other people in the markets, it’s just a fraternal spat among capital, and doesn’t affect the fundamental divide in the post-Piketty world. Until a poorly-tested algorithm goes berserk and freezes the financial system, that is.

Citigroup CEO Named To “Key Administration Post”

Tue, 04/01/2014 - 00:44

By Simon Johnson

Just a few short days ago, it looked like Citigroup was on the ropes. The company’s proposal for redistributing capital back to shareholders was rejected by the Board of Governors of the Federal Reserve System. Given the global bank’s repeated fiascos – including most recently the theft of around $400 million from its Mexican unit – it is hardly surprising that the Fed has said “no” (and for the second time in three years).

The idea that Citigroup might now or soon have a viable “living will” now seems preposterous. If top management cannot run sensible financial projections (that’s the Fed’s view; see p.7 of the full report), what is the chance that they can lay out a plausible plan to explain how the company, operating in more than 100 countries worldwide, could be wound down through bankruptcy – without any financial assistance from the government? According to the Dodd-Frank financial reform law, failure to submit a viable living will should result in remedial action by the authorities.

Such action has now been taken: CEO Michael Corbat has been named to a top White House job, with responsibility for helping to develop “financial capability for young Americans.”

Given that today is April 1st, this announcement may seem a fairly obvious canard (along the lines of some previous April Fools’ Posts on this website, including regarding the gold standard last year).

But the White House announcement is dated March 27, 2014 (just as the failed stress test news was breaking) – and it is their media team who use the term “top administration post”. Mr. Corbat’s new job has subsequently been confirmed by the Financial Services Roundtable (roundup email of 03/28/14), and no one knows more about the detailed relationship between Big Finance and government.

Presumably, Mr. Corbat’s appointment will help prepare the next generation of Americans for deep recession, job losses, and dismal prospects due to major miscalculations by Citigroup and other big banks – including what these firms have done, what they are doing now, and what they will do.

The agenda for discussion with current distinguished members of this policy council (full name: President’s Advisory Council on Financial Capability for Young Americans) could also usefully include:

The White House may be onto something. If only we could all behave like top Citigroup executives, as a nation we could become much wealthier – systematically expropriating from investors without any adverse consequences for our careers or even our immediate compensation. This is the kind of logic that won the Institute of International Finance two Nobel prizes in 2011 and that lies behind continued opposition to the Volcker Rule.

At the end of his detailed account of miscalculation and overconfidence among Citigroup executives, published in 1995, Phillip L. Zweig writes (Wriston: Walter Wriston, Citibank, and the Rise and Fall of American Financial Supremacy, p. 3) that,

“Citigroup had essentially lost a decade. But along the way, Reed [then-CEO] and his institution had lost much of their hubris. Because of that, there was finally reason to believe that their near-fatal mistakes would not soon be repeated.”

Executives at Citi and elsewhere definitely learned the lessons of the 1970s and 1980s, but not in the way Mr. Zweig envisaged.

Size is power in the modern American economy. If you are building a bank, executives reasoned in the 1990s and early 2000s, it’s better to make it as big as possible. From a personal point of view, they have been proved right again and again. (From a social point of view, this has proved an unmitigated disaster.)

The truth is Citigroup is now and has long been a badly run company.   It should be euthanized by the market, but continues in existence because it is protected by regulation and regulators against being taken over and broken up into more efficient pieces (with some of the worst businesses simply being closed).

The Citigroup case is fascinating because it suggests the Federal Reserve may now be standing up to at least the weakest (from a management perspective) of the Too Big to Fail US banks.

From a political perspective, what matters is not so much the Fed as the White House.

As with everyone in Washington, watch what they do, not what they say.

And the most important question is: Who is admitted to top policy circles? What kind of experience makes someone into an expert who speaks directly to the president – and into a role model held out for young people to emulate?

Mr. Corbat’s new position confirms that, once again, it doesn’t matter how badly Citigroup did on your watch – the White House will hire you for your supposed expertise in any case.

The Desperation of the Vanishing Middle Class

Mon, 03/31/2014 - 13:30

By James Kwak

I recently finished reading Pound Foolish, by Helaine Olen, which I discussed earlier (while one-third of the way through). The book is a condemnation of just almost every form of personal financial advice out there, from the personal finance gurus (Suze Orman, Dave Ramsey) to the variable annuity salespeople to the peddlers of real estate get-rich-quick schemes to Sesame Street‘s corporate-sponsored financial education programs. (Of them all, Jane Bryant Quinn is one of the few who generally come off as more good than evil.)

A lot of what’s going on is just semi-sleazy entrepreneurs trying to make a buck, taking “advice” that is equal parts routine, wrong, and contradictory and packaging it into attractive-looking books, TV shows, and in-person events. A lot of the rest is marketing by the real financial industry, which either (a) wants to make a show of promoting financial education so people will think they are good or (b) wants to teach people that they need their products. (You pick.)

The underlying problem with financial advice—besides the fact that most of it is wrong, conflicted (in the conflict of interest sense), or covert marketing—is that, even in the best case, it rarely works. The underlying financial problem that most Americans have isn’t that they buy too many lattes or pick the wrong stocks. It’s that they don’t make enough money to begin with, at a time when many necessities like health care and education are getting more expensive. (Measured inflation is low in part because things we don’t need, like fancy electronics, are getting cheaper.) This, as I’ve written before, is the fundamental reason why many people won’t be prepared for retirement. Olen has a similar viewpoint: the blind spot of the personal finance industry, she argues, is its refusal to even consider the macroeconomic factors that are the real problem.

But the big question is why this stuff is so popular. As Olen points out, we haven’t always had a personal finance advice industry, and it’s only recently that financial education has been embraced as the solution to all our problems. One reason, she suggests, is that we live in an age of stagnant real wages and rising inequality. Add that to a culture that fetishizes individualism and rejects government support programs, and you have a market that is ripe for self-proclaimed gurus or self-interested advertising campaigns that claim that you can get ahead by (insert your choice) drinking less coffee, or going into more real estate debt, or buying a variable annuity, or picking the right stocks. The governments (state and federal) that promote financial education are like Marie-Antoinette advising people to eat cake; if they could eat cake in the first place, they wouldn’t need financial education.

Many of the people Olen talked to were too embarrassed by their financial plight to let her use their names in the book. Somehow we ended up blaming ourselves for the fact that we don’t have a decent minimum wage, real national health insurance, subsidized child care that made it easier to hold a job, or long-term unemployment insurance (other than in special circumstances). If we saw individuals’ financial struggles as a political issue—or a class issue—things might be different.

Perhaps The Most Boring Important Topic In Economics

Mon, 03/31/2014 - 00:53

By Simon Johnson

International economic policy making is a contender for the title of “most boring important topic” in economics.  And within the field there is nothing quite as dull as the International Monetary Fund (IMF).  Try getting an article about the Fund on the front page of any newspaper.

And even for aficionados of the Fund, the issues associated with reforming its “quota” and “voting rights” seem arcane – and are fully understood by few.

Dullness in this context is not an accident – it’s a protective wrapping against political interference, particularly by the US Congress.

Now, however, the IMF needs a change in its ownership structure, and the sole remaining holdup is Congress.

The Obama administration let this issue slide for a long while, and then attempted to link it with financial aid being extended to Ukraine.  That attempt failed last week.

In a column for Project Syndicate, I discuss why this matters and what comes next.  Try not to fall asleep.

The Chinese Boom-Bust Cycle

Sun, 03/30/2014 - 15:40

By Simon Johnson

Should we fear some sort of financial crash in China, along the lines of what we saw in 2008 in the US or after 2010 in the euro area?

Given the rate of growth in credit and the expansion of the so-called shadow banking sector over the past five years in China, some sort of financial bust seems hard to avoid.

But this need not be the hard landing seen in more developed countries – and the impact on the world economy will likely be much more moderate.  At the same time, however, bigger problems await in the not-too-distant future.

Peter Boone and I review the details in a column for NYT.com’s Economix blog.

Stress Tests, Lending, and Capital Requirements

Fri, 03/28/2014 - 10:41

By James Kwak

Despite the much-publicized black eye to Citigroup’s management, the bottom line of the Federal Reserve’s stress tests is that every other large U.S. bank will be allowed to pay out more cash to its shareholders, either as increased dividends or stock buybacks. And pay out more cash they will: at least $22 billion in increased dividends (that includes all the banks subject to stress tests), plus increased buyback plans.

Those cash payouts come straight out of the banks’ capital, since they reduce assets without reducing liabilities. Alternatively, the banks could have chosen to keep the cash and increase their balance sheets—that is, by lending more to companies and households. The fact that they choose to distribute the cash to shareholders indicates that they cannot find additional, profitable lending opportunities.

This puts the lie to the banks’ mantra that capital requirements will constrain lending and therefore reduce growth (made most famously in the Institute of International Finance’s amateurish report claiming that increased regulation would make the world’s advanced economies 3 percent smaller). Capital isn’t the constraint on bank lending: it’s their willingness to lend.

Let’s look at this a little more closely. Let’s say that, instead of letting the banks increase their dividends and buybacks, the Federal Reserve increased capital requirements and said that banks had to hold onto their cash to meet those higher requirements. What would happen to bank lending? Nothing. Banks wouldn’t have to reduce their balance sheets because they already have the cash; they would just be not paying it out to shareholders.

The counterargument is this: banks only want to lend if their expected rate of return exceeds their cost of capital; but higher capital requirements increase the cost of capital (because equity capital is more expensive than debt capital); therefore the set of attractive lending opportunities will shrink.

But this is a fallacy, as spelled out by Admati and Hellwig in The Banker’s New Clothes. According to Modigliani-Miller, capital structure doesn’t affect the overall cost of capital, so retaining cash shouldn’t reduce the set of attractive lending opportunities. We all know Modigliani-Miller doesn’t hold in the real world, but the main reason it doesn’t hold is the tax subsidy for debt. (The second-biggest reason it doesn’t hold is agency costs, which dictate that more debt is bad.) In other words, to the extent that more debt lowers the cost of capital, it’s due to a distorting government intervention. The lower cost of capital due to increased leverage is a social bad, not a social good.

Bank CEOs can’t have it both ways. If the best use of their cash really is returning it to shareholders, then they might as well be keeping it in their accounts at the Federal Reserve. And that way we would have safer banks, and a safer financial system.

A Book That Needed To Be Written

Wed, 03/26/2014 - 12:38

By James Kwak

I have previously written about (here, for example) what I call economism, or excessive belief in the little bit that you remember from Economics 101. The problem is twofold. First, Economics 101 usually paints a highly stylized, unrealistic view of the world in which free markets always produce optimal outcomes. Second, most people in the world who have taken any economics have only taken first-year economics, and so they never learned that, from a practical perspective, just about everything in Economics 101 is wrong. (Complete information? Rational actors? Perfectly competitive markets?) This produces a nation of people like Paul Ryan, who repeats reflexively that free market solutions are always good, journalists who repeat what Paul Ryan says, and ordinary people who nod their heads in agreement.

The problem is not the economics profession per se. These days, to make your mark as an economist, it helps to be arguing (or, better yet, proving) that the free market caricature of Economics 101 is wrong. The problem is the way it is taught to first-year students, which pretty much assumes that Joseph Stiglitz, Daniel Kahnemann, Elinor Ostrom, and many others had never existed.

What we need, I have often thought, is a companion book for students in Economics 101, one that points out the problems with the standard material that is covered in the textbook. For a while I was thinking of writing such a book, but I decided against it for a number of reasons, one of them being that I am not actually an economist. Fortunately, John Komlos, who really is an economist, has written a book along these lines, titled What Every Economics Student Needs to Know and Doesn’t Get in the Usual Principles Text.

Komlos’s book takes aim at what he calls “market fundamentalism,” the ideology that markets are always good. Like all successful ideologies, market fundamentalism pretends not to be an ideology, which is why it likes to dress up in mathematical equations. But as most people in most other social sciences would agree, ideology is inescapable. Komlos is explicit about his: the goal of economics should be to improve people’s quality of life, which includes the ability of people to live meaningful lives. He also seems to agree that there is nothing wrong with the field of economics in itself: the problem is that many of the most important developments in economics have been left out of introductory courses and textbooks. The result is that “most students of Econ 101 . . . are never even exposed to the more nuanced version of the discipline and are therefore indoctrinated for the rest of their lives” (pp. 10–11).

Most of the book after the first couple of chapters presents specific criticisms of the basic models presented in Economics 101. Chapter 3, for example, discusses the problems with assuming that consumer demands are exogenously determined and that indifference curves are smooth and reversible (that is, ignoring the fact that we experience loss aversion in considering changes in consumption levels). Chapter 4 summarizes the evidence against the assumption of the rational decision maker and discusses what that means for the principle of utility maximization. And so on.

The book covers a lot of topics, many of which could warrant much further discussion. But it should do an excellent job at its primary mission: showing first-year students that most of what they learn cannot be applied in the real world, at least not without significant modification. The world is a complex, messy place, and markets are complex, messy institutions like any others. The more people learn that lesson, the better.

More on Wasting Shareholders’ Money

Tue, 03/25/2014 - 13:30

By James Kwak

A few weeks ago I wrote a post about my most recent “academic” paper, on the issue of whether corporate political contributions might constitute a breach of insiders’ fiduciary duty toward shareholders. The thrust of that paper was that some political contributions could be contested as breaches of the duty of loyalty—for example, if a CEO causes the corporation to give money to a candidate who promises to lower the CEO’s individual income taxes—which would result in the courts applying a higher standard of review.

Joseph Leahy, another law professor, recently directed me to a paper that he wrote last year (but is still being edited for publication in the Missouri Law Review) on basically the same topic. He argues first that corporate political contributions do not qualify as “waste” (which has a precise legal definition), barring the kind of extreme facts that you only see in law school hypotheticals. I agree with that, although my only discussion of the point was in a footnote (79).

Second, Leahy argues that a corporate political contribution might qualify as self-dealing, citing in particular the example where a CEO directs a corporate donation to the candidate who is best for his personal taxes. As Leahy says, “it is certainly plausible that a jury would conclude that a corporate political donation constitutes self-dealing by the corporation’s rich directors or offices, even if the contribution also plausibly benefits the corporation” (p. 88).

Leahy does strike a slightly different tone than I do. On balance, although he finds this line of attack plausible, he thinks it is likely to fail in most circumstances. The problem, he writes, is that “any financial benefit to the director or her proxies will be indirect and highly uncertain, so plaintiffs will have to show that the financial benefit was sufficiently important in order to be material to the donor” (p. 96). One problem with establishing materiality is that, in general, an individual donation is unlikely to affect the outcome of an election. (But if we’re going to say that contributions are immaterial on that ground, then we’re halfway down the rabbit hole, since the same could be said of all political contributions, which brings us back to where we started: why do corporations do this with shareholders’ money?)

I do agree with Leahy that this type of challenge is likely to fail in most circumstances, given the current attitudes of our courts. But I also think that there is enough precedent in the cases for the Delaware Chancery Court to uphold such a challenge, if one of the chancellors wants to.

Stopping Russia

Mon, 03/24/2014 - 11:05

By Simon Johnson

The rhetoric of confrontation with Russia seems to be escalating, including with the remarkable suggestion – from Mike Rogers, the chairman of the House Intelligence Committee – that the US provide “small arms and radio equipment” to Ukraine.

Encouragement for a military confrontation is not what Ukraine needs.  As Peter Boone and I have argued in a pair of recent columns for the NYT.com’s Economix blog, Ukraine needs economic reform (with a massive reduction in corruption as the top priority).   This reform requires, above all, a massive and immediate reduction in – or elimination of – corruption.

Throwing a lot of external financial assistance at Ukraine’s government, for example with a very large loan from the International Monetary Fund, is unlikely to prove helpful.  Based on recent prior experience, such lending may even prove counterproductive.

And this seems to be exactly the path that our foreign policy elite has placed us on.


Fri, 03/21/2014 - 12:10

By James Kwak

There is a common phenomenon in legal disputes over the value of something, be it a company, a piece of land, or a person’s expected lifetime earnings. Each side hires an “expert” who produces an estimate based on some kind of model. And miraculously, every single time, the expert for the party that wants a higher number comes up with a high number, while the expert for the party that wants a lower number comes up with a low number. No one is surprised by this.

Yesterday, the Federal Reserve posted the results of the latest periodic bank stress tests mandated by the Dodd-Frank Act. For these tests, the Fed comes up with various scenarios of how things could go badly in the economy, and the goal is to see how banks’ income statements and balance sheets would respond. The key metrics are the banks’ capital ratios; the goal is to identify if, in bad states of the world, the banks would still remain solvent. If not, the banks won’t be allowed to do things that reduce their capital ratios today, like paying dividends or buying back stock.

For the most part, the results look pretty good: capital levels even under the severely adverse scenario should remain above the levels reached during the 2008–2009 crisis. (Of course, there are several huge caveats here. You have to believe: first, that the scenarios are sufficiently pessimistic; second, that the banks’ current financials are accurately represented; third, that the model is sensible; and fourth, that the capital levels set by current law are high enough.)

But there’s something else going on here. As part of the stress testing routine, each bank is supposed to do its own simulation of how it would respond to the scenarios specified by the Fed, using its own internal model. And—surprise, surprise!—the banks virtually uniformly predict that they will do better than the Fed.

At the high end, Goldman Sachs and Citigroup predict that they would have capital levels 3.9 and 3.0 percentage points, respectively, higher than expected by the Federal Reserve. Since the Fed predicted minimum Tier 1 capital levels for these two banks of 6.8 and 7.0 percent, those are huge differences: 57 percent higher for Goldman and 41% higher for Citi. The other four big banks also claimed their capital levels would be 0.2 to 2.6 percentage points higher than in the Fed’s model.

Now if everyone were being above board here, the expected difference between the banks’ estimates and the Fed’s estimates should be zero. But of course that’s not the case. Banks do things to make money, and in this exercise their goal is to make the case that they can get by with less rather than more capital. There are honest differences of opinion on how to model things, but you can systematically make plausible choices that produce higher rather than lower numbers. And that’s almost certainly what’s going on. Which means that the banks’ estimates aren’t worth the electrons who died (OK, not literally) sending them to you across the Internet.

But, you may be thinking, isn’t the Federal Reserve systematically trying to produce low numbers? Not necessarily. The Fed’s incentive in the first instance isn’t to force banks to maintain more capital; it’s to make sure that banks are holding the right amount of capital. The Fed is supposed to protect the financial system and ensure economic growth, so if you believe in the capital-growth tradeoff, the Fed doesn’t have an incentive to force banks to hold lots of capital. (And if you don’t believe in it, then you should already agree with Admati and Hellwig that every bank should have lots more capital.) In other words, Fed economists don’t make any more money by arguing that banks need more capital.

Although there’s no a priori reason why the Fed as an institution would want banks to hold more capital, it’s also possible that the specific people at the Fed do think that banks should be holding more capital, and they are using the stress tests as a backdoor way to push that agenda. But if that’s the case, there’s another, more powerful tool they should be using: they should be boosting the leverage ratio (which, counterintuitively, is  measured as equity over assets, not debt over equity).

Finally, this whole thing proves a point that I argued a long time ago: capital doesn’t exist as an object in the world. It’s inherently probabilistic, since it is based off of the values of things whose value depends on unknown probability distributions. That’s why it’s possible for Goldman to argue with a straight face that its capital will be 57 percent higher in some state of the world than the Federal Reserve thinks it will be. And that’s why, if you’re counting on capital requirements to protect the financial system from disaster, you had better err far on the side of safety.

Whiskey Costs Money

Thu, 03/20/2014 - 20:37

By James Kwak

A few days ago I wrote a post that began with New York Fed President William Dudley talking tough about banks: “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” The thrust of that post was that I’m not very encouraged when regulators talk about culture and the “trust issue” but don’t indicate how they are going to actually affect industry behavior.

As they say, talk is cheap, whiskey costs money. What’s more important than what regulators say is what they do—and don’t talk about. Peter Eavis (who wrote the earlier story about bank regulators that my previous post was responding to) wrote a new article detailing how that same William Dudley has delayed the finalization of the supplementary leverage ratio: the backup capital standard that requires banks to maintain capital based on their total assets, not using risk weighting.

Dudley has said, “I do not feel that I in any way hold any allegiance or loyalty to the financial industry whatsoever.” That may be true; he certainly made enough at Goldman that he has no real financial incentive to continue to make nice with Wall Street.* Yet at the same time he appears to be parroting concerns raised by some of the big banks, raising a concern about the leverage rule that Felix Salmon calls “very silly” and that, according to Eavis, the Federal Reserve mother ship in Washington didn’t consider significant.

In the grand scheme of banks and their allies weakening and slowing down new regulation, this is probably not a particularly momentous battle. But it does put things in perspective.

* Of course, we know that among some people (many of whom live in New York and work in finance), no amount of money is ever enough.

There’s No Substitute for the Government

Tue, 03/18/2014 - 13:34

By James Kwak

Mike Konczal wrote an excellent article for Democracy about the problems with a voluntary safety net and the superiority of government social insurance. The article draws on serious historical research (by other people) to prove two main points: first, there never was a Golden Age of purely voluntary charity; second, and more important, what charitable support mechanisms existed were not up to the challenges of the Second Industrial Revolution of the late nineteenth century and completely collapsed with the onset of the Great Depression.

This shouldn’t come as a surprise. There are basic economic reasons why public social insurance is superior to voluntary charity. The goal here is to protect people against risk: of unemployment, of health emergency, of outliving one’s savings, and so on. For a risk-mitigation scheme to work, there are a few things that are necessary. One is that people actually be covered. This is something you can never have with a private system (unless it’s regulated to the point of being essentially public), since charities get to pick and choose whom they want to help. As Konczal says of private agencies before the Depression,

“They were also concerned they’d lose their ability to stigmatize—or to protect—various populations; by playing a role in determining who wasn’t deserving of assistance, they could shield those they felt worthy of their support.”

Another thing you want is the assurance that the system has the financial capacity to actually protect you in the event of a crisis. That’s why you don’t depend on your neighbors to rebuild your house if it burns down. Besides the fact that they may not like you, they probably don’t have enough money—especially if you lose your house in a fire that burns down the entire neighborhood. As I’ve said many times before, there is no other entity in the country—and not really one in the world—with the financial capacity of the federal government. Even state governments scramble to cut benefits when push comes to shove, which is one reason why some states provide Medicaid coverage to almost no one.

We like to think that we are a nation of generous people who will help each other out, but that isn’t really true. We do have a much larger charitable sector than other advanced economies, where the state shoulders more of the burden. But more than half of our total donations go to religious organizations, private schools, and medical organizations, with only 12 percent going to human services organizations. Some money does filter from other organizations to the poor, but at most you can get to one-third of the total. (The vast majority of my donations have gone to services for the poor, primarily legal services.) I’ve argued elsewhere that we should place limits on the tax deductibility of charitable contributions, which are effectively a way that rich people can force other taxpayers to contribute to their pet charities. But as long as we have this idealized picture of our charitable sector, it isn’t going to happen.

You Don’t Say

Mon, 03/17/2014 - 13:30

By James Kwak

Last week Peter Eavis of DealBook highlighted a statement made last year by New York Fed President William Dudley (formerly of Goldman Sachs, then a top lieutenant to Tim Geithner): “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” There was a point, say in 2008, when many people probably thought that our largest banks were just guilty of shoddy risk management, dubious sales practices, and excessive risk-taking. Since then, we’ve had to add price fixing, money laundering, bribery,  and systematic fraud on the judicial system, among other things. 

Eavis also tried to make something positive out of a couple of other recent comments. Dudley said, “I think that trust issue is of their own doing—they have done it to themselves,” while OCC head Thomas Curry said, “It is not going to work if we approach it from a lawyerly standpoint. It is more like a priest-penitent relationship.”

I don’t see much reason for optimism. First, framing the problem as a “trust issue”—customers no longer see banks as trustworthy institutions—is beside the point. Wall Street’s main defense is that its clients already realize that investment banks do not have their buy-side clients’ best interests at heart, and clients who don’t realize that are chumps. And in the wake of the financial crisis, I suspect there are few individuals out there who believe that their banks are there to help them. The banking industry has discovered that it can thrive without trust, which is not surprising; retail depositors trust the FDIC, and bond investors know that trust isn’t part of the equation.

Second, when an entire industry shows a deep proclivity to flaunt the law, it’s distressing that one of its top regulators sees himself more as a priest than as a lawyer. With a priest, the presumption is that the congregant actually wants to be saved, and therefore will listen to the priest. Wall Street banks just care about profits, which is only natural. Once they’ve learned that they can be profitable without being ethical, there’s no turning back. The only way to change the equation is to make lawbreaking unprofitable, which means serious penalties, both civil and criminal. 

In that vein, the SEC is especially proud of a judge’s decision last week to impose an $825,000 fine on Fabrice Tourre, the Goldman employee implicated in the ABACUS deal. The SEC’s enforcement director claimed that the penalty reflected “the S.E.C.’s intent of pursuing meaningful sanctions to punish individuals responsible for misconduct and deter others from violating the federal securities laws.” If only.

That is a meaningful sanction, particularly because the judge prohibited Goldman from covering Tourre’s penalty of $650,000. I doubt, however, that she could stop Goldman employees from individually gifting cash to Tourre. And, if they have any kind of sense of fairness, they should start passing the hat—because Tourre was the only one out of probably thousands of people engaged in similar behavior who got busted. Which means that, if you want to structure deals so they are likely to collapse and lie about it to your buy-side clients, the odds are spectacularly in your favor. More important, if you are a senior executive and you want to pressure your employees (including by promising them huge bonuses) to structure deals that are likely to collapse and lie about it to your buy-side clients, the odds in your favor approach certainty.

Talk is cheap. But ultimately, it’s hard to see how anyone’s behavior is going to change with the regulators we’ve got.