Author Archives: Corbett

Revised: IP Rights – A Double Edged Sword

According to Rod Hunter, senior vice president of Pharmaceutical Research and Manufacturers of America, it is commonly thought that developed and developing countries should enforce different degrees of Intellectual Property (IP) Rights.  Specifically, many policy makers (especially those in India) believe that strong IP rights hurt developing countries by hindering free economic development.  This train of thought has resulted in strong IP rights in high-income countries (like the USA) and weak IP rights in low-income countries (like India).

Interestingly, a comparison of IP rights and FDI in India, China, and the USA illustrates that most policy makers have the relationship between IP rights and economic growth backwards; rather than limiting development, strong IP rights foster economic growth by attracting foreign investment.  It is obvious that large corporations looking to invest in research and development are attracted to countries with strong IP rights, as investing in these countries provides a safer return.  In the United States, legally protected intellectual property represents 44% of aggregate firm value.  Therefore in the absence of IP protection, US firms would lose nearly half of their asset base.  Given the relationship between IP rights and corporate value, it would be foolish for any firm to invest in countries lacking IP protection.  In this way, IP Rights are the “dynamo of growth for developed and developing countries alike,” as they increase FDI, thereby fueling economies, creating jobs, and allowing for higher levels of consumption.

Currently India pursues a strategy of weak IP Rights.  China on the other hand has a medium degree of IP protection, and the United States has an enormous level of protection.  These three countries’ share of the world’s research-and-development-related-FDI follows a similar pattern.  The United States and China command 31% and 18% of the world’s R&D related FDI respectively, while India only receives 2.7%.  While correlation does not necessarily imply causation, there seems to be powerful evidence that stronger IP rights fuel higher levels of FDI.  Economist Rob Shapiro agrees with this statement, claiming that if India adopted the same levels of IP protection as China, its share of the world’s R&D related FDI would grow 33% each year!

It therefore seems clear that strong IP rights can serve as a catalyst for growth, thereby fueling economic development in low-income countries.  That said, FDI and economic growth certainly do not tell the whole story when it comes to quality of life.  Case in Point – the African AIDS crisis in early 2000.  In the beginning of 2000, nearly 24 million Africans were infected with HIV, and nearly 6,000 died from AIDS each day.  At the same time, companies like Bristol-Myers Squibb and Merck were producing powerful drugs to help treat the symptoms of HIV.  That said, these companies needed to charge high prices in order to recoup the large investments necessary to initially develop these drugs.  Unfortunately, these high prices meant that most of Africa could not afford potentially lifesaving treatments.  While generic versions of these drugs (legally available in countries like Brazil) were quite affordable, the IP rights that existed between Africa and North America legally prohibited African countries from importing these generic versions.

Consequently, doctors took matters into their own hands.  Doctors without Borders imported generic AIDS drugs, consciously violating the IP laws governing Africa.  According to Toby Kasper, a spokesperson for Doctors without Borders at the time, the organization would not tolerate using expensive, brand name drugs when it could treat twice as many patients with generics.

Here we see how IP protection is a double-edged sword.  While economically, strong IP rights inspire increased levels of FDI, during crises, IP rights can lead to the unnecessary deaths of thousands of people.  Fortunately, in the case of AIDS in Africa, many large Pharma companies did not press charges for IP violations, and some also donated AIDS drugs for free.  That said, the potential downside of IP rights generates a very difficult policy issue: How do we incentivize firms to invest in developing countries without creating a potential for crisis?

Revised: The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most unique policy tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance is merely a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so allows investors to understand when and how future interest rates will change, thereby reducing uncertainty and encouraging investment today.  This heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  At the onset of the lost decade in the 1990’s, the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, just a few years after the NASDAQ crashed, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy changes), the zero lower bound necessitates its use even today.  Because the Fed is unable to lower short-term interest rates to their necessary, negative value, it has no choice but to alter long-term rates in an effort to stimulate today’s economy.

While forward guidance seems to have been an effective (though painfully slow) policy tool in the last 6 years, recent debate has me worried about its legitimacy.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once a 6.5% unemployment rate is achieved, the Fed should raise interest rates per it’s promise.  However an intriguingly titled Wall Street Journal article caught my eye recently.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me worried that the Fed will not keep its promise to raise interest rates once 6.5% unemployment is achieved.

The article notes that some Fed doves are concerned about low levels of inflation.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated average inflation of 1.3% (uncertainty about the effects of Quantitative Easing has resulted in more conservative stimulus).  As shown in the graph below, this discrepancy in rates has caused a large discrepancy between predicted and actual price levels.  Many doves support the continuation of low interest rates (even after unemployment reaches 6.5%) so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

Screen shot 2014-03-24 at 12.00.01 PM

I have two concerns about continually low interest rates.  The first relates to the motivation for boosting inflation.  I certainly agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates.  However, once the Fed reaches its 6.5% unemployment target, its has achieved its goals.  Accordingly there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promise.

The issue of commitment brings me to my second and more important concern about continually low interest rates: failing to raise interest rates undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a useful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change once unemployment reaches 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) think like me, they will also lose trust in the Fed.  Should private investors lose trust in the Fed, forward guidance will be eliminated as a policy tool entirely, making economic stimulus at the zero lower bound extremely difficult.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the long-term strategy of central banks.  But today, this consensus simply does not exist, and there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, this type of debate will always exist.  And I think this debate should exist.  The Federal Reserve would be foolish to not reassess its long-term strategies given changes in the economic environment.  Like a successful business, an effective central bank should not commit to a single strategy, but rather should address each economic situation individually to respond optimally.

For this reason, I believe forward guidance, while powerful, is a foolish economic tool.  In order to preserve private investors’ trust, forward guidance locks the Fed into a single long-term strategy, inhibiting its ability to respond to unanticipated changes in economic conditions.  Unfortunately, given the zero lower bound, forward guidance has become necessary (as short term interest rates of 0% do not provide sufficient stimulus).  Therefore, in order to eliminate forward guidance as a policy tool, I believe addressing the zero lower bound should be a key priority of central banks.  So long as the zero lower bound exists and forward guidance remains necessary, the Fed cannot do its job as well as possible.

Reversing the Flow of the Corporate Bathtub

Reversing the Flow of the Corporate Bathtub

Savings is commonly modeled through the use of a bathtub.  In the picture of a bathtub below, imaging the water as cash reserves.  The incoming water represents the savings rate and the outgoing water represents the spending rate.  When the saving rate is higher than the spending rate, the tub fills up; when spending is higher than savings, the tub empties.

Bath tup

Since the recession, the corporate bathtub has really filled up.  The two graphs below illustrate that while corporate profits have achieved record levels, so too have cash reserves.  According to the Wall Street Journal, this hoarding of cash is largely due to corporate concern about market volatility.  Given America’s uncertain economic environment, it has been difficult for firms to find projects offering a sufficient, risk-adjusted rate of return.  Instead of investing, firms have mostly undergone cost-cutting programs to increase efficiency and stock buyback programs to reduce liabilities to shareholders.  Both of these initiatives have resulted in a huge increase in corporate cash reserves, hovering around $3.4 trillion.

PROFITS

Cash

Corporations, however, are not the only ones who have acted conservatively since the Great Recession.  Lending, also took a hit in the wake of the financial crisis.  Given the lax lending standards that contributed to this recession, many banks have increased lending standards and made it much more difficult to acquire a loan.  Coupled with corporate disinterest in investment (as discussed above), these higher standards have curbed the rate of corporate lending.  Indeed, the graph below shows that it has taken nearly 6 years for commercial lending to return to its pre-crisis levels.

Lending

But what is really most interesting about the graph shown above is the uptick in the lending rate since the beginning of 2014.  The graph below makes it very clear that since the begging of 2014, the US economy has observed an increase in commercial lending.  According to the Wall Street Journal, outstanding commercial loans grew 8.3% YOY in Q1 2014 as 14% of commercial banks relaxed commercial lending standards.  From January to March of this year, the rate on a fixed, long-term commercial loan fell from 4.51% to 3.8%.  Outstanding lines of credit are ramping up as well; Q1 2014 saw a 12% YOY increase in credit-line commitments.  All of these indicate that banks are beginning to trust the economic recovery and want to get back in the game.

New lending

It is my hope that this increase in lending will soon be followed by an increase in corporate spending.  According to a Bloomberg report, this is likely to be the case.  2014 is expected to be a record year for corporate investment as firms put their cash reserves (and now borrowed cash) to work.  Ford is expected to increase spending by $1 billion this year, and Microsoft is expected to double its investment expenditure.  It is likely that most of this spending will go to growth opportunities (and not payroll), but as these investments start generating real returns, strong payroll growth should follow.  While I am surprised that corporations are borrowing to fund investment (in place of spending their huge cash reserves), I am comforted by the strong investment prospects.  Even though it took more than half a decade, it seems that Bernanke has done his job and that the corporate bathtub is about to start emptying.

Teaching Financial Literacy…There’s an App for That

I recently wrote a post discussing how myRA (Obama’s latest effort to address retirement savings in America) has the potential to foster better savings habits, but given the restrictions placed on investment options, has very little potential to foster financial literacy.  And financial literacy is certainly an important issue in the United States, as many Americans know much less about investing than they think they do.

In a 2009 survey, 40% of respondents stated they didn’t know whether a single company’s stock or a diversified mutual fund offered a safer return.  Additionally, only 28% of respondents knew the inverse relationship between bond prices and interest rates.  Ironically, 67% of these respondents identified themselves as having a “high” level of financial knowledge.  These responses seem to suggest that there is a huge discrepancy between what investors think they know and what they actually know.  And this discrepancy is not being addressed in schools.  Only 13 states require students to take a personal-finance course in high school, and of the teachers instructing these courses, less than 20% feel “very competent” to do so.

From personal experience, I know that it is much easier to build investment literacy by doing rather than by hearing (indeed, I didn’t develop an affinity for “going long” on broad-based indexes until after I lost money trying to “short” individual stocks).  Assuming that this “learning-by-doing” approach can help foster investment literacy (as I believe it has for me – I did rather well on the FINRA financial literacy quiz available here), then an up-and-coming app could be a partial solution to America’s financial illiteracy problem.  This app, called Acorns, uses a learning-by-doing approach to foster financial literacy by eliminating the large capital investments typically required to open a brokerage account.

Acorns is pioneering a new concept called “micro investing” – an easy way to get millennials invested in securities by incorporating investment into everyday transactions.  The Acorns app works very similarly to Bank of America’s “Keep the Change” program.  For every transaction made on a debit or credit card, Acorns will round up the purchase amount to the nearest dollar and invest the change in an index fund.  For example, if you spend $0.75 to buy blue books for finals week, Acorns will invest $0.25 on your behalf.  The logistics behind this investment depend on synchronizing your mobile phone with your credit card or debit card.

To determine which index fund to invest in, Acorns users must answer some initial questions about their risk tolerance.  Based on your risk tolerance, Acorns will invest your change in 1 of 5 different portfolios.  In this way, Acorns helps individuals develop investment strategies (based on risk tolerance) while simultaneously familiarizing individuals with index funds (and accordingly diversification).  And Acorns is doing so in a user-friendly way with few capital barriers.

Currently the Acorns app is in its beta phase, but it should be released later this year.  Personally, I believe apps like this have the potential to make investing accessible to everyday people, thereby helping them to develop financial literacy via a learning-by-doing approach.  That said, I still have some quibbles with Acorns.  To make a profit, Acorns charges a $1 monthly fee for all users (reasonable if you are a big spender who will sock away large amounts of “change” from monthly purchases).  However, Acorns also charges a 1% management fee for all accounts.  If your account balance exceeds $5,000, this management fee drops to 0.25%.  Certainly, I am not willing to pay a 1% management fee!  And even 0.25% is rather high.  It is my hope, however, that if Acorns is successful, more and more firms will enter the micro investing business, pushing down management fees and making micro investing affordable.

While the Acorns app may not be the solution to financial illiteracy, I think the concept of micro investing is a step in the right direction.  Should micro investing become affordable (which in time I believe it will), it should provide a good way for the everyday American to develop investment literacy via a “learning-by-doing” approach.  Indeed, I think it is important for both policymakers and private businesses to make investing more approachable and less intimidating.  Doing so not only has a huge potential for profits (at the private level), but should also help address the issues of financial illiteracy and insufficient retirement savings in the United States.

MyRA – The Good and the Bad

During his State of the Union address in January, President Obama introduced  the “myRA.”  A myRA is a retirement savings account targeted primarily towards low income-workers without access to a work-sponsored 401K account.  According to the White House, the ultimate goal of the myRA is to foster retirement savings across all income levels.  Given that only 57% of American save for retirement, and that only 49% of all works have access to sponsored retirement savings (like a 401K), this is a very caring goal.  Given that social security is expected to go insolvent by 2033, this is a very practical goal as well.  That said, the nuances of the myRA are extremely limiting, making it a half-hearted attempt to fix a very important problem.

Before addressing the negative aspects of a myRA, it is important to understand the benefits.  Most importantly, the myRA account offers a way for low-income workers to develop a habit for savings.  The myRA account is essentially a modified Roth IRA; deposits are made after-taxes, and earnings grow tax-free.  Unlike a Roth IRA however, myRA’s have very few barriers to entry: the minimum balance to open a myRA savings account is only $25, and additional deposits can be made in increments as small as $5.  Furthermore, there are no fees associated with a myRA account.  Finally, for those risk-averse investors, the principal is guaranteed (much like a traditional savings account).  All of these qualities make the myRA an attractive savings vehicle.  Given its ease of use, I agree with Obama that, given the write promotion campaign, a myRA can encourage better savings habits among low-income workers.

That said, it is important to understand the difference between savings literacy and investment literacy.  It is one thing to save money for retirement.  It is another thing to wisely invest this savings so that it earns a reasonable rate of return.  While the myRA program may foster savings literacy, numerous restrictions greatly inhibit its ability to develop good investment literacy.

The two most important of these restrictions are a savings cap and a requirement investment asset.  Firstly, all myRA accounts are limited to $15,000.  If someone’s myRA account has a value that exceeds $15,000, the excess must be rolled over into a Roth IRA (given that the principal is guaranteed, this makes logical sense; the FDIC can only afford to insure so much money).  While $15,000 is a good start, it is, under almost no circumstances, a sufficient nest egg.  It is my fear that this cap will signal to myRA investors (who will  likely be rather savings illiterate), that the $15,000 is a sufficient quantity of retirement savings.  Unless the White House develops an excellent transitions program to help individuals roll over their myRA to an IRA, this cap will likely result in many grossly underfunded retirement accounts.

The second and most important myRA restriction is its lack of investment options.  Whereas a Roth IRA allows individuals to invest in nearly any security, myRA’s can only be invested in a US government savings bond called the Government Securities Investment Fund (more informally referred to as the “G Fund”).  Since 2003, the G Fund has offered an annual, nominal rate or return of 3.61%.  During that same time frame, inflation has averaged 2.5%.  This means that the real rate of return of the G Fund has barely topped 1% in the last decade.  While this return is higher than a traditional savings account, it is well below what a standard index fund (ie: Russell 2000 or S&P 500) is capable of earning.  I understand that Obama wants to protect investors from making foolish investment decisions (like buying all penny stocks).  But by limiting investment to the G Fund, I fear that myRA’s will foster too much risk aversion and prevent investors from growing their nest eggs at a reasonable rate.

Ultimately, the myRA is a step on the right direction.  It is about time that the US Government address private savings in order to supplement social security.  That said, it is important to realize that savings literacy and investment literacy are not the same thing.  Thus while the myRA has the potential to foster better savings habits across low income levels, it seems to have very little potential to foster intelligent investment habits.  I believe that a modification to the current social security tax would accomplish this goal much more efficiently (see my post: “Should Social Security Switch to a Defined Contribution Plan?”).  Whatever happens though, it is crucial that policymakers begin to address savings and investment literacy before social security becomes insolvent.

Revised: Should Social Security Switch to a Defined Contribution Plan?

Just recently, I had the opportunity to have dinner with my dad.  Given our mutual interests, our conversation naturally drifted towards finance.  My dad playfully joked how excited he is to start receiving pension checks in just a few years.  Even though these checks will be small, I responded jealously; when I start working this fall, there will be no pension program waiting.

This shift away from pension programs is not unique to my father and me.  Over the last 40 years, many employers have switched away from pension retirement plans (more generally called defined benefit (DB) plans), for defined contribution (DC) plans (like 401K’s).  Under DB plans, employers pay a predetermined amount of cash to former employees after those employees reach retirement age.  Under DC plans, employers set aside a certain amount of money each year to assist employees in developing a retirement savings account.  As the graph below shows, the shift away from DB plans to DC plans has been staggering.  Since 1979, for employees lucky enough to have corporate-sponsored retirement plans, enrollment in DB plans has dropped 57% while enrollment in DC plans has grown 55%.

Screen shot 2014-05-27 at 3.01.33 PM

This transition to DC plans is largely due to an increase in life expectancy rendering DB plans unsustainable (ie: as people live longer they collect benefits longer, increasing the onus placed on firms and requiring progressively more cash to fund DB plans).  This year, the Society of Actuaries released new life expectancies for the first time since 2000.  In the last 14 years, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase.  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion.  After this revision, these liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and doing so is no easy task.  Considering that life expectancy is expected to grow further, it’s not surprising that firms are switching to DC plans from DB, as doing so helps reduce total liabilities.  Specifically, the switch to DC from DB helps reduce liabilities by shifting investment risk away from firms and to retirees.  Under a DB plan, firms are responsible for paying a set amount of retirement income in the future.  To generate this future outflow, firms invest cash now, hoping it will grow enough to fund the promised pension payments.  Unfortunately, very few firms invest enough to meet the entire defined benefit payment, as most firms assume unrealistically high returns when making investments.  Doing so causes many firms to drastically underfund their DB plans, generating enormous liabilities (with potentially crippling consequences) in the process.  In contrast, a DC plan is much more sustainable because it does not promise any future cash payments, and therefore does not create any liabilities.  Rather, a DC plan only requires firms to presently invest cash on behalf of its employees, with the future retiree bearing the investment risk.

Does this mean that the switch from DB to DC is a bad thing for retirees?  After research, I believe it’s a wash.  That said, I did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB.  A study by Dartmouth College found that the typical DC 401K-retirement plan, “provides an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”

If you check my sources, however, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs.  But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last ten years, DB benefits have only outperformed DC plans by 0.86%.  Furthermore, most of this underperformance is due to a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will be similar under both options.  However, I am largely in favor of DC plans because they eliminate the liabilities associated with DB payments.  So how is this conclusion relevant to social security?  Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions could help solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033.  However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058).  Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DC plan.  While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.”  For example, if social security tax is currently 10% of income, I propose it should be reduced to 5% of income in, let’s say, ten years.  In those ten years, the social security withholding should grow to 5% of income.  Eventually, social security tax should fall to 0% of income and be replaced entirely by the withholding (Personally, because I think savings is so important, I think that this withholding should ultimately represent a higher percentage of income than social security tax ever has or will).

Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis.  Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan.  As individuals continue to work, instead of paying taxes to fund social security, they will pay withholdings to help fund their own retirement.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe, well-diversified indexes (like a global fund).  If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money.  On average, even professional money mangers cannot outperform indexes that track the aggregate market).  Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

My proposed plan has some similarities to George W. Bush’s proposal of private savings accounts in early 2000.  Under the most successful of Bush’s privatization proposals, taxpayers could divert 4% of taxable wages or a maximum of $1000 from FICA payments to fund personally managed retirement accounts.  These contributions would not replace, but rather would offset, social security’s existing DB payments.  Workers would then have the option to invest their private accounts in 5 different funds.

The key difference between my proposal and Bush’s proposal is the long-term implications for social security.  Bush’s proposal aimed to prolong, not eliminate, the insolvency date of social security by offsetting social security’s DB payments with some DC payments.  In contrast, my plan proposes a gradual but complete transition of social security from a DB plan to a DC plan, thereby rendering insolvency irrelevant.

While my plan is not perfect, I believe it effectively addresses the sustainability of social security by gradually eliminating government-paid DB benefits.  Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxable income with government-mandated savings.  I believe this system, by eliminating the liabilities related to DB retirement plans, is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy.  As always, I welcome any and all suggestions as we collectively try to address the issue of social security sustainability.

Revised: How to Deflate the Education Bubble

In the last 15 years, outstanding student debt in the United States has grown from $240 billion to an astonishing $1.2 trillion, driven largely by rapidly accelerating tuition rates.  During the same time period, average wages have only grown a mere 10%, making student debt an increasingly uncomfortable topic.  In fact, JP Morgan deemed the student loan market so overladen with risk that in October of 2013, the firm stopped issuing any additional student loans.

Based on these signs, I agree with a recent Huffington Post article that relates the higher education bubble to the housing bubble America experienced in 2008.  The loose lending standards (low down payments), securitization of mortgages (MBS), and high levels of speculation (overwhelming belief that the housings values will continue to rise) that contributed to 2008 bubble burst all have parallels in the higher education market.  Many students pay no downpayment and have poor (if any) credit history.  Student loans are being packaged and resold as student loan asset backed securities (SLABS) to hedge lender risk.  And despite the 44% undermployment rate of young college graduates, most Americans continue to believe that a college education is an ideal (if not necessary) investment.  All these factors suggest another bubble is about to burst, and in an attempt to offer a partial solution, this post will focus on the speculation involved in the higher education market.

However before considering a solution, it is important to first understand the route cause of asset bubbles.  In A Random Walk Down Wall Street, Burton Malkiel makes the cause of asset bubbles very clear in his explanation of the tulip-bulb craze that plagued Holland in the early 1600s.  After the mosaic virus created striped tulips in the late 1500s, Dutch citizens desperately wanted the most unique tulips in their gardens, and they were willing to pay a handsome premium for them.  As more and more people bid up the price of tulip bulbs, more and more believed these bulbs were a smart investment.  Indeed, by the 1620’s people were selling their jewels, furniture, and even land to buy tulips!  Nevertheless, no bubble can grow forever, and in February 1637, Dutch public opinion changed.  The price of bulbs fell more than 20-fold that month, and despite the government’s best attempt to prevent a sell-off, the bulb bubble burst, leaving an abundance of disappointed and bankrupt investors.

The Tulip-Bulb craze perfectly illustrates the result of what Malkiel refers to as “Castle-in-the-Air” investment theory.  Under this theory, an investment’s value is based on public opinion, and decisions to buy and sell are based on random guesses about changes in public opinion.  When public opinion changes, bubbles can burst and investors can suffer huge losses.  In my opinion, the “Castle-in-the-Air” investment theory applies perfectly to college education (tuition costs are rising despite the fact that tuition benefits, ie: employment and wages, are falling).

I’d argue, and I think Malkiel would agree, that a switch in investment theory could reduce the risk of asset bubbles.  In addition to “Castle-in-the-Air” theory, Malkiel also explains  the “Firm-Foundation” theory, which is an investment strategy based on the intrinsic value of investments.  When the price of an investment is less than its intrinsic value, you should buy; when the price is more than intrinsic value, you should sell.  Because this form of investing is based on data and not public opinion, it is arguably less susceptible to speculative attack.  Indeed, Malkiel points out that firm-foundation investing is how Warren Buffet made his fortune.

It therefore seems that to reduce the risk of a student loan bubble, we need to switch investment in higher education from a “Castle-in-the-Air” model to a “Firm-Foundation” Model.  But how?  I believe the answer lies in a recent Wall Street Journal article.  In “Colleges Are Tested by Push to Prove Graduates’ Career Success,” author Melissa Korn points out a trend in prospective students requesting information on graduates’ salaries.  Given that college is an investment (that should generate a real return after an initial payment), this request seems extremely logical!  Why would anybody spend $200,000 on out-of-state tuition at UM without assurance (or at least data supporting) a sizable income stream after graduation?

If firms are required to release GAAP-audited financial statements to give prospective investors a prediction of future cash flows, I believe universities should have to do the same.  While there is currently significant push back from universities to release this data, I think that reporting graduate salaries based on school, major, GPA, etc. is an essential step in changing college education from a “Castle-in-the-Air” investment to a “Firm-Foundation” investment.  (The implications of this are consequential indeed, as it would likely force the cost of well-paying majors like business and engineering higher than the cost of low-paying majors like anthropology and agriculture.  That said, this is a consequence that is completely in line and appropriate given a “Firm-Foundation” investing environment, and it is one that I am comfortable with.).  Personally, I believe if we can successfully alter the way students choose to invest in college education (by reducing speculation), we can effectively reduce the risk involved in student loans and prevent student debt from repeating the Dutch Tulip Crisis and pushing America back into recession.

 

Should Social Security Switch to a Defined Contribution Plan?

After discussing defined benefit (DB) and defined contribution (DC) retirement plans in class yesterday, I was  intrigued to explore the issue further.  Professor Kimball mentioned that DC plans are starting to replace DB plans, but what is motivating this switch?  And are there any implications for social security?  After a little research, I’ve concluded that, given the growth in life expectancies, DB plans are unsustainable.  As such, firms are necessarily switching to DC plans to avoid insolvency.

This year, the Society of Actuaries released new life expectancies for the first time since 2000.  Since 2000, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase (Professor Kimball joked that we may be one of the last generations to die).  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion.  After this revision, these outstanding liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and paying down the above mentioned DB liabilities is no easy task.  Considering that life expectancy, and in turn outstanding DB liabilities, is expected to grow further, it’s not surprising that firms are switching to DC plans from DB.  Indeed, while some 60 million Americans are still covered by DB plans, since 1979, DB enrollment has fallen from 38% of Americans to 14%.  In the past decade alone, enrollment in DC plans has more than doubled to include over 40% of Americans.  Given the magnitude of outstanding DB-related liabilities, firms have had little choice but to initiate this switch.

But is the switch from DB to DC a bad thing?  After research, I believe it’s a wash.  That said, did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB.  A study by Dartmouth College found that the typical DC 401K-retirement plan, “provide an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”  

That said, if you check my sources, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs.  But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last 10 years, DB benefits have only outperformed DC plans by 0.86%, with most of this underperformance caused by a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will likely be similar under both options.  That said, I am in largely in favor of DC plans because they eliminate the liabilities associated with DB plans.  So how is this relevant to social security?  Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions will solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033.  However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058).  Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DCB plan.  While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.”  Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis.  Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan.  As individuals continue to work,  instead of paying taxes to fund social security, they will pay witholdings to help fund their own retirement plan.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe indexes (like the Russell 2000 or the S&P 500).  If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money.  On average, even profession money mangers cannot outperform indexes tracking the market).  Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

I believe this plan effectively addresses the sustainability of social security.  It eliminates the need for the government to pay DB payments in the form of social security.  Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxed income with government-mandated savings.  While this is not a perfect system, I believe it is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy.  As always, I welcome any of your suggestions as we collectively try to address the issue of social security sustainability.

Revised: Why Farm Subsidies are Stupid

In the United States, the Farm Bill, which is passed every 5 years, determines our agricultural spending on both food subsidies and food stamps.  This post will focus on the subsidies portion of the farm bill, which accounts for approximately 20% of the bill’s spending. The following chart from the Wall Street Journal helps illustrates the tremendous amount of money spent on farm subsidies each year:

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As this chart makes apparent, the ten states that consume the most farm subsidy dollars consumed $9.445 billion in 2012.  While this expenditure doesn’t compare to the government’s massive defense or social security budget, $9.5 billion is not a trivial value.  After adding in farm subsidies paid throughout the rest of the United States, total annual expenditures is close to $17.5 billion.

It’s interesting to examine what crops the government is subsidizing.  If you watch the movie King Corn, or you read the Live Science article “Junk Food Subsidies Threaten American Health,” you’ll learn that the most commonly subsidized crops are commodity crops like corn or soybeans (they are called “commodity” crops because, given the way these crops are grown, they are not edible until processed into secondary products like High Fructose Corn Syrup).  Furthermore, without the existing government subsidies, many farmers would not profit from the production of commodity crops.  For example, the selling price for a bushel of corn is lower than the cost to produce a bushel; nevertheless, farmers continue to earn profits because of government subsidies.  As anyone who has taken Econ 101 knows, these subsidies ultimately distort the commodity crop market, leading to deadweight loss at the expense of American taxpayers (who are footing the bill for these subsidy payments).

Many support farm subsidies because they believe subsidies are necessary for America’s backbone (ie: Mom-&-Pop farmers) to support themselves.  Indeed, Thomas Jefferson believed that “Those who labor in the Earth are the chosen people of God.”  Whether or not you agree with Jefferson, the above statement about subsidies is simply not true.  Per the US census, farm household income has exceeded the average household income in America for over a decade and a half, and today the average farming household earns 53% more than the average non-farming household (maybe farmers really are God’s chosen people).  Additionally, the subsidies given out by the US government do not favor the Mom-&-Pop farmers living the American Dream.  Instead they support enormous commercial farms.  Of the $17.5 billion of farm subsidies paid out by the US government each year, 80% goes to the wealthiest 15% of farmers, whose wealth is usually measured in millions of dollars.

Thus it seems obvious that farm subsidies are negatively impacting the United States in three ways: (1) they distort the market for commodity crops (2) they place an additional tax burden on Americans who indirectly pay for farm subsidies (3) they contribute to economic inequality by favoring already wealthy, commercial farmers.

That said, there is another and more important way that farm subsidies adversely impact the economy: health care bills.  The American Heart Association identifies cardiovascular disease as one the most pressing health problems in the United States, with over 40% of Americans expected to suffer from cardiovascular disease by 2030.  With this increase in prevalence comes an increase in the costs associated with treating cardiovascular disease, which are expected to grow from $273 billion in 2010 to $818 billion in 2030.  So how is cardiovascular disease relevant to farm subsidies?  One of the leading causes of cardiovascular disease is obesity, and one of the leading causes of obesity is the exorbitant consumption of high fructose corn syrup.  And why are Americans consuming so much high fructose corn syrup?  Because US farm subsidies favor the production of commodity crops that make high fructose corn syrup so cheap to produce.

It is true that come 2030, the United States government will not be paying all $818 billion of the costs associated with cardiovascular disease.  But these rising health care costs will have a significant impact on Medicare and Medicaid payments, which already represent over $700 billion of federal spending (which is over 20% of the federal budget – see chart below).  And the onus of funding these payments will ultimately fall on the American taxpayer, depressing real wealth levels and spending.  Given the magnitude of Medicare and Medicaid payments, health care costs are responsible for the majority of the economic loss brought about by farm subsidies.

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Certainly there are many logical reasons to support farm subsidies.  While most farm subsidies support huge commercial farms, it is true that some Mom-&-Pop farmers would go under without government support.  Additionally, farm subsidies, by keeping commodity crop prices low, help keep food prices more affordable (especially highly processed foods, which typically are staples in the diets of low-income Americans).  Despite these benefits, I strongly support a gradual elimination of food subsidies.  And fortunately, the newest version of the Farm Bill, passed earlier this year, is doing just that (I believe tapering should be more aggressive, but you can only ask for so much at once).  While in the short-run, this tapering will likely cause marginal increases in food prices and adversely impact some Mom-&-Pop farmers, in the long run, I think the reduction in government expenditure and health care costs will certainly justify the tapering.

 

The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most powerful tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance describes a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so increases investor confidence because investors know that interest rates will not increase until unemployment hits 6.5%.  With a good estimate of future interest rates, investors feel safer making investments now.  In turn, this heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  In the 1990’s the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy decisions), the zero lower bound necessitates its use even today.  Unable to lower short-term interest rates to their necessary, negative rate, forward guidance allows the Fed to impact long-term rates and long-term risk tolerance in an effort to stimulate the economy.

That said, recent debate has me worried about the legitimacy of forward guidance.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once this 6.5% unemployment is achieved, the Fed should raise interest rates and keep its promise.  However an intriguingly titled Wall Street Journal article caught my eye this morning.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me concerned as to whether the Fed will actually keep its promise to raise interest rates once 6.5% unemployment is reached.

The article notes that some Fed doves are concerned about low inflation rates.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated inflation of 1.3%.  As shown in the graph below, this discrepancy in rates has caused a discrepancy between predicted price levels and actual price levels.  Many doves support the continuation of low interest rates so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

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Personally, I have two issues with this decision.  The first relates to the motivation for boosting inflation to match actual and predicted price levels.  I agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates and increased economic investment.  That said, once the Fed reaches its 6.5% unemployment target, its goals have been met, and there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promises.

Which brings me to my second and more important issue with this decision: it undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a powerful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change at 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) are like me, they will also lose trust in the Fed, thereby eliminating forward guidance as policy tool.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the goals of central banks.  Today, there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, there will always be debate as to which metrics the Fed should target.  And I think there should be.  The Fed should not pick a single goal, but rather should address each economic situation individual to respond optimally.

For this reason, I believe forward guidance, while powerful, is a ridiculous economic tool.  It locks the Fed into a long-term strategy and inhibits its ability to respond to unanticipated changes in economic conditions.  Interestingly, the elimination of the zero lower bound would eliminate the need for forward guidance.  As such, I believe that addressing the zero lower bound should be a key priority for the Federal Reserve, as the Fed’s current need to use forward guidance hinders its ability to do its job well.