Month: December 2012

Picture: T. Boone Pickens *not* benefiting from his $165 million dollar donation to OSU. That’s the head coach of the football team, Mike Gundy, he is casually chatting up.

The prospects for a grand bargain that includes tax and entitlement reform dim by the day as we get closer to the fiscal cliff, a set of spending cuts and tax increases automatically scheduled to take place on January 1st absent new legislation. Lawmakers on both sides of the aisle are scrambling to reach a deal that would prevent the Bush tax cuts for the middle class from expiring, though the Republicans aren’t giving up the tax cuts for the rich without a fight. This tight deadline means significant action on the long-term debt problem will most likely have to wait till next year. In the meantime, before the debate over which tax deductions are worthwhile resumes again, I want to make a small point on the semantics of charitable giving.

First, some background: In a tax reformer’s fantasy, all deductions would be eliminated (also known as base broadening) and tax rates would be lowered. This change could be revenue-neutral or it could aim to increase revenues to pay down the federal debt. Tax reformers hate deductions because they distort incentives and cause people to consume too much of certain goods, like health care and housing. The main impediment to this fantasy becoming a reality is the fact that many of the current tax deductions are very popular. People like being able to deduct their mortgage interest, charitable contributions, and state and local taxes from their federal tax bill.

The charitable tax deduction in particular has been hotly debated as a source of potential revenue. Charities have argued that we cannot get rid of the charitable tax deduction because giving will go down without the tax break. Proponents of the deduction say we cannot cap total deductions either, at say $50,000, because that would eliminate the incentive for giving when a person reaches that threshold. Instead, they argue, we should put a floor on the deduction, possibly around 2% of income. A floor would preserve incentives to give while raising significant amounts of revenue. Conservatives in particular like the charitable tax deduction because they view it as a free market poverty program. Instead of financing big government programs to ameliorate poverty, like Medicaid and Social Security, conservatives believe taxpayers should use their money to support charities of their own choosing.

All of this makes logical sense to me and I hope policymakers listen to the tax wonks when the make their reforms. The problem I have is one of semantics. Diana Aviv, the head of a trade group for nonprofits, crystallizes the conventional wisdom with this line, courtesy of a wonderful piece by Mina Kimes on the charitable deduction:

“‘The charitable deduction is not the same as other deductions,’ she says. ‘It doesn’t benefit the individual.'”

No. No. A thousand times, no. Charitable giving, and therefore the deduction, most certainly benefits the individual. Let’s consider two cases of charitable giving: large and small. Large charitable contributions provide the most manifest example of how charitable giving benefits individuals. Billionaires who have the means to write checks with eight digits or more are often invited to sit on the boards of the organizations they give to. That means they just bought power and influence in a respectable organization. Additionally, large enough donations are bound to attract media attention. See John Paulson’s $100 million gift to Central Park or T. Boone Pickens $165 million donation to Oklahoma State athletics (yep, donations to college football teams are still tax deductible). So, Paulson endeared himself to millions of New Yorkers and Oklahoma State renamed their football stadium after their most generous benefactor. No personal benefit I can see there.

The second case, small charitable giving has a subtler benefit to the giver: good feelings. Charitable giving, even on the small scale, has all the characteristics of a textbook economic exchange. You give the charity money and in return you get to feel like a good person for awhile. A boost to your moral fiber may not be as tangible as a new car or new clothes, but the utility it gives you is just as real.

Heads of charity trade groups, like Diana Aviv, don’t like to point this stuff out, or put it so bluntly, but this is the actual context in which charitable giving takes place. Let me be clear, by no means am I opposed to having special tax breaks for charitable giving. I, like the conservatives, believe it is a more efficient way to help the poor and indigent than another government program would be. However, just because the charitable deduction is desirable, that does not mean we should propagate falsehoods like, “The charitable deduction… does not benefit the individual.” It clearly does. The mortgage interest deduction does, too. There is also a case to be made that homeownership has positive externalities, which means society benefits from having a tax code that incentivizes homeownership. So, instead of having a simplistic discussion where the charitable deduction is a sacred cow protected by selfless saints, let’s have a real debate about how we can create a tax code that is best for society.

 

In one of my first posts on this blog, I discussed a possible method for curing Baumol’s cost disease: turn services into goods. For those of you who didn’t read that post, Baumol’s cost disease describes the situation where wages rise in industries that do not experience productivity growth to remain competitive for labor with industries that do experience productivity growth. Most commonly, the industries that are affected by Baumol’s cost disease are service-based and rely heavily on non-routine labor.

Baumol’s cost disease has yet to vanish from the economy since I detailed the cure, so I think we can safely assume it will be with us for the foreseeable future. As labor costs rise in sectors of the economy that do not increase worker productivity, we should expect to see less production from those sectors (companies cannot raise prices indefinitely to account for increasing labor costs). A simple example that we have already seen is the decline of live theater performances. Outside of New York City, plays and musicals are rarely produced as profit-seeking ventures. Based on the implications of Baumol’s cost disease, I want to make a few predictions of my own about the economy:

1. All men’s haircuts will be buzz cuts. Barbers do quintessentially non-routine work when they cut people’s hair. Every head of hair is unique in some way and people have distinctly heterogeneous preferences about what hairstyles look good. In the future, however, they won’t be able to afford such stylish hairdos. As barbers’ wages increase to keep up with the wage increases in, say, the automobile assembly industry, a barber’s time will become more expensive to rent out. At some point, most budget-conscious men will opt for the buzz cut to avoid paying a hundred bucks for the Bieber.

2. Your waiter will be an iPad. Among the most innovative companies in the restaurant industry over the past few years are Chipotle and Chop’t. What’s their secret? They deliver sit-down quality food at near-fast food prices. They are only able to do this by maximizing efficiency and cutting out the waitstaff. They still have cashiers though, and the next logical innovation step will be replacing them with iPads. Look for this change to happen at restaurants all across the cost spectrum, not just at the assembly line fast food joints. Now that socially acceptable tipping has creeped int the fifteen to twenty percent range, isn’t it time we brought in the computers? They don’t forgot drink orders and they definitely won’t spit in your food.

3. You won’t have a mailbox. Alright, this one is a little easy to predict, considering the United States Postal Service is losing $25 million dollars a day and is currently the largest employer in the U.S. At a certain point those labor costs were bound to sink the post office. Coupled with the rise of email, texting, and Facebook, the decline in mail volume should spark a major restructuring of the USPS. Among likely changes, guaranteed mail delivery to rural areas, which are more expensive to service on a per capita basis than urban ones, will come to an end. As some people begin to lose mail service entirely, network effects will start operating in reverse. As fewer people have mailboxes, it becomes less necessary to have a mailbox yourself.

4. Your banker will be your smartphone. I already wrote a full-length post about the coming revolution in the banking industry, but here’s the gist: it no longer makes sense for banks to provide services through full-service branches. Smartphone apps, point-of-sale machines, and third-party outlets can delivery the vast majority of banking services without incurring the costs of building, staffing, and maintaining brick-and-mortar bank branches. Tellers haven’t become drastically better at counting money over the past few decades (low productivity increase), but their wages have had to rise as the wages in other industries have gone up. In the near future, banks will replace their employees with the smartphone in your pocket.

There are many more predictions that could be made based on extrapolations of Baumol’s cost disease, but I’ll leave it at four. If you have any predictions of your own, please share them in the comments below.

 

The risk-free rate of return, which is the return on investment that is required as compensation for not having access to the capital for a period of time, is a fascinating theoretical notion from the finance world. In essence, the risk-free rate is trying to untie the time value of money from the risk premium, i.e. the rate of return required in excess of the risk-free rate to account for default risk. Together, these two factors determine the interest rates for all debt obligations. I say that the risk-free rate is a theoretical notion because there is no such thing as a truly risk-free investment. Even 3-month U.S. Treasury bills, the most commonly used proxy for the risk-free rate, still have some remote risk of default (in the event of a nuclear war, the Treasury might miss a payment or two). For context, the graph below shows some historical data on the 3-month U.S. Treasury bill:

The purpose of this post is to question whether it makes sense for finance professionals to use the 3-month U.S. Treasury bill as a proxy for the risk-free rate of return. First, I want to change the time period of the sovereign bonds I will consider from three months to ten years. I am doing this because it is much easier to do a cross-country analysis of 10-year bonds, which almost every debt-issuing country has, than of 3-month bonds. I don’t think this will detract from the validity of my analysis significantly because though there is a higher risk premium associated with a longer time period, it makes sense that the “risk-free” country over the next three months is also the least likely to default over the next ten years.

Now let’s look at some data for 10-year government bonds from various countries:

The data above are provided by The Financial Times and you can see updated figures by clicking on the table. The main takeaway from this is that the United States does not have the lowest yield on its 10-year bonds. In fact, as of this writing, there are eight countries who have a lower cost of funds than we do. That means global investors believe the risk associated with those government bonds is lower than the risk associated with U.S. government bonds. They believe those countries are more likely to make all their payments on time than the richest country on earth is. Why is that?

For starters, we have a seriously dysfunctional political system in which artificial crises are manufactured by the two-parties (think debt ceilings and fiscal cliffs) in order to score political points. Many people claim these crises are the only way policymakers in Washington can get anything done anymore. But instead of getting things done, they just end up kicking the can down the road to another unnecessary flashpoint. One of these days, we could end up with a staring contest in which neither party blinks and the Treasury Department is forced to default on some of our debt.

Secondly, the U.S. debt-to-GDP ratio, which represents our ability to pay back our debt, has been rising at an alarming pace over the last decade (we haven’t had a budget surplus since the Clinton Administration). As of yet, there has been no run on the U.S. Treasury (as reflected in our historically low interest rates), and it does not appear as though an attack from the bond vigilantes is imminent. Nevertheless, it can’t help our Treasury yields that our debt-to-GDP ratio is approaching an all time high:

Critics of my argument might point out that Switzerland recently pegged its currency to the euro prevent it from appreciating further and that Japan has a gargantuan debt, coupled with low growth prospects. These reasons might explain why Switzerland and Japan have lower yields on their 10-year bonds, without having to claim they are more “risk-free” than U.S. debt. But what about the other six countries ahead of us on the list? Many of them have strong fundamentals (e.g. low debt, strong growth, current account surplus) and unlike the United States, they are unlikely to default via a gridlocked political system.

So, does it make sense to continue to use the U.S. 3-month Treasury bill yield as a substitute for the theoretical risk-free rate? There are eight countries who have lower yields on their 10-year bonds and many of them appear more stable than the United States. I think it’s about time we reconsidered which country is the least likely to default on a 3-month debt obligation and therefore is the closest to the theoretical risk-free rate of return. Right now, I wouldn’t bet on that being us.

Since the Great Recession in June of 2009, the United States economy has failed to produce the kind of catch up growth necessary to return to its pre-recession trend of growth (also known as potential GDP). Two percent growth in real GDP, which is roughly what we’ve experienced since we reached the trough of the business cycle, is just not getting it done. Many economists view this as a problem, and rightly so, because slow growth means fewer jobs for workers and fewer goods and services for people to enjoy. But all is not doom and gloom and, in the spirit of the holiday season, I want to point out a new economic trend that may put a positive spin on the recent sluggish growth. Put simply, we don’t pay for anything anymore. That may be a bit hyperbolic, but it gets at the core truth that “free” is an option for many more goods and services than it ever has been before.

A quick survey of a few industries will reveal the prevalence of this trend:

Entertainment: In addition to the old AM/FM radio, music listeners now enjoy free music streaming on Spotify and free custom radio stations on Pandora. Movies and shows are available to stream for free from websites like Hulu and Youtube, and sometimes even from the networks themselves. Consumers with e-readers or tablets can read almost any book in the public domain for free thanks to Project Gutenberg. Zynga is the hottest company in video games, especially social gaming, but they offer their wares for free through Facebook.

Communication Technologies: Instead of paying for postage and envelopes, we now send emails and instant messages over the internet for free. If we would rather see the people we’re communicating with, we can use the free videoconferencing service from Skype. Facebook and Twitter both allow you to stay in contact with hundreds of people simultaneously. Both are free. Text messages are now free through Apple’s iMessage app and soon people may be allowed to make phone calls over the internet for free (the technology already exists), instead of paying for a cell phone plan.

News: It’s difficult to find an industry that has been hammered harder than the newspaper industry over the last 10 years by falling revenue. Basically, their business model has imploded because the bundled product they traditionally sold is now unbundled and the new competition charges zero dollars. The old business model relied on a combination of physical newspaper sales, general advertising, and classified advertising. Craigslist has singlehandedly wiped out the classified advertising market for newspapers with its free online platform. With the rise of tablets and smartphones, it’s now much easier and more convenient to access the news on the go without actually buying a physical newspaper. And that’s only possible because they are giving away the exact same content from the physical newspaper for free online. The only major newspaper with an ironclad paywall is The Financial Times. The other major U.S. papers, such as The New York Times, The Wall Street Journal, and The Washington Post, either give away all their content for free online, or have extremely porous paywalls that are easily bypassed. That leaves the newspaper industry with only general advertising as a means of generating revenue. Worse yet, the newspapers are only able to charge a fraction of the price for the same ad in digital form than they would in print form because marketers are still skeptical of how effective online advertising is. These developments, among others, have lead to the event in the graph below:

There are two important things to consider along with this emerging trend. First, many “free” goods and services depend on the internet for delivery, so having an internet connection is necessary to access them. Though there are free places to access the internet, it is still very common for people to pay a monthly bill for the privilege. Second, and this should be the alarming part, is that all the companies that offer “free” products make their money from advertising. But the competition for advertising revenues is usually a zero-sum game. Corporations tend to set their advertising budgets for the next year in advance and they spend that money in the as advertising opportunities arise. Most new companies that have an advertising-based revenue model will be taking that money away from other businesses that also need it to survive.

Finally, the substitution effect will most likely drive down revenues in any industry with a competitor offering the good or service for free or at a low-cost. Consumers make relative comparisons on prices offered by suppliers, and it sure is hard to pass up free. This phenomenon creates a race-to-the-bottom type mentality for producers, who reasonably feel like their only option is to give away their product and make money on the backend through advertising. Furthermore, consumers who have been trained to expect free or near-free pricing may be hesitant to pay for luxury goods in other markets where they still charge you for the goods. Time is a finite asset and there are many ways to fill it with things that don’t cost any money.

This new free economy is great for consumers, who get to keep all the economic surplus of the exchanges, but it’s horrible for headline GDP numbers. After reading the news, it may feel like we’re not much better off than we were ten years ago, but don’t forgot about all the wonderful things you can get for free!

According to the National Bureau of Economic Research, the official arbiter of when recessions begin and end, the Great Recession began in December 2007 and ended in June 2009. For the millions of Americans who still cannot find a job, the recovery that began in July 2009 has been disappointing, to say the least. Now that we are approaching the fiscal cliff, which is a set automatic spending cuts and the expiration of the Bush tax cuts, recessionary forces are looming once again. Sadly, economists are still debating the exact causes of the last recession and what the optimal response to it would have been. For the purposes of this post, I will focus on the use of fiscal policy as a way to stimulate the economy. More specifically, I will address the optimal balance of tax cuts and spending increases that the federal government should implement to get the economy back on track when it has slipped off the rails. I will put aside the issue of monetary policy, though it remains a very strong tool for combating recessions.

After receiving input from his team of economists and other advisers, President Obama proposed the American Recovery and Reinvestment Act (ARRA) of 2009 as a way to boost the flagging economy he encountered upon taking office. Though other government programs, such as the Troubled Asset Relief Program (TARP), were already underway to counteract the financial crisis and economic downturn, the ARRA represented arguably the strongest action taken by the federal government to fill output gap caused by the recession (here, output gap is defined as the difference between potential GDP and actual GDP). One of the most contentious aspects of any stimulus package is how to balance tax cuts and increase in government spending. In the case of the ARRA, Obama chose a balance of about 2 to 1 for spending increases to tax cuts.

The strongest case for including more tax cuts in the package at the time was that they would take effect immediately and boost consumer spending in short oder. This stands in contrast to government spending programs, which normally take months or even years to fully go into effect because of the scarcity of true “shovel-ready” projects at any point in time. In fact, the argument for more tax cuts could be made by just looking at the title of the Act: the American Recovery and Reinvestment Act of 2009. The ARRA was signed into law on February 17th, 2009 by President Obama, but by that point the economy had already been contracting for almost fifteen months.

The argument for tilting a stimulus package toward government spending has always been that this type of stimulus has a larger fiscal multiplier than tax cuts do, meaning for each dollar spent there will be larger boost to national income. Fiscal multipliers are notoriously difficult to measure, but most economists believe the multiplier for government spending is higher than the multiplier for tax cuts (they mainly disagree on the magnitude of this difference).

So if tax cuts are the faster form of economics stimulus, but government spending has a larger impact, how should policymakers respond to recessions? What’s the optimal balance? I believe the debate over this issue is missing one key element that would change the calculus: deleveraging. At the time of the debate over the ARRA, critics of the tax cuts approach argued that people would just pay off debts with their free money, rather than spend it on goods and services. This, they said, is why tax cuts have such a low multiplier and are the inferior method of economic stimulus. But deleveraging is exactly what the economy needed to achieve an enduring recovery, as opposed to the occasional “recovery summer” or “recovery winter.” In an article for the Washington Post about the role of mortgage debt in the recovery, Zachary Goldfarb cited the work of economists Atif Mian and Amir Sufi to explain how debt effects consumer spending:

“But Mian and Sufi’s research showed something more specific and powerful at work: People who owed huge debts when their home values declined cut back dramatically on buying cars, appliances, furniture and groceries. The more they owed, the less they spent. People with little debt hardly slowed spending at all.”

Also, in a must read piece for the Boston Review, Mike Konczal laid out the argument for why what we went through can best be described as a “balance sheet recession”:

“In the housing bubble prior to the economic crisis, households took on significant amounts of mortgage debt. But homeowners judged the debt to be manageable because it was balanced by double-digit growth in housing values. Those housing values started to crash in 2006. Households then began to pull back on their consumption in order to pay down debts and restore their balance sheets.”

If we are to trust the work of Mian and Sufi and the analysis of Konczal, then the biggest critique of favoring tax cuts in the 2009 stimulus package, that they would be used to pay down debts rather than spent in the economy, turns out to be one of their most appealing qualities. Since we now know that consumer spending, which accounts for roughly two-thirds of our economy, is highly sensitive the an individual’s level of indebtedness, the optimal response in a balance sheet-type recession would be to help along the deleveraging process as much as possible. Hopefully after the next recession, “mostly used to pay down debts” will be listed in the “pro” column and not the “con” column for tax cuts.

Total U.S. Household Debt (not adjusted for inflation) 

The euro crisis has been with us for more than a few years now, but there are still some fundamental questions left to be answered before there can be stability in the eurozone. In case you haven’t been following the news out of Europe, here’s some brief background on the situation: After the introduction of the euro in 2002, eurozone member countries enjoyed historically low interest rates on their government bonds. Investors were willing to loan their money to these countries at such low rates because they believed there was an implicit guarantee behind every government bond denominated in euros. That is, they believed German bonds carried equivalent risk to Greek bonds because they were both members of the eurozone and therefore had similar default risks. Once the global recession hit in 2008, many countries in the periphery of the eurozone started to run substantial budget deficits (and revealed that past deficits were larger than previously reported), which quickly disabused investors of their one-size-fits-all approach to risk valuation. That lead to the increasing interest rates shown in the graph above. The rapid rise in interest rates subsequently made it more expensive for these governments to service their debt, adding to their already ballooning deficits. Larger deficits spurred higher interest rates, and the vicious cycle continued until the European Central Bank (ECB) took decisive action to put a ceiling on certain countries’ interest rates, temporarily halting the crisis.

Before the crisis can be permanently put to rest, Germany needs to decide how much austerity (i.e. spending cuts and tax increases) and reform it ultimately wants from the periphery countries, Greece, Italy, Portugal, Spain, and Ireland. In an ideal world for Germany, these heavily indebted countries would slash their national budgets quickly and severely to repent for their previous fiscal sins. Unfortunately for the Germans, and for the other strong eurozone countries, like Finland and the Netherlands, the first steps toward austerity in the periphery have been a drag on those countries’ GDP growth, further deteriorating their debt-to-GDP ratios and making already hesitant international investors more skeptical of their ability pay off their debts. Furthermore, German fears about hyperinflation, which they experienced during the interwar period of the 1920’s, have prevented the ECB from pursuing looser monetary policy. If the ECB were to announce that it would tolerate inflation closer to 4 or 5 percent, rather than 2 percent (see graph below), then periphery countries could inflate some of their debt away and, more importantly, real wages would fall more quickly, bringing them closer to their market clearing level.

As of November 2012, unemployment in the eurozone was 11.6%, while Spain and Greece had 26% and 25% unemployment, respectively. With such a large percentage of their labor forces sitting idle, these countries are failing to achieve their potential economic output, which only exacerbates their debt problems.

Germany is determined to make the budgets of the periphery countries as austere as possible to atone for their past profligacy. This seems somewhat reasonable, given that those countries committed to running small deficits as a condition of joining the eurozone. But if fiscal consolidation is a rational demand to make of these countries, that only leaves looser monetary policy as a way to prevent a breakup of the eurozone. The important question is this: why should Germany, especially given its intimate history with hyperinflation, tolerate a rise in the inflation rate? Put simply, it must do so because it has benefited the most from eurozone-wide low and stable inflation. Prior to the creation of the eurozone, countries like Italy, Greece, and Spain would devalue their currencies to make their exports more competitive in the global marketplace. German workers are notoriously more productive than their counterparts in Southern Europe, so currency devaluation served as a convenient way for those countries to level the playing field in the export market. Now that there is a single currency, that option is off the table.

The New York Times recently ran an op-ed by Gunnar Beck that made the argument that Germany did not benefit the most from the creation of the eurozone. His main data regarding the import/export market, which we would expect to be most affected by the move to a single currency, was this:

“German exports rose most — by 154 percent — to the rest of the world; by 116 percent to non-euro E.U. members; and least of all, 89 percent, to other euro zone members. In 1998 the euro zone still accounted for 45 percent of all German exports; in 2011 that share had declined to 39 percent.”

Though this information may appear to imply that Germany does not in fact owe the other countries in the eurozone anything, it neglects to account for the most significant global economic trend of the past twenty years: the rapid and sustained growth of the emerging economies (e.g. Brazil, Russia, India, China, etc.). Those countries, and many others included in the “rest of the world” category, have experienced years of double-digit growth in the past couple decades. When you measure growth in German exports to countries using 1998 as the base year, of course the increase in exports to the rest of the world would be larger than the increase in exports to other eurozone countries — the rest of the world was growing extremely fast!

The data put forth by Mr. Beck obfuscates the real and significant benefit Germany receives from the euro: control of a significant number of its trading partners’ inflation rates. Countries like Greece can no longer run double-digit rates of inflation to make their exports more competitive relative to Germany’s. To give you an idea of how dramatic of a paradigm shift this is, look at the chart below of Greece’s inflation rate history:

Prior to its adoption of the euro, Greece depended heavily on currency depreciation to offset the low productivity of its labor force and to maintain the competitiveness of its exports on world markets. Now Greece, and every other country struggling with burdensome debt levels, is committed to 2% inflation forever because Germans neither need nor want the price level to rise more rapidly. But if Germany wants to safeguard the progress made toward European unification, it needs to let the ECB pursue a higher inflation target, possibly in conjunction with an unemployment target similar to the one adopted by the Federal Reserve this month. Germany owes the eurozone at least that much.