Dad's Inflation, Granddad's Investing

I caught a story in the The Economist about a study by Ulrike Malmendier of Cal (Berkeley) and Stefan Nagel of Stanford suggesting that people who live through periods of high inflation anticipate future inflation being higher than those who have not lived through such times, and those who live through economic crises tend to make investment decisions that are heavily influenced by that experience.

This strongly conforms to anecdotal evidence I have from my own father. For my entire life, at least since infancy, I’ve been fortunate enough to live in a time and country where inflation has been exceedingly low by international and historical standards. Core inflation in the U.S. has consistently been under 5% since the mid-1980s, and has usually been much lower. (In fact, a major danger in our current economic crisis is that inflation will be too low, or even negative.) Four dollars today has about the same value as two dollars did in 1985. In other words, it took 24 years for the value of a dollar to halve, which works out to an average inflation rate of about 3% over that period, using the “Rule of 72.” (72/24 = 3) That’s about the figure I use in my head when trying to calculate the time value of money. From my privileged modern American perspective, that’s “normal.”

My father entered the workforce in the mid-1970s, right as the U.S. entered a brutal period of inflation. Those two 1985 dollars I mentioned that would be worth four dollars today, they would have been worth only one dollar in 1974. That means the value of a dollar halved in just 11 years, at an average inflation rate between 6% and 7%. That’s a fairly typical number in some countries, but history suggests that’s no longer the norm in the U.S.: It took 21 years for the value of a dollar to halve between 1953 and 1974, which is pretty close to the inflation history I lived through. (And most of that inflation came in the early 70s; U.S. inflation was under 3% during the 1950s and 1960s.)

But when my dad tries to calculate what money was worth in the past, he does the math like the 1970s never ended, wildly overestimating the rate of inflation. Eventually I called him out on it so many times that it became one of our inside jokes that I call “The Dad Rate of Inflation.” Today, he’ll poke fun at it, and in stories he’ll facetiously say things like “it cost a dollar back then, which would probably be like 500 dollars today.” So it doesn’t surprise me that Malmendier and Nagel found this to be a common fallacy among age cohorts.

More broadly, what Malmendier and Nagel found is that people who were born at certain times are disproportionately affected in their thinking by certain economic events, and make very different financial decisions, including decisions about the way they invest money.

This has profound implications for people in my age cohort. It suggests that the current economic crisis, which stands to be a formative experience for our generation, will likely influence the investing decisions that we make for the rest of our lives. I suspect it will cause many in our cohort to consistently overprice risk the way my father overprices inflation, and that this will cause a lot of people to inefficiently manage their portfolio, probably for their entire working lives. However, if our generation draws the correct lessons from this crisis, there’s at least the chance that we might act as a stabilizing force for both asset prices (stocks, housing prices, et. al.) and the overall economy.

There are lots of lessons one could draw from this crisis, but if I had to shake folks by the collar and impart just one lesson it would be this: the laws of economic gravity have not been repealed. Eventually, the market corrects itself, bubbles pop, and prices of things fall back into line with their actual value.

In the real world, if the price of oranges go up, people will buy fewer oranges, creating a balance between price and demand. In finance, if something goes up in value, everybody rushes in to buy more of it, assuming it will keep going up in value. And, indeed, for a while it does go up in value, because a greater number of people are chasing a limited supply of assets. And that causes more people to want to jump in on the “growth opportunity.” This is how bubbles form.

But like I said, the laws of economic gravity have not been repealed. The assets, whether they are stocks or whatever, haven’t really gained any extra worth. Stocks are just a claim on the future value of the company, which in turn is just a reflection of the value that company contributes to the economy. Individual companies can and occasionally do grow exponentially in terms of what they produce and how much they are worth. So individual stocks can shoot up in value and the price can still accurately reflect the company’s underlying value. But the stock market as a whole can’t do that. As said, stocks prices merely claims on the value of future goods and services produced. In the late 1990s, the value of the major U.S. stock markets more than doubled in just a few years. Some companies really have been become twice as valuable in that period. But American industry as a whole clearly had not. The total output of our production hadn’t increased by anything approaching that amount. The result was a bubble—the paper gains in people’s investment accounts were all illusory.

Few people seemed to be worried about a bubble. The only thing people worried about, for the most part, was how to get some of that money for themselves. More people wanted to get into the stock market, and they were willing to pay far more for the privilege of doing so. This drove up prices, and it also something called the price-to-earnings (P/E) ratio of most stocks. A company’s earnings reflect the value of what it actually produces, and P/E is sort of like the gravity that keeps stock prices tethered to the Earth. If a company’s stock price shoots up and up even though earnings stay relatively constant, then the P/E will shoot up. A high P/E ratio is usually a warning to investors. The only thing that justified a high P/E is the expectation that earnings will greatly increase in the future. For any one specific company, that might be a very realistic expectation. But like I said, that can’t be true for the entire market. So the S&P Composite P/E is a simple but very useful measure of whether stocks are overvalued (a bubble). There’s another metric called the dividend-to-price ratio (D/P) that goes down during a stock bubble, and this metric suggested the exact same thing the P/E did.

For most of the post-Depression period, P/E has hovered between 10 and 20. That’s a reasonable range. At the height of the stock bubble, the P/E had climbed over 40. That should have been a signal that it was actually a really bad time to buy stocks because they were overvalued. But everybody wanted to buy stocks because they kept going up in value and the assumption was that this would continue forever. Of course, it couldn’t.

The inverse applied during recessions. The P/E is back down within a pretty normal range, even though earnings are down, and D/P has shot way up. So this would actually be a really good time to invest in the stock market if anyone had any money left. But very few people want to invest in the stock market right now … because prices have gone down so much. It’s like looking at the laws of price and demand through a fun house mirror. People seem totally immune to the central tenet of investing, which is to buy low and sell high.

Incidentally, the same thing happened to housing prices. In fact, some people have suggested that part of what happened is that the pressure deflating from the dot-com stock bubble largely got pumped right back into a housing bubble. Housing prices went up, and so people became willing to pay more for houses because they were such great investments that were certain to keep going up in value. Again, the housing market’s version of P/E, the price-to-rent ratio, soared sky high, but few people took this as a sign that houses were seriously overvalued. The problem was further exacerbated by something that doesn’t really have a parallel in the stock market: because housing prices were going up, people were rushing to build more houses. This meant that supply started to outstrip demand, and thus when the housing bubble popped, it popped especially harshly and is probably not yet finished deflating.

So what would it mean if people of our generation are sufficiently scarred by the current crisis that, as a group, we tend to absorb the whole “buy low, sell high” lesson and get skittish about investing in a climate that bears all the signs of a bubble? It certainly wouldn’t end the bubble as we know it, but it might mitigate the intensity of bubbles somewhat. If more people had looked at a P/E in the high 30s and decided that maybe they’d be better off investing their money in bonds or something than investing it in stocks, demand would have slacked off and prices probably wouldn’t have climbed to quite such perilous heights. They still would have been overvalued, and there still would have been a market correction, but perhaps the fall wouldn’t have been quite so steep or so painful. The test, of course, will be to see if investors can take what they learned from a stock bubble and a housing bubble and later apply it to future bubbles. If people, particularly the ones who are now experiencing the crisis first hand, learn the right lessons, they can be a counter-cyclical force that helps to prevent deep recessions.

And if not, we’ll pretty much get what The Onion joked about in one its headlines: “Recession-Plagued Nation Demands New Bubble To Invest In.” Let’s hope for the best, though.

Woody Gets an Election

There’s a great episode, despite the juvenile title, from the final season of Cheers called “Woody Gets an Election.” In it, Frasier Crane bets that he could train a chimp to spout meaningless shibboleth and still garner ten percent of the vote in the upcoming city council election. No chimp being handy, it’s agreed that Woody Boyd, by far by the dumbest of Cheers’ characters, would make a fine surrogate. Woody’s campaign rhetoric consists of farming stories that the press mistakes for political analogies, and this being television, Woody duly gets elected to Boston’s City Council.

Sadly, this sort of thing happens in real life all too frequently at the local level, but mainly because so few people know the people for whom they’re voting. But could it happen at the U.S. Congressional level? Not usually to that extreme, perhaps, but something only slightly less insidious happens on a fairly consistent basis.

Legislators are called upon to regulate all sorts of things. Some such things, like fiscal policy, banking law, environmental regulation and health care policy, are really quite complicated. Other things, like “Do we post the Ten Commandments in the hallway?” are easily within the grasp of your average simpleton. The same set of legislators, however, will decide both how we regulate multinational banks and whether we post the Ten Commandments in the hallway. The thing that we as voters get to decide is whether we choose our legislators based on their views on the former or on the latter.

When evaluating candidates in a political debate, I think it’s helpful to evaluate them based on the decidedly non-partisan Woody Test. The one question of the Woody Test is, “How smart would this person (Woody) need to be in order for me (Frasier) to train them to answer these questions in front of a camera?”

It takes almost no intelligence to get up and say, for instance, that you oppose abortion in all cases. To be fair, it takes just the same amount of intelligence to say that you want to make sure that all women have abortion rights. Similarly, it takes zero intelligence to say that you believe a marriage should only be between one man and one woman, or say that everyone should be allowed to marry, no matter what their orientation. This is not to say that some very, very intelligent people couldn’t hold any of these beliefs. It’s just to say that if someone does hold such beliefs, it in no way suggests that they possess some greater intelligence.

On the other hand, it is much tougher for the below-average rube to get up there and fake knowledge of banking law. Granted, someone can advocate bad policy in a way that sounds very intelligent and convincing, but if all a candidate can do is get up there and fire off simplistic and extremist slogans, that’s going to show through. So you won’t be guaranteed to get superb policy, but at a minimum, you’re at least unlikely to get a Woody-style complete idiot.

From that, it makes sense that if we judged candidates based on their stances on issues that the average Woody couldn’t fake convincingly, we would get better legislators, and thus better government, than if our legislatures were forums for the sort of social issues that are easily understood by the masses, but not terribly relevant to the business of running a country.

So take the following idea as thought experiment rather than a recommendation of policy: I firmly believe that we would get better government if wedge issues like abortion and gay marriage were taken out of the political process. Now, this is in and of itself doesn’t imply how those issues should be resolved. If there were suddenly either a constitutional amendment banning all abortions, or ensconcing the right to have one, either of those would presumably take the issue out of the legislatures. The same could be said of amendments banning gay marriage or declaring it a fundamental right. Further, I’m also not saying that because such resolutions would probably have a positive effect that we should run out and try to implement them—indeed, it would at least temporarily exacerbate the very problem they seek to correct.

But, the principle can inform our voting patterns, even if we agree that such issues need to be left within the public square. This is why I don’t understand why so many voters make it a priority to find to the most pro-life and anti-gay marriage candidate possible and then vote for that person in the primaries, given that there are plenty of (presumably) acceptably pro-life and anti-gay marriage candidates from which to choose. If a candidate is asked something about how we deal with global warming and says something like, “We should assume it isn’t real,” or is asked a complex question about banking and says, “Let’s just let the banks fail,” that’s a really bad idea. What’s more, it is probably not the only bad idea this person has. This person is probably chock full of disastrous ideas. When candidates expose their ignorance and imprudence in this way, that is nature’s way of removing them from the political gene pool. But if voters say, “Yeah, but he had such great things to say about the sanctity of marriage,” they subvert nature’s process. My point, at the moment, is not that these positions are bad in themselves. My point is that people should be able to find much smarter people with almost the same views on those issues, but they seem disinclined to look.

I’ve probably tipped my partisan hand at this point. True, Democratic primaries mechanistically filter out candidates who are not pro-choice and increasing those who oppose marriage equality, and this has some unfortunate consequences. But Democratic voters in no way seem concerned with finding the candidates who take the most extremist positions on these issues. Democratic primaries largely focus on issues like the economy, health care and the environment, and voters seem to be looking for thoughtful answers on these subjects and usually reward the candidates who can provide them. It makes it difficult, though not impossible, for a Woody to slip through. Thus, we by and large get Democrats who can speak intelligently about a wide range of complicated civic issues. That does not per se guarantee their wisdom on all those matters, but it is certainly a good omen.

Republicans, conversely, put great pressure on their candidates and tend to winnow the field based on who can deliver the best sound bites about the Woody issues and tack furthest to the right. Sometimes a thoughtful, knowledgeable candidate will get through despite the hurdles. But there’s absolutely nothing about familiarity with social issues that implies competency in complicated issues, and the same legislators will have to decide both kinds of matters. So the Republican vetting process, if you will, has produced an awful lot of Woodies. As a result, we have a large chunk of the Republican caucus that can’t offer anything constructive to the debates. All they can do is rattle off very simplistic talking points: “Tax cuts!” “Government bad!” “Global warming is a hoax!” “Tax cuts!”

In a democracy, if you’re lucky, you get just barely as good a government as you deserve. Republicans have leaders that are just as good as the party deserves. Those leaders led the country into an economic ditch and a military boondoggle, have gotten smacked hard in two straight elections because of it, fail to offer anything useful to the current policy debates, and as such are leading the party down a road to irrelevance. So that should tell us something about how well Republicans have discharged their duty to elect productive leaders.

Particularly, the inability to constructively add to debates is worrisome because the solutions proffered by Democrats, while generally productive, are never perfect, and more often much less than perfect. So it would always be helpful to have two parties offering useful ideas instead of one. Changing the Republican culture is a long-term project, but perhaps a change is called for to a greater focus on thoughtfulness and competency rather than simplicity and extremism. This in and of itself doesn’t even require changing their positions on social wedge issues, but it does require that the other business of government get more attention. If and until that happens, the ill effects of public policy will be steep, and the effects on the Republican Party could be fatal.

We Never Even Had Time to Miss Him

Republican Senator Judd Gregg withdrew from his nomination to become President Obama's Commerce Secretary yesterday and will remain a Senator until the end of his term, at which point he says he will likely retire. A lot of Republicans seem to be reacting with glee that Gregg removed his name. I'm not entirely sure I understand why, but I do understand a couple of important things this teaches us about Obama's cabinet.

First, the President is still the boss. I think a lot of Democrats exaggerated any differences in policy that would occur if Gregg became Commerce Secretary. Similarly, I think a lot of Republicans exaggerate the influence of some of Obama's other nominees, especially Secretary of State Clinton. Mrs. Clinton is not going to run the State Department her way, she's going to run it President Obama's way. This works much like any other company: the President is still the boss, and cabinet secretaries are like high-level employees, and when push come to shove, employees still take their marching orders from the boss. Sen. Gregg didn't like the President's marching orders, so he bailed out of the job. That's his prerogative, but it's also a reminder of who sets the policy, and it's not the Republican.

So if the President still calls the shots, why do these appointments even matter? Why not lavish them on your unqualified friends as political patronage like President Bush did? They matter because they determine the quality of counsel the President gets, and that is very important. I think President Obama is extremely smart, but nobody is so smart that they know everything about everything in the federal government. Cabinet secretaries are crucially important because they provide counsel to the President in their areas of expertise. The President is free to ignore their advice, as Bush was wont to do, but a good President listens to the advice of his best people. If a secretary can't add any value to the analysis, then policy is only as smart as the guy in the Oval Office. And even in the best of circumstances, that can get dicey at times.

On the whole, I think President Obama has picked some excellent secretaries. Particularly, he's taken positions that both parties have used as dumping grounds for party hacks, and brought in respected experts in those fields. Nobel Prize-winning physicist Stephen Chu is now Energy Secretary. We've never once had a scientist heading the Energy Department, which may partly explain why we've never had a coherent energy policy. Chu can offer the President a highly valuable perspective. Similarly, Education Secretary Arne Duncan was CEO of Chicago's public schools, and Tom Daschle's withdrawal as Health Secretary designate offers the chance to name a medical doctor to that post--something else we've never had. (Paging Dr. Dean...)

As for Gregg, he's spent his career clinging to conservative economic theories that have had great trouble matching with economic reality. As such, I don't know what he could have added to policy formation, and so I don't think he would have been a particularly good Commerce Secretary. The one thing he would have added was more evidence of Obama's post-partisanship. But while Obama may be post-partisan, the rest of the world, and particularly the Republican Party, is decidedly not. I think the refusal of Gregg and others to put aside partisan differences and work together should be a clear lesson that will result in a Democrat getting appointed as Commerce Secretary.

And the best part for me is that Gregg is still retiring from the Senate, and in two years' time his seat will likely be held by Democrat Paul Hodes. And, to follow up my earlier post about the death of Republicans in the Northeast, the other news yesterday was that Sen. Arlen Specter (R-PA) will get a challenge in 2o10 ... from ultra-conservative Republicans in the state who feel that Specter, the rare Republican representing a state Obama carried by ten points, isn't conservative enough. For such heresy, they are determined to torpedo the one Republican who could actually (maybe) win that state.

I double-checked, but it was not my birthday.

But it was Abraham Lincoln's (and Charles Darwin's) 200th birthday, which I guess is occasion enough. President Obama spoke at Lincoln's old home yesterday, and was buoyant enough to joke about the Commerce flap. He described the young Lincoln, "possibly in his law office, his feet on a cluttered desk, his sons playing around him, his clothes a bit too small to fit his uncommon frame, maybe wondering if somebody might call him up and ask him to be Commerce Secretary."

At least he hasn't lost his sense of humor about it.

If You Think Our Politics Are Crazy...

So I've been following the election results from Israel. Oh vey, it's so meshugeh.

Actually, it could have gone a lot worse. The polling leading up to the election suggested that Likud, the hard-right party, was going to easily eclipse Kadima, a party committed to negotiating a peace based upon a two-state solution. In the event, Kadima actually edged out Likud, though that still might not be good enough. These elections are actually really important because they will likely profoundly impact the path of Israeli-Palestinian negotiations, so the process is worth a bit of explanation.

In the U.S., we vote for two house of Congress at regularly scheduled elections every two years. The structure of our democracy makes it very difficult for more than two parties to amass any significant power at any given time. This means that one party always constitutes a majority in a house, and the other constitutes the minority, and usually the same party controls both houses. In addition, we vote separately for a President who has very real and important powers. Thus, the head of state may be from an entirely different party as the leaders of the legislature.

Most democracies use some variation of the parliamentary system, which is what Israel uses. First, there's only one house of legislature, or parliament. Second, voters don't vote for people, they vote for parties. And there are lots and lots of parties. Parties offer up a slate of candidates and are awarded seats in the parliament, or the Knesset in Israel, based on how many votes they get. If a party gets enough votes for ten seats, the first ten candidates listed on its slate become MPs (members of parliament). The complexity is that with all those parties, rarely does a single party win enough seats to take an outright majority. Then things get interesting.

There are 120 seats in the Knesset, so it takes 61 to "form a government." In other words, one party has to find 61 MPs to unify around its choice for leader of parliament. That person then becomes prime minister, the chief executive of the country. Israel has a President, but his powers are largely ceremonial. The prime minister leads the country, and unlike an American President, by definition has a majority of the legislature supporting him or her. Occasionally, coalitions fracture, leaving the prime minister unable to find the support of 61 MPs. In such a case, no government can be formed, parliament is dissolved, and emergency elections are held. That's how we wound up with these elections in the first place. The coalition of parties that previously formed the government broke apart, and so a new parliament was needed.

So let's fast forward to election night. Bucking the predictions of pollsters, Kadima, led by Tzipi Livni, appears to have won the most seats with 28. Likud, led by Binyamin Netanyahu, appears to be right behind them with 27, pending the counting of just a few more votes. So far, so good for Kadima, but Livni still needs to find 33 more votes before she can form a government. She can count on 13 votes from the Labor Party, which was a junior partner in the previous government. After that, things get very unusual, at least from an American perspective.

What comes next is a lot of horse-trading and intense negotiations over things like what parties get to fill which Cabinet posts. Frequently smaller parties will back whatever party gives them the sweeter deal rather than what party is more ideologically in tune with them. After Kadima, Likud and Labor, there are only two other parties big enough to be worth courting: Yisrael Beiteinu (15 seats) and Shas (11). Yes, I know, Israeli parties have far more interesting names than ours. If Kadima can join both YB and Shas to support them, that's 61 votes right there. Even if they just got one or the other, they could probably cobble together enough votes from the seven smaller parties to just barely get over the hump. But Shas was the party that pulled out on them and necessitated new elections in the first place. And YB seems to be far closer to Likud on the Palestine issue. If Netanyahu can win the backing of YB and Shas, that would get him 53 votes, and he could surely find the rest among the smaller parties.

In other words, then, it may take no less than five parties coalescing to form a government in Israel, one that would be led by the guy who finished second in the election. And that's the most likely scenario at the moment, although it's possible that Livni could still get it done.

That's a little troubling, because a Likud coalition would likely take a very hawkish stance toward Palestine at a moment otherwise pretty ripe for real progress in negotiations. Kadima supports the consensus solution that pretty much the rest of the world has been cajoling both sides to accept for some time: a secure Israel with normalized relations with its Arab neighbors and an independent state for Palestine roughly conforming to the pre-1967 borders, with some acre-for-acre swapping of land to accommodate Israeli settlers, and compensation to Palestinian families unable to be returned to their homeland. That's really the only workable blueprint for a real peace. In a lot of ways, Likud understand this, too, but Netanyahu would certainly take a more bellicose and recriminatory stance in negotiations and be less likely to offer reasonable concessions to the Palestinian side. This, in turn, would make President Obama's pursuit of peace in the region incrementally more difficult. The Israeli left seeks a solution that will leave both sides more secure, while the Israeli right is still bogged down in a mentality that negotiations will have winners and losers, and Palestinians need to be the losers.

Peace in the Holy Land will be extremely difficult no matter who becomes Israel's prime minister. For one thing, the Israeli political divide is still but a tiny gap compared to the fundamental chasm between Palestine's Fatah and Hamas factions. But with a newly focused American administration, there is a lot that can be done to advance the cause of peace over the next four to eight years. It's very important to take advantage of that opportunity, and Kadima appears to be in far better shape to do so. The chances of their forming a government look much better than they did a few weeks ago, but they still don't look all that great.

Despite the fact that they, you know, "won" and all.

As Vermont Goes, so Goes the Nation

I've lived in North Carolina for a long time, but I'm still very much a product of the Northeast, where I grew up and went to college. For that reason, a lot of the people I associate with the words "traditional Republican" are in fact very moderate, maybe even liberal, Northeastern Republicans. I remember greatly respecting, and still greatly respect, Republicans like William Cohen, Christie Whitman, Lincoln Chafee, James Jeffords and various others. And when I stop to ask myself just how I came to grow such contempt for today's Republican Party, I remember what those people I respect are doing these days. Chafee and Jeffords got so disgusted with the Republican Party that they left it. Whitman is still in the party, but a pariah within it. Cohen was last seen in politics as Defense Secretary for the Clinton Administration. So maybe it's little surprise that I find almost nothing redeeming in today's Republican Party, or that the electoral trends show that many of my fellow Northeasterners have come to that same assessment. What is surprising is just how hard conservatives are working to make sure we continue to feel that way and thus ensure that they remain a feeble political minority.

In his book, "What's the Matter With Kansas?" Robert Frank writes extensively about how Republicans pushed the narrative of the red state-blue state divide. They upheld the South and middle America as "real" America, the pro-America America. The two coasts were portrayed as the land of latte-sipping liberals out of touch with good old American values. You still hear this nonsense today from people like Sarah Palin. And then Republicans went out and voted in ways very consistent with that narrative, apparently never stopping to wonder how long they could get away with that before people in those "elitist" states would stop voting for them completely.

The Northeast used to be a pretty Republican place. Vermont and Maine, believe it or not, used to be two of the most reliably Republican states in the Union, the only two that never voted for FDR. By the 1990s, the whole Northeast was solidly Democratic on the Presidential level, but hardcore social conservatives apparently failed to notice that it still elected a lot of Republican senators and congressmen. From 1995 to 2007, Republicans controlled Congress, but in that whole span, Democrats were never less than six seats away from control of the Senate. During that whole span, Republicans held two Senate seats each in Maine, New Hampshire and Pennsylvania, and a seat in Rhode Island. They also held a seat each in Vermont and Delaware until 2001, and a seat in New York until 1999. In fact, there has never been a Republican majority in either house of Congress that wasn't dependent on seats from the Northeast.

So what in the hell makes Republicans think they can form one now?

It's not just a matter of targeting seats in those states, it's a matter of the ways Republicans in Congress vote and the image they project as a party. As of today, there are four Republicans from the Northeast in the Senate. One, Judd Gregg, is about to resign to become President Obama's Commerce Secretary. The other three (Olympia Snowe, Susan Collins and Arlen Specter) are by far the most moderate members of the caucus and have been routinely breaking party ranks to support President Obama's agenda. They were the only three Republicans to vote for the stimulus package. They, along with the only two other female Republicans in the Senate, were the only ones to support the Ledbetter Fair Pay Act for women. The rest of the caucus seems hellbent on taking positions as conservative, obstructionist and out of touch with the American mainstream and general good sense as is humanly possible.

The voting public, to its credit, is holding it against them. Some of these Republican Senators are only still around in the first place because they haven't been up for re-election in almost six years. (By contrast, there are exactly zero Republican congressmen from New England, and only three Republicans from New York out of twenty-nine seats.) There's no way Republicans hold the seat in New Hampshire in 2010 now that Gregg is retiring. Democrats will likely capture Specter's seat in Pennsylvania, too. Only the women from Maine look safe, and even then only for as long as they feel like sticking around as lonely voices against the tide. This will only put Republicans in a deeper electoral hole, and the only tools they seem to have at their disposal is more shovels. That is, the reason why these Northeastern Republicans keep losing their seats is not because they are personally unpopular, it's because the 'R' next to their name is more politically damaging than the Mark of Cain. No matter how often they break ranks to support popular legislation, they still vote for the Republican leadership, and outside the reddest areas of the country, people despise the Republican leadership.

The success of Snowe and Collins, both of whom were re-elected recently, in overcoming that handicap, should be like a flashing neon sign pointing the way back to political relevance: move to the center, act in a spirit of bipartisanship, stop pandering to the reactionary and Rush Limbaugh wings of the party, stop making everything secondary to ideology and start embracing common sense. They'd be in much better shape if they voted more like Snowe does and Chafee used to. But they're not doing that, of course. So many people have left that the party is controlled by its worst elements. The nativists, the homophobes and the Rush Limbaugh acolytes all have majorities within the reshaped Republican Party. They're in control now. The direction they've chosen has been truly and completely awful, and I wonder what exactly it would take to get them to change it. I'm sure that a move to the center will not happen easily.

Eventually, someday, hardliner conservatives will look around at how unpopular they are and realize that their current ideology is bankrupt. But for now, they're determined to, if I may borrow their phrase, "stay the course." And the rest of us are determined to keep them out of power for a good long while.

So, If People Will Do What You Reward Them For...

President Obama announced Wednesday that executives at companies receiving support from the Troubled Assets Relief Program (the $700 billion bank bailout) will have their salaries capped at $500,000.

Good for him.

There's been a lot of screaming about this from self-interested hedge fund executive types. They argue, without any apparent sense of irony, that capping compensation will lead to a "talent drain," and that it might steer the best minds away from Wall Street. It might be snarky to pass judgment on the sort of "talent" hedge funds have assembled thus far, but I won't do that, because the argument is largely correct. Smart people will find ways to do what the incentive system rewards them for doing, and the people who ran the shadow banking system into the ground were in fact very smart people. The problem was that the incentive system encouraged them to do all the wrong things.

First off, let's start with a reminder that the financial industry is special. If the financial industry collapses, it takes the entire real economy down with it. Furthermore, unlike real industries, the financial industry can be taken down through self-fulfilling prophecies known as "bank runs." At any given time, a bank only has on reserve a fraction of the money needed to cover liabilities to all its depositors. If a rumor starts that a bank is insolvent, everyone will rush to withdraw their money, and the bank won't have enough to cover all its chits, and the bank really will go under--even if the bank was totally healthy before the rumor started. Bank runs are what made the Great Depression so great and so depressing, and much of our current troubles are due to the equivalent of runs on the modern shadow banking system.

For that reason, deposits at real banks are insured by the FDIC. Not only will the government insure losses if a bank goes under, but the very presence of the insurance obviates the whole reason to make a run on the bank in the first place. For that reason, deposit insurance is a great thing, but the downside is that if the government is just going to cover the losses anyway, it creates incentives for all kinds of risks. As such, membership in government insurance plans comes with all kinds of regulations attached to ensure that if governments are going to insure a bank's deposits, that the bank is going to act prudently and keep itself properly capitalized. This system has worked out very well; between the insurance and the regulations, banks in the U.S. very rarely go under, and FDIC-insured banks have been far from the center of the current banking crisis.

The downside, from the perspective of the banks, is that all these cumbersome regulations get in the way of profit-making. Federal regulations on the amount banks need to keep in reserve limits how much banks can leverage deposits in order to make profits. Bankers, therefore, are pretty anxious to find ways of getting outside the scope of regulation. They can make more money that way, and, getting back to the point of this post, that's what the incentive system rewards them for doing. Since the 1980s, they've made a lot of headway in this endeavor, and massive deregulation created sort of a shadow banking system with lots of entities like hedge funds. They looked a lot like banks, in that they took deposited and then lent it back out, but they were still outside the banking regulatory scheme. Unfortunately, when they went bust, they had to be bailed out just like banks to prevent major damage to the underlying economy.

This deregulation was championed by Republicans when they controlled Congress, of course. But to be fair, it was also indulged, and sometimes even supported, by the Clinton administration.

Okay, so we have these shadow banks that need to be bailed out by taxpayers when they go under, but aren't subject to the same regulations as real banks. That's bad enough. The worse part is that banks don't screw up; people who run banks screw up. And it turns out that, yes, Adam Smith was right: if the rules are such that some people can get rich by taking reckless gambles with other people's money, then some very smart people will eventually figure out how to do that and take those reckless gambles with money that money and get rich in the process.

In theory, there should be a countervailing incentive: if the bets turn bad, the bank could go out of business, the person who took the gambles will be out of a job. In theory then, bankers should be very careful to ensure that doesn't happen. The problem, however, occurs when yearly salaries are so high that an executive can make himself (and it's almost always a him) obscenely wealthy for life just by creating wealth, or the mere appearance of it, for a short period of time. If people can make $20 million a year managing a hedge fund, the incentive is to do whatever they can to maximize profits in the short term, because even if the fund gets run into the ground in three years, the executive walks away with $60 million after bonuses. What's more, we as taxpayers are responsible for cleaning up the mess anyway.

So I disagree with people who denounce the barons of Wall Street as idiots. They did exactly what the incentive system encouraged them to do. They're smart people. Unscrupulous, amoral, covetous and selfish people, but smart ones. And, yes, just like Adam Smith said, people are motivated by financial reward, not by any sense of the common good. They didn't screw up; we did by allowing such a system to exist in the first place.

There's going to be a healthy appetite for regulation of the shadow banking system subjecting it to the same rules as traditional banks. Regulation is not a panacea that will cure all ills, and not every proposed regulation will be a good idea, but regulation of executive compensation will be an important part of the new rules for the financial industry. The rules for compensation need to structured in a way such that sustainable, long-term management is rewarded, and failure and short-sightedness is punished.

To that end, I strongly support another change made by the Obama administration that got far less fanfare: allowing additional compensation in the form of restricted stock that can’t be sold until taxpayers have been paid back with interest. The financial system is in a mess, and if a bank can bring in a talent that steers it back to financial health, then that talent deserves to be richly compensated for his skill. I support that. But anything that needs to be bailed out like a bank needs to be regulated like a bank, and if executives can make kingly sums in such a short period of time that the consequences of their gambles will be borne by someone else, then it will only be a matter of time before we go through another round of bank failures and another round of expensive bank bailouts.

Because people will do exactly what you pay them to do, just like the bankers are arguing.

We're All Keynesians, again

I didn't want to let go of the economic stimulus without discussing the politics behind this debate. I couldn't resist entirely, but in discussing the substantive merits of the proposal I tried not to take too many potshots at the track record of the people opposing it. The economic stimulus plan is either a good idea or it isn't and it is or isn't regardless of whether or not the people opposing it are grandstanding jerks.

As mentioned, I've come to know more about the American "Family" Association than I'd ever care to learn, and I can aver that during the Bush years, it didn't seem overly concerned with the federal deficit specifically or even economic issues generally. Actually, its overriding concern appeared to be the grave danger than someday homosexuals might become first-class citizens. (It turned out to be only a brief holiday; the AFA is already carping about Obama nominating a gay man to a generic mid-level bureaucratic post, and the moral decline certain to follow.)

But in general, complaining about the size of the federal debt only now that Bush has left office is much like closing the barn door after lots, and lots, and lots, and lots of horses have already left. During the Bush years, the size of the federal debt nearly doubled from just over $5 billion to perhaps as much as $10 billion. In other words, Bush created about as much debt as all his predecessors combined. He accomplished this mostly by passing a large tax cut early in his first term, and then increasing federal spending to its highest totals ever. Not surprisingly, massive tax cuts plus massive spending increases produced, over the course of eight years, massive debt.
But now things are different. Specifically, they're different because now a Democrat is proposing spending increases and additional debt. When the Republican did it, that was okay, but when the Democrat does it, then it's a disastrous idea that must be opposed by any means possible. I say that not to point out the double standard, which is obvious, but to point out something a little more subtle and insidious: cognitive dissonance.

Cognitive dissonance is basically an uncomfortable feeling caused by holding two contradictory ideas simultaneously. For instance, trying to juggle the ideas that "Barack Obama is a horrible, awful person because he supports abortion" and "Yeah, but he has some really good ideas about how to get the economy going" is mentally taxing for many people. One of those ideas needs to be reoriented to relieve the dissonance. The idea will not be that abortion must be okay if a smart guy like Barack Obama concedes that it should be legal. The idea will almost always be that textbook Keynesian increases in federal spending to make up for a lack of private demand must be a bad idea if a rabidly crazy pro-choice liberal like Barack Obama supports it. Thus, a group of people, social conservatives, who otherwise ought to have a broadly diverse range of opinions about the stimulus plan wind up in near unanimity in their opposition to it. (It also helps that macroeconomics is a hard subject and difficult to explain to anyone whose political attention span is limited only to what can be made to fit on a bumper sticker.)

Similarly, the ideas that "Bush is such a strong spiritual leader for our country" and "Yeah, but he's a real dolt when it comes to the economy" also cause dissonance, which is likely a big part of the reason why conservatives were so insouciant about $5 trillion added to the national debt. If a righteous man like George W. proposed it, well, by golly, it must be the medicine we need.

So am I just as much a victim of this cognitive dissonance? After all, I spent eight year arguing that Bush's "tax cuts" weren't really tax cuts if they were accompanied by spending increases; they were really just tax deferments passed along to my generation. Now Barack Obama is proposing half a trillion in deficit spending, and I'm pushing for him to increase the ante. Is that just a little hypocritical?

I'd argue not, naturally. My economic philosophy is that governments should increase spending and run deficits during economic downturns, and run balanced budgets or modest surpluses during better times. Bush ran major deficits in each of his eight years. In the case of the final year, the deficit was definitely warranted because the economy was in such dire straits. If Republicans want to argue that the economy was in real peril for all of Bush's eight years, I'm happy to let them argue that. But that should be immediately followed by a discussion of why, again, we would ever want to trust our economy to a Republican president.

Also, not all spending is created equal. In my last post, I argued that the vast majority of the money allocated in the stimulus would be spent very judiciously. In contrast, much of the Bush deficit comes from spending on the Iraq war, which only led to trillions of dollars in ancillary costs and provided few if any lasting benefits. The traditional Keynesian definition of spending for the sake of spending was paying some people to dig holes and others to fill them back up. Maybe the more modern definition should be paying some of the people to bomb holes in Iraq and others to shoddily fill them back up. Further, not all tax cuts are created equal. Bush's tax cuts were aimed at those who already have the most while Obama's are aimed at middle-class and working-class Americans.

Finally, if Obama runs large-scale deficits for an entire eight-year Presidency, I will be severely disappointed, and I will have greatly misjudged the man. But I strongly believe that such will not be the case. I believe in Obama's commitment to fiscal discipline and his determination to balance the budget as early as possible--and I believe that passing this stimulus package is vital to boosting the economy and hastening the day when we can do that. Policy should change as circumstances change, but not necessarily as partisan considerations change.

And so we have Sen. John Thune (R-SD) on the floor of the Senate describing just how much a trillion dollars is based on visual depictions of stacks of hundred dollar bills. How ever many times a trillion dollars reaches to the moon, it's only one fifth as many times as does the amount of money that Bush added to the federal debt without objection from Republicans. And one Republican after another gripes about spending provisions that are piddlingly small compared to the billions appropriated for the Iraq War and treated as sacrosanct. The only stimulus package the Republicans are willing to support, it seems, is one built around their failed ideology that no matter what the problem, tax cuts are the solution.

Incidentally, I don't think that the Obama tax cuts are bad ideas; in fact, I support them. The tax cuts in this plan are the ones that Obama promised on the campaign trail to cut taxes for 95% of all Americans. That's a worthy idea, but it's not likely to be as useful as some might think for the immediate task of reigniting the economy. I would have liked to have seen the tax cut and the stimulus packaged in separate bills to clarify in the public mind the distinct difference between the two. Politically, though, the move probably made sense, since Obama is having a tough enough time getting the stimulus package passed even with the tax cuts added to grease the wheels. But it's worth remembering that the hefty figures tossed around for the package's plan include the money being sent out in the forms of tax cuts, and where the Senate has been trimming the bill, it's only been to reduce spending, which is the part of stimulus where we get the most bang for the buck.

Remember that the dollars allocated for stimulus spending have three benefits. First, they produce something of value. If we spend a billion dollars on roads, we get more roads, which may be very useful to have. Second, we employ millions of people who would otherwise not have work, and this brings down the skyrocketing unemployment rate. Finally, those people who now have jobs spend a lot more money than they would if they were unemployed, and that spending goes to support other businesses, and preserve jobs for those businesses. And, of course, those people whose jobs were preserved now have more money that they can spend. This is called the multiplier effect, and its the most important of the three benefits we derive. If the multiplier effect is high enough, increased spending will boost the economy to where it can get back on the path to recovery. If executed properly (and that's a big if), the plan will work.

In another post for another day, I'll have to expand further about how conservatives keep their economic theories so well insulated from contradictory evidence. Maybe blogging will become a regular pursuit after all. I find it much more enjoyable to right about these things now that the votes are such that victories for good government and common sense tend to outnumber those for its dedicated opponents.