Archive for the ‘Economics’ Category.

Problems With Pigouvian Taxes

Pigouvian taxes are taxes meant to help markets and prices better account for certain externalities that wouldn't otherwise be priced in.  A good example is that to the extent one thinks that CO2 is having a deleterious effect on the environment, a carbon tax would be a pigouvian tax.  This brief note at Cato discusses some problems with Pigouvian taxes.  This note reminded me of another issue:  in real life, Pigouvian taxes are more likely to reflect biases and faulty assumptions and virtue signalling of politicians rather than real science and economics.  Here are two situations that come to mind, presented without comment:

The Best New Technologies Don't Just Unseat Incumbents, They Grow the Market

I love Mark Perry's blog but I think he missed an opportunity to point out something awesome in this chart:

We spend a lot of time discussing how Uber and its app-based peers are upending the traditional taxi monopoly.  And no one enjoys seeing a government enforced crony monopoly overturned more than I.  But let's not miss the other story here, which is the tremendous increase in customer well-being and mobility.  Forget the mix for a second and add the two lines.  Monthly passenger rides, which were stuck in the 12-13 million a month range for years, have almost overnight doubled to about 25 million rides with the advent of ride-hailing and the entry of many ordinary folks without taxi medallions into the drive-for-hire business.  This is amazing!

A Chinese Consumer's Perspective on Chinese Trade Policy

This is, plus or minus, a reprint of an article on trade policy written 12 years ago at our Chinese sister publication, Panda Blog.

Our Chinese government continues to pursue a policy of export promotion, patting itself on the back for its trade surplus in manufactured goods with the United States. The Chinese government does so through a number of avenues, including:

  • Limiting yuan convertibility, and keeping the yuan's value artificially low
  • Selling exports below cost and well below domestic prices (what the Americans call "dumping") and subsidizing products for export

It is important to note that each and every one of these government interventions subsidizes US citizens and consumers at the expense of Chinese citizens and consumers. A low yuan makes Chinese products cheap for Americans but makes imports relatively dear for Chinese. So-called "dumping" represents an even clearer direct subsidy of American consumers over their Chinese counterparts.  We Chinese send our resources, our capital, and the output of our most productive workers overseas to be enjoyed by American consumers, and what do we get in return?  A trillion dollars or so of foreign exchange surpluses that our government invests for 2% returns in US government bonds.  Yes, that's right -- not only are we subsidizing American consumers, but we are subsidizing their taxpayers by financing their government's debt at low interest rates.

This policy of raping the domestic market in pursuit of exports and trade surpluses was one that Japan followed in the seventies and eighties. It sacrificed its own consumers, protecting local producers in the domestic market while subsidizing exports. Japanese consumers had to live with some of the highest prices in the world, so that Americans could get some of the lowest prices on those same goods. Japanese customers endured limited product choices and a horrendously outdated retail sector that were all protected by government regulation, all in the name of creating trade surpluses. And surpluses they did create. Japan achieved massive trade surpluses with the US, and built the largest accumulation of foreign exchange (mostly dollars) in the world. And what did this get them? Decades of recession, from which the country is only now emerging, while the US economy happily continued to grow and create wealth in astonishing proportions, seemingly unaware that is was supposed to have been "defeated" by Japan.

We at Panda Blog believe it is insane for our Chinese government to continue to chase the chimera of ever-growing foreign exchange and trade surpluses. These achieved nothing lasting for Japan and they will achieve nothing for China. In fact, the only thing that amazes us more than China's subsidize-Americans strategy is that the Americans seem to complain about it so much. They complain about their trade deficits, which are nothing more than a reflection of their incredible wealth. They complain about the yuan exchange rate, which is set today to give discounts to Americans and price premiums to Chinese. They complain about China buying their government bonds, which does nothing more than reduce the costs of their Congress's insane deficit spending. They even complain about dumping, which is nothing more than a direct subsidy by China of lower prices for American consumers.

And, incredibly, the Americans complain that it is they that run a security risk with their current trade deficit with China! This claim is so crazy, we at Panda Blog have come to the conclusion that it must be the result of a misdirection campaign by the CIA-controlled American media. After all, the fact that China exports more to the US than the US does to China means that by definition, more of China's economic production is dependent on the well-being of the American economy than vice-versa. And, with well over a trillion dollars in foreign exchange invested heavily in US government bonds, it is China that has the most riding on the continued stability of the American government, rather than the reverse. American commentators invent scenarios where the Chinese could hurt the American economy, which we could, but only at the cost of hurting ourselves worse. Mutual Assured Destruction is alive and well, but today it is not just a feature of nuclear strategy but a fact of the global economy.

NCAA: The World's Last Bastion of British Aristocratic Privilege

It is incredible to me that we still fetishize amateurism, which in a large sense is just a holdover from British and other European aristocracies.  Historically, the mark of the true aristocrat was one who was completely unproductive.  I am not exaggerating -- doing any paid work of any sort made one a tradesman, and at best lowered ones status (in England) or essentially caused your aristocratic credentials to be revoked (France).

The whole notion of amateurism was originally tied up in this aristocratic nonsense.  It's fine to play cricket or serve in Parliament unpaid, but take money for doing so and you are out.  This had the benefit of essentially clearing the pitch in both politics and sports (and even fields like science, for a time) for the aristocracy, since no one else could afford to dedicate time to these pursuits and not get paid.  These attitudes carried over into things like the Olympics and even early American baseball, though both eventually gave up on the concept as outdated.

But the one last bastion of support of these old British aristocratic privileges is the NCAA, which still dedicates enormous resources, with an assist from the FBI, to track down anyone who gets a dollar when they are a college athlete.  Jason Gay has a great column on this today in the WSJ:

This is where we are now, like it or not. College basketball—and college football—are not the sepia-toned postcards of nostalgia from generations past. They’re a multibillion dollar market economy in which almost everyone benefits, and only one valve—to the players—is shut off, because of some creaky, indefensible adherence to amateurism. Of course some money finds its way to the players. That’s what the details of this case show. Not a scandal. A market.

Don’t look for the NCAA to acknowledge this, however. “These allegations, if true, point to systematic failures that must be fixed and fixed now if we want college sports in America. Simply put, people who engage in this kind of behavior have no place in college sports,” NCAA president Mark Emmert said in a statement that deserved confetti and a laughing donkey noise at the end of it.

I am not necessarily advocating that schools should or should have to pay student athletes, though that may (as Gay predicts) be coming some day.  But as a minimum the ban on athletes accepting any outside money for any reason is just insane.   As I wrote before, athletes are the only  students at a University that are not allowed to earn money in what they are good at.  Ever hear of an amateurism requirement for student poets?  For engineers?

When I was a senior at Princeton, Brooke Shields was a freshman.  At the time of her matriculation, she was already a highly paid professional model and actress (Blue Lagoon).  No one ever suggested that she not be allowed to participate in the amateur Princeton Triangle Club shows because she was already a professional.

When I was a sophomore at Princeton, I used to sit in my small dining hall (the now-defunct Madison Society) and listen to a guy named Stanley Jordan play guitar in a really odd way.  Jordan was already a professional musician (a few years after he graduated he would release an album that was #1 on the jazz charts for nearly a year).  Despite the fact that Jordan was a professional and already earned a lot of money from his music, no one ever suggested that he not be allowed to participate in a number of amateur Princeton music groups and shows.

My daughter is an art major at a school called Art Center in Pasadena (where she upsets my preconceived notions of art school by working way harder than I did in college).  She and many, if not most of her fellow students have sold their art for money already, but no one as ever suggested that they not be allowed to participate in school art shows and competitions.

I actually first wrote about this in Forbes way back in 2011.  Jason Gay makes the exact same points in his editorial today.  Good.  Finally someone who actually has an audience is stating the obvious:

In the shorter term, I like the proposals out there to eliminate the amateurism requirement—allow a college athlete in any sport (not just football or basketball) to accept sponsor dollars, outside jobs, agents, any side income they can get. The Olympics did this long ago, and somehow survived. I also think we’ll see, in basketball, the NBA stepping up and widening its developmental league—junking the dreadful one-and-one policy, lowering its age minimum, but simultaneously creating a more attractive alternative to the college game. If a player still opts to go to college, they’ll need to stay on at least a couple of seasons.

If you still think the scholarship is sufficient payment for an athlete in a high-revenue sport, ask yourself this question. There are all kinds of scholarships—academic, artistic, etc. Why are athletic scholarship recipients the only ones held to an amateurism standard? A sophomore on a creative writing scholarship gets a short story accepted to the New Yorker. Is he or she prohibited from collecting on the money? Heck no! As the Hamilton Place Strategies founder and former U.S. treasury secretary Tony Fratto succinctly put it on Twitter: “No one cares about a music scholarship student getting paid to play gigs.”


"Water Is The Most Mispriced Commodity In The World". I agree

A few years ago there was a contest here in Arizona to see who could submit the best water conservation marketing campaign.   I submitted a picture of my water bill with the price photo-shopped so it was doubled.  Politicians here in Arizona subsidize the hell out of water, block or refuse to fund infrastructure projects that would produce more, and then blame consumers for shortages.

Anyway, Zero Hedge quotes a guy named Rick Rule, who I don't know, on a variety of commodities but his bit on water really struck me:

Following their discussion of nuclear energy and the future of uranium pricing, Townsend posed a much broader question: What will be the most important themes in the natural resources market in the coming years and decades.

Rule's answer might reinforce readers' anxieties over the availability of water - something that's already been widely discussed because of Cape Town's looming "Day Zero." Rule even went so far as to call water "the most mispriced commodity on Earth".

The third place – and this is very much more difficult to implement – is water. Water is the most mispriced commodity in the world. Because water is allocated politically. It is believed to be a right, as opposed to a commodity. The consequence of that – as an example, here in the US Southwest, we have taken sources of water, like the Colorado River, and we have allocated approximately 130% of the flow of the river to various claimants. This is sort of hard on the river. You have a circumstance where water flows uphill to votes rather than downhill for money. And you can’t allocate something that doesn’t exist.

And also because of the structure of the American water business. Because of the fact that most of it is delivered politically rather than via markets. The rents that go to water, while they are insufficient to maintain supply, go to municipalities. And they go to fund current political goals as opposed to maintaining the infrastructure for the production and distribution of water.

It is believed, on a country-wide basis, that we have deferred as much as 3 trillion dollars in sustaining capital investments in the water business. I can’t tell you when this theme comes home to roost. But when it does come home to roost, this might be one of the great resource themes of all time.

So You Think You Have Property Rights in This Country?

You do have property rights ... right up to the point where someone with political pull wants to change the use of your property.

In Tempe, AZ, an intersection has been empty for a number of years after a gas station went out of business.  A local entrepreneur acquired rights to the land to build a car wash.  The city approved all his various permits and he was just starting to build when a powerful local developer who owned a strip mall next door decided he did not want a car wash next door to his businesses, and sought to rally the local community against the car wash with fears of traffic and poisonous chemicals.  The result?

After nearly three hours of debate, the Tempe City Council revoked permits for a Quick Quack Car Wash planned at Baseline Road and McClintock Drive.

The Council Chamber was standing-room only Thursday as more than 40 residents spoke. Opponents were in the majority by a 3-to-1 margin.

The residents' concerns largely revolved around noise and traffic. Those residents in favor of the development said a car wash was an upgrade from the old gas station that use to be at the corner.

Michael Pollack, who owns the nearby Peter Piper Pizza Plaza along with other commercial properties in the East Valley, hired an attorney to appeal the city's Design Review Board decision to grant permits for the car wash.

"I have nothing against ducks," Pollack told the council. "I would love to see something that harmonizes with that area."

Like residents, Pollack was concerned about noise and how a car wash would impact property values — points that representatives from Quick Quack said were unfounded.

Of course they are being generous here to the real influencer, pretending that Pollack was merely one more person in the community with concerns rather than the person who likely organized much of the opposition.

By the way, here is the Mr. Pollack's super-lovely strip mall he is concerned about "harmonizing" with

Don Boudreaux has a great quote from Bastiat today that seems to apply:

Admit it, what is worrying you is right and justice; what is worrying you is ownership – not yours, of course, but that of others.  You find it difficult to accept that others are free to dispose of their property (the only way to be an owner); you want to dispose of your property . . . and theirs.


Automation, or Perhaps Not (At Least for a While)

I thought this letter from Dan Hanson to Tyler Cowen was really thought provoking:

I wonder how many of the people making predictions about the future of truck drivers have ever ridden with one to see what they do?

One of the big failings of high-level analyses of future trends is that in general they either ignore or seriously underestimate the complexity of the job at a detailed level. Lots of jobs look simple or rote from a think tank or government office, but turn out to be quite complex when you dive into the details.

For example, truck drivers don’t just drive trucks. They also secure loads, including determining what to load first and last and how to tie it all down securely. They act as agents for the trunking company. They verify that what they are picking up is what is on the manifest. They are the early warning system for vehicle maintenance. They deal with the government and others at weighing stations. When sleeping in the cab, they act as security for the load. If the vehicle breaks down, they set up road flares and contact authorities. If the vehicle doesn’t handle correctly, the driver has to stop and analyze what’s wrong – blown tire, shifting load, whatever.

In addition, many truckers are sole proprietors who own their own trucks. This means they also do all the bookwork, preventative maintenance, taxes, etc. These people have local knowledge that is not easily transferable. They know the quirks of the routes, they have relationships with customers, they learn how best to navigate through certain areas, they understand how to optimize by splitting loads or arranging for return loads at their destination, etc. They also learn which customers pay promptly, which ones provide their loads in a way that’s easy to get on the truck, which ones generally have their paperwork in order, etc. Loading docks are not all equal. Some are very ad-hoc and require serious judgement to be able to manoever large trucks around them. Never underestimate the importance of local knowledge.

I’ve been working in automation for 20 years. When you see how hard it is to simply digitize a paper process inside a single plant (often a multi-year project), you start to roll your eyes at ivory tower claims of entire industries being totally transformed by automation in a few years. One thing I’ve learned is a fundamentally Hayekian insight: When it comes to large scale activities, nothing about change is easy, and top-down change generally fails. Just figuring out the requirements for computerizing a job is a laborious process full of potential errors. Many automation projects fail because the people at the high levels who plan them simply do not understand the needs of the people who have to live with the results.

Take factory automation. This is the simplest environment to automate, because factories are local, closed environments that can be modified to make things simpler. A lot of the activities that go on in a factory are extremely well defined and repetitive. Factory robots are readily available that can be trained to do just about anything physically a person can do. And yet, many factories have not automated simply because there are little details about how they work that are hard to define and automate, or because they aren’t organized enough in terms of information flow, paperwork, processes, etc. It can take a team of engineers many man years to just figure out exactly what a factory needs to do to make itself ready to be automated. Often that requires changes to the physical plant, digitization of manual processes, Statistical analysis of variance in output to determine where the process is not being defined correctly, etc.

A lot of pundits have a sense that automation is accelerating in replacing jobs. In fact, I predict it will slow down, because we have been picking the low hanging fruit first. That has given us an unrealistic idea of how hard it is to fully automate a job.

Based on this I can still think of some labor-saving, but not labor-eliminating, automation roles in trucking.

  • Convoying, allowing one driver to lead multiple additional automated trucks
  • Reduction in team driving.  Currently Federal rules (e.g. for rest breaks and maximum driving times) have created incentives for teams of two drivers to move priority freight that needs to be moving constantly and not parked while the driver sleeps.  Automation might allow one person plus the automated driver to keep trucks moving continuously and safely.

One thing not mentioned by Mr. Hanson is the role of regulation.  Safe automated trucks will likely exist LONG before Federal regulatory changes will occur to allow them much use.  This is not just because there is some delay with regulators getting comfortable with the safety aspects, but because affected groups with political pull who wish to keep the status quo will use safety concerns, real or imagined, to hold up the regulatory process.

If you think I am being too pessimistic, here is a story.  The typical steam engine of the 1930's needed a driver and a fireman -- the latter's job was to make sure the furnace was correctly fueled and operating well.  When diesel locomotives came along, one benefit among many was that the fireman was no longer needed.  Seeing this on the horizon, the fireman's union was ready to dig in their heals.  They actually, boldly, took the position NOT that a diesel locomotive needed a fireman, but that it should be required to have 2 firemen!  This was partially a subject for union negotiation, but in the dysfunctional world of railroad labor regulation, it also required some regulatory changes  (as the first industry with large workforces, the government took its first shot at labor regulation in a railroad-specific manner and the result was largely dysfunctional; fortunately for the rest of industry it did a better job with labor regulation later for everyone else).  It took years to totally eliminated fireman from diesel engines.  In fact, nearly every railroad labor saving technology like this (e.g. automatic brakes rather than men on roofs turning break wheels) led to regulatory foot-dagging that allowed the new technology but resisted the reduction in personnel.

The Best Thing For Low-Skill Workers Would Be To Make It Enormously Profitable to Employ Them

I am constantly amazed how little people understand about economics and prosperity.  I have to give some background first.  Yesterday Mickey Kaus tweeted, "Isn't point of 'Americans are dreamers too' that there *are* zero-sum aspects: American lo-skill workers, who haven't done well for decades, have to compete for jobs/wages w/ DREAMers and (more important) new illegals a big DREAM amnesty will attract."

People talking about zero-sums in economics always get my hackles up, because they are frequently feared and seldom actually exist.  There is a lot of research that immigration does not reduced native-born unskilled employment, but it is impossible to discuss such things on Twitter without devolving into dueling appeals to authority.  Instead I wrote:

So what about a bipartisan compromise that increases immigration while simultaneously repealing labor regulations that make profitably employing low-skill workers difficult?

This was towards the end of my time on Twitter when I was mad that it was making me a worse person and I resolved to instead focus on trying to bridge differences.  But this proposal got a response I had not expected.

I am willing to believe I don't understand his point or Twitter is limiting his ability to explain himself, but this just seems really ignorant of how markets work.  How are jobs for low-skill workers going to exist if it is NOT profitable to employ them?

Here is how the world works:  Profits attract investment.  Profits are the fresh blood in the water that attracts sharks.   If I am making a good profit employing low-skill workers, then I am likely to reinvest those profits to grow and get more of those profits next year.  But even if I don't, at the same time other people will start to notice my profits and want to copy what I am doing.  Through all of this, we will all be hiring more and more unskilled workers.  None of this growth, none of this investment, none of this job creation happens without the profits.

This is why I have said for years that the greatest thing that could ever happen to low-skill workers in America is for entrepreneurs to find ways to make a fortune employing them.  I always get folks who consider this statement grossly exploitative, but it is the literal truth.  There are tons of well-paying jobs for programmers because a bunch of companies like Google are very visibly making a ton of money employing them.  Unfortunately, it is harder and harder to make the economics of a business that hires low-skill workers a success, something I know well because I run such a business.  The local, state and Federal governments are layering on more and more labor regulations that make it increasingly difficult to viably employ lower-skill workers.   I have a lot to say on this, and hopefully a paper I have written on the topic will soon be published and we can talk about it more.

Postscript:  Margaret Peters argues that one reason the Republican Party is more nativist is that the business sectors of the party that traditionally lobbied in support of immigration have reduced their support, at least for unskilled immigration, because they just don't have as much demand for unskilled labor any more.

As part of my research, I checked to see whether businesses are indeed lobbying less often on immigration. To find this out, I examined which groups testified before Congress on immigration, using that as one measure of lobbying.
Here's what I found. In the 1950s, on average, more than eight businesses used to testify before Congress at each hearing on immigration. By 2010, that number had dropped to two, as you can see in the figure below. The decline has been even steeper for industries that have been exposed to increased imports from foreign countries -- from eight businesses that produce goods that can be traded per hearing in the 1950s to less than one today.

Some industry groups have increased their lobbying for more immigration -- but those are in the tech sector and others that use high-skill labor. We should expect, then, that Trump will continue to push in his State of the Union address Tuesday for a "merit-based system" in which immigrants with high skills get priority.

In contrast, lobbying by nativist groups has hardly increased.

Google beats the doors down in DC lobbying for more immigration spots for programmers.  If someone were making good money hiring unskilled labor, they would be doing the same for unskilled immigration.

OK, I Have Devised A Brilliant New Trojan Horse Plan For Using Trump To Promote Freedom

Since Progressives refuse to accept and opposes anything Trump supports, let's get Trump to start professing interest in all sorts of bad socialist ideas.  Perhaps we can steer Progressives away from some of their own worst proposals.

Trump's proposal to nationalize the future 5G data network is a good start along these lines.  This article in and of itself is proof my strategy works.  I can guarantee that if Barack Obama has proposed a nationalized data network using social justice and inter-sectional language, the economically illiterate socialist millennials at Engadget would have been writing articles about what a fabulous idea it was, and not about how it would be impossible.

Am I The Only One Who Finds This Paul Krugman Tweet Weirdly Ironic?

Maybe one character could be an economist who entered the world of political punditry and subsequently walked away from many of his earlier economic beliefs when they conflicted with his party loyalty.

e.g. here, here

Postscript:  By the way, my first Venn diagram, which Mark Perry has credited as the inspiration for what he has since turned into an art form, involved Mr. Krugman:

Why Monopsony Employer Power Is Virtually Irrelevant to the Impact of a Higher Minimum Wage on Employment

Most of us who took Econ 101 would expect that an increase in the minimum wage would increase unemployment, at least among low-skilled and younger workers most affected by the minimum wage.  After all, demand curves slope downwards so that an increase in price of labor should result in a decrease in demand for that labor.

There is a great body of work on employment effects of minimum wage, and surveying this corpus is beyond the scope of this paper, but a good starting point might be the recent detailed and careful study by Jardim et. al. of the University of Washington, which analyzed the employment effects of the increase in minimum wages in Seattle from $11 to $13.  They found that while average hourly wages for lower-paid workers went up by 3%, the total hours worked went down by 9%, resulting in a net reduction in total wages for lower-paid, lower-skill workers at the same time that other sectors of the Seattle economy were booming.

Monopsony Power & The Labor Market

Supporters of the minimum wage, however, argue that these employment effects are exaggerated, because employers have something called monopsony power when hiring low-skill workers.  What a monopoly is to customers – it limits choices – a monopsony does to suppliers, in this case the suppliers of labor.  The argument is that due to a bargaining power imbalance, employers can hire workers for less than they would be willing to pay in a truly competitive market, gaining the company added savings that increase its profits.  Under this theory, minimum wage laws help to offset this power imbalance and force companies to disgorge some of their excess profits in favor of higher wages.  If this assumption is true, then demand for labor would not be reduced due to a minimum wage increase because, prior to the wage increase, companies were paying less than they were willing to pay and thus are still willing to continue to pay the wages at the new higher rates.

While economists argue about this monopsony theory, my intuition as an employer makes me skeptical.  However, rather than argue about whether my little company that scrambles to staff itself every year somehow wields excess power in the labor markets, I am going to argue that the existence of monopsony power is irrelevant to the employment effects of a minimum wage increase: Even if companies are able to pay workers less than they might via such bargaining power imbalances, whatever gains they reap from workers will end up in consumer hands.  As a result, minimum wage increases still must result either in employment reductions or consumer price increases or more likely both.

Why? Well, we need to back up and do a bit of business theory.  Just as macroeconomics (all the way back to Adam Smith) spends a lot of time thinking about why some countries are rich and some are poor, business theory spends a lot of time trying to figure out why some firms are profitable and some are not.  One of the seminal works in this area was Michael Porter's Five Forces model, where he outlines five characteristics of markets and firms that tend to drive profitability.  We won't go into them all, but the most important of the forces for us (and likely for Porter) is the threat of new entrants -- how easy or hard is it for new firms to enter the marketplace and begin competing against an incumbent firm?  If new companies can enter into competition easily, a profitable firm will simply attract new competitors, and keep attracting them until the returns in that market are competed down to some minimum level.

Let’s consider a company paying minimum wage to most of its employees.  At least at current minimum wage levels, minimum wage employees will likely be in low-skill positions, ones that require little beyond a high school education.  Almost by definition, firms that depend on low-skill workers to deliver their product or service have difficulty establishing barriers to competition. One can’t be doing anything particularly tricky or hard to copy relying on workers with limited skills. As soon as one firm demonstrates there is money to be made using low-skill workers in a certain way, it is far too easy to copy that model.    As a result, most businesses that hire low-skill workers will have had their margins competed down to the lowest tolerable level.  Firms that rely mainly on low-skill workers almost all have single digit profit margins probably averaging around 5% of revenues (for comparison, last year Microsoft had a pre-tax net income margin of over 23%).

If there were some margin windfall to be obtained from labor market power that allowed a company to hire people for far less than their labor was worth to it, and thus earn well above this lowest tolerable margin,  new companies would try to enter the market, probably by lowering prices to consumers using some of that labor premium.  Eventually, even if the monopsony premium exists, it is given away to consumers in the form of lower prices.  If the wholesale price of gasoline suddenly falls sharply, gasoline retailers don't get to earn a much higher margin, at least not for very long.  Competition quickly causes the retailer's lowered costs to be passed on to consumers in the form of lower retail prices.  The same goes for any lowering of labor costs due to monopsony power  -- if such a windfall exists, it is quickly passed on to consumers.

As a result, the least likely response to increasing labor costs due to regulation is that such costs will be offset out of profits, because for most of these firms, profits have already been competed down to the minimum necessary to cover capital investment and the minimum returns to keep owners interested in the business. The much more likely responses will be:

  • Raising prices to cover the increased costs. While competitors that are subject to the same laws will likely have similar increases, the increase may not be acceptable to consumers and almost certainly will result in some loss in unit sales.
  • Reducing employment. There are a variety of ways in which a minimum wage increase could result in employment losses.  A company might raise its prices to compensate for higher costs, only to find its unit volumes falling, necessitating a layoff in staff.  Or the staff reductions may also be due to targeted technology investments, as increases in labor costs also increase the returns to investments in capital equipment that substitutes for labor
  • Exiting one or more businesses and laying everyone off. This may take the form of exiting a few selected low-margin lines of business, or liquidation of the entire company if the business is no longer viable with the higher labor costs.

A Real-World Minimum Wage Increase Example

A concrete example should help. Imagine a service business that relies mainly on minimum wage employees in which wages and other labor related costs (payroll taxes, workers compensation, etc.) constitute about 50% of the company’s revenues. Imagine another 45% of company revenues going towards covering fixed costs, leaving 5% of revenues as profit.  This is a very typical cost breakdown, and in fact is close to that of my own business.  The 5% profit margin is likely the minimum required to support capital spending and to keep the owners of the company interested in retaining their investment in this business.

Now, imagine that the required minimum wage rises from $10 to $15 (exactly the increase we are in the middle of in places like Seattle and California).  This will, all things equal, increase our example company's total wage bill by 50%. With the higher minimum wage, the company will be paying not 50% but 75% of its revenues to wages. Fixed costs will still be 45% of revenues, so now profits have shifted from 5% of revenues to a loss of 20% of revenues. This is why I tell folks the math of supposedly absorbing the wage increase in profits is often not even close.  Even if the company were to choose to become a non-profit charity outfit and work for no profit, barely a fifth of this minimum wage increase in this case could be absorbed.  Something else has to give -- it is simply math.

The absolute best case scenario for the business is that it can raise its prices 25% without any loss in volume. With this price increase, it will return to the same, minimum acceptable profit it was making before the regulation changed (profit in this case in absolute dollars -- the actual profit margin will be lowered to 4%). But note that this is a huge price increase.   It is likely that some customers will stop buying, or buy less, at the new higher prices. If we assume the company loses 1% of unit volume for every 2% price increase, we find that the company now will have to raise prices 36% to stay even given both the minimum wage increase and the lost volume. Under this scenario, the company would lose 18% of its unit sales and is assumed to reduce employee hours by the same amount.

In the short term, just for the company to survive, this minimum wage increase leads to a substantial price increase and a layoff of nearly 20% of the workers.   Of course, in real life there are other choices.  For example, rather than raise prices this much, companies may execute stealth price increases by laying off workers and reducing service levels for the same price (e.g. cleaning the bathroom less frequently in a restaurant).  In the long-term, a 50% increase in wage rates will suddenly make a lot of labor-saving capital investments more viable, and companies will likely substitute capital for labor, reducing employment even further but keeping prices more stable for consumers.

As you can see, in our example we don’t need to know anything about bargaining power and the fairness of wages. Simple math tells us that the typical low-margin service business that employs low-skill workers is going to have to respond with a combination of price increases and job reductions.

Classic Government Economics: Subsidize Demand, Restrict Supply.

Name the field:  Housing, education, health care.  In most any industry you can name, the sum of the government's interventions tend to subsidize demand and restrict supply.  In health care for example, programs like Medicaid, Obamacare, Medicare, and others subsidize demand while physician licensing, long drug approvals and prescription requirements, certificates of need, etc restrict supply.

If you are wondering why, it turns out that most government regulatory processes are captured by current incumbents, who work to get the government to subsidize customers to buy their product or service while simultaneously having the government block upstart competitors, either foreign or domestic.  For example in housing, existing homeowners form a powerful lobby that limits housing supply through restrictive zoning while demanding that the government subsidize mortgage interest (as well as low-cost mortgage programs) and give special tax treatment to capital gains from homes.   The result in every industry is supply shortages and rising prices.

Yesterday, we saw another classic example.  Federal, state and local governments have spent billions of dollars over the last decades subsidizing solar panel installations in homes and businesses.  But now, they are also simultaneously restricting the supply of solar panels:

President Donald Trump is once again burnishing his protectionist bona fides by slapping imported solar cells and washing machines with 30% tariffs - his most significant action taking aim at the world's second-largest economy since he ordered an investigation into Chinese IP practices that could result in tariffs.

Acting on recommendations from US Trade Representative Robert Lighthizer, Trump imposed the sliding tariffs. Solar imports will face a 30% tarifffor the first year, then the tariff will decline to 15% by the fourth year.It also exempts the first 2.5 gigawatts of imported cells and modules, according to Bloomberg.

And... who would have guessed that Elon Musk would be on the receiving end of another government crony handout?  The patron saint of subsidy consumption will get yet another, as Tesla's solar city is currently building a large domestic panel manufacturing plant, an investment decision that makes little sense without tariff protection.

Who'd Have Thought? Scarce Resources Are Still Scarce Even (Especially) When They Are Free

Via Mark Perry, this chart from socialized Canadian medicine:

In his article Mark also has a letter to a woman telling her the wait for an appointment would be 4.5 years.


Transparent and Visible Cross-Subsidy: Unethical; Invisible Legally-Mandated Cross-Subsidy at the Behest of a Special Interest: A-OK

From Engadget, apparently the EU has banned retailers for adding a surcharge on credit card purchases.  Since it is an absolute fact that credit card sales cost retailers at least 3% more (due to merchant processing fees) than cash sales, I likely would have written about this story something like "EU knuckles under special interest lobbying from credit card processors and forces non-customers (ie those paying in cash) to subsidize credit card purchases."  Of course, given the consistent and predictable economic ignorance of Engadget, that is not how the story actually was written:

Thanks to new EU regulations, you won't have to put up with irritating card surcharges for much longer. Unfortunately, minimum card spends you come across in small shops and such will stick around, but from January 13th, the Payment Services Directive comes into play. This stops retailers from charging you more for, say, using a credit card than a debit card, or generally just passing the transaction fee onto the customer. It won't, however, make your Just Eat delivery any cheaper. That's because yesterday, ahead of the new EU rules being implemented, Just Eat did away with its 50p fee for paying by card, and instead created a new 50p "service charge" that applies to all orders.

What's particularly cheeky is pay-by-cash customers now also have to fish between the sofa cushions for an extra coin -- a move Just Eat calls "fairness for all" (lol) -- meaning it's making even more moolah while sticking a middle finger up to the spirit of the EU directive. Just Eat told the BBC it had previously thought about tweaking charges, while also totally confessing that "the change to legislation did play a part in prompting the review." A spokesperson also said, predictably, that it'll enable the company to keep providing its stellar services: "The 50p charge simply means that along with our restaurant partners, we can continue to deliver the best possible takeaway experience."

The law essentially forces cash customers to subsidize credit card customers.  I know what retail profits look like (think small single digits) and the lost surcharge is not coming out of profits, it is going to be covered by establishments in generally higher prices paid by everyone, including cash customers.  In my mind, this retailer is a hero, by actually making this legally-mandated cross subsidy transparent.

Better Measurement of State by State Prosperity

I have always been suspicious of metrics showing that people in, say, San Francisco are way richer than everyone else in the country.  Sure, they have a larger number on their paycheck, but they also very likely have a larger number on their mortgage check.  In a paper by Cletus C. Coughlin, Charles S. Gascon, and Kevin L. Kliesen, the authors publish this map of state per capita income, both before and after adjusting for local cost of living (Link via a long chain that started at Maggies Farm).  As usual click to enlarge.

Worker Mobility and Exploitation

The other day I commented on an interview with an author who felt that seniors living in RV's and "work camping" were somehow more vulnerable to exploitation.

Imagine a person in a small town with a home and she works in the local factory, really the only major employer in that small town.  If she thinks she is getting hosed at work, what can she do?  She can certainly quit, but then she likely must sell her house, find a new place to live, move to a new city, etc.  Basically, she has high job switching costs and thus probably would have to put up with more cr*p before she would leave.  Now imagine our work campers.  I once had an employee tell me that I had to treat him well, because he had wheels on his home and could leave any time.  And he was right.   Work campers, being more mobile, have much lower job switching costs.  Economically, this should make them less, rather than more, vulnerable to exploitation.

As a side note, this is one reason (beyond the obvious ones highlighted by the 2008 crash) that I have always thought the government promotion of home ownership was counter-productive.  I call this cargo cult economics -- legislators observe that successful people own homes, so therefore pass legislation on the assumption that having people own a home will make them successful.  But in fact I think for many classes of workers, home ownership is counter-productive because it reduces their mobility and greatly increases their job switching costs.  I personally, between the ages of 24 and 40, had jobs in 7 different cities in pursuit both of opportunity and employment that matched my interests and skills.  Had I locked myself into my first location (Baytown, Texas) I can't imagine I would be as well off today.

Uber Is About To Become A Much Worse Place To Work

Here are some cool things about working for Uber:

  • You can work any time you want, for as long as you want.  You can work from 2-4 in the morning if you like, and if there are no customers, that is your risk
  • You can work in any location you choose.  You can park at your house and sit in your living room and take any jobs that come up, and then ignore new jobs until you get back home (I actually have a neighbor who is retired who does just this, he has driven me about 6 times now).
  • The company has no productivity metrics or expectations.  As long as your driver rating is good and you follow the rules, you are fine.

All of this is going to change.  Why?  Due to lawsuits in most countries that seek to redefine Uber drivers as employees rather than contractors.  One such suit just succeeded in England:

Is Uber a taxi firm or a technology company, and are its drivers self-employed or mistreated employees? These questions are being asked of Uber the world over, and last year an employment tribunal case in the UK concluded two drivers were, in fact, entitled to minimum wage, holiday pay and other benefits. The ride-hailing service contested this potentially precedent-setting decision, as you'd expect, but today Uber lost its appeal. In other words, the appeal tribunal upheld the original ruling that drivers should be classed as workers rather than self-employed.

The appeal tribunal agreed that when a driver is logged in and waiting for a job, that's still tantamount to "working time." Working time they aren't getting paid for, of course. Interestingly, the ruling also noted that Uber basically has a monopoly on private hire via an app. Therefore, drivers are beholden to them and can't reasonably engage in other work while also being at Uber's disposal.

GMB, the union for professional drivers that's behind the original case, is calling it "a landmark victory." Naturally, the law firm representing the GMB and Uber drivers feels much the same. No points for guessing who has a slightly different opinion.

Despite Engadget's usual economic ignorance that this must be all good for drivers, in fact this is going to destroy about everything that makes Uber attractive as compared to 9-5 office jobs.  That is, if rulings like this don't kill the company entirely, as I have previously prophesied.

This is going to add a new cost for Uber, forcing them to pay money to drivers for dead time when they are not actually driving a passenger.  Let's make the reasonable assumption that Uber's first response to this is to A) stay in business and B) attempt to keep prices to customers from rising.  The only way they can do this is to minimize dead time.

Want to park at your house in an unpromising neighborhood with little business?  Forget it, Uber can't allow that in the future.  Want to work at an unproductive hour of your choosing?  Forget it.  Uber is going to have to set quotas on certain regions and hours of the day that are less productive and find a way to ban drivers from working those times.   In addition, they are likely to institute some sort of productivity metric for drivers, ie something like revenue minutes as a percent of total, and then they are going to rank all the drivers and start cutting drivers from the bottom of the list.  If Uber survives, it is going to be a very different company to work for, and is going to feel much more like a regular office job with a boss hanging around your cubicle pestering you about TPS reports.

Progressives Hate When You Make Job Choices That They Would Not Make Themselves

I must say I was tremendously surprised when a reader sent me this interview and book review, which is summarized thus:

In her powerful new book, “Nomadland,” award-winning journalist Jessica Bruder reveals the dark, depressing and sometimes physically painful life of a tribe of men and women in their 50s and 60s who are — as the subtitle says — “surviving America in the twenty-first century.” Not quite homeless, they are “houseless,” living in secondhand RVs, trailers and vans and driving from one location to another to pick up seasonal low-wage jobs, if they can get them, with little or no benefits.

The book seems to be mostly focused on Amazon, at least from what I can glean from this interview, and I will say that I am pretty much totally unaware of working conditions at Amazon or how happy their employees are, so I cannot comment on them.  I do know that Amazon seems to be starting to eclipse even Walmart as the new target for progressive teeth-gnashing about working conditions.

However, the author seems to be painting with a pretty broad brush here, and is trying to apply her comments to all "workampers," or folks who have given up a settled lifestyle and live a quasi-nomadic lifestyle in an RV.  I am very familiar with this basic concept, as my company hires about 350 of these folks every year to live and work in the campgrounds and recreation areas we operate (this is how the camp host job works).

The article was surprising because I get about 25,000 applications every year from these workampers for about 50 open job positions.  It seems like something people really want to do.  People call me begging me for a job, which includes both physically easy tasks (e.g. checking in campers) and physically more difficult tasks (e.g. cleaning bathrooms and raking).  Most of our employees love the experience, and articles like this one about our hosts and how much they like the work are not uncommon.

Anyway, I wanted to offer a few random thoughts on this interview:

  1.  It is really common, especially among progressives, for folks to say some sort of employment is objectively bad mainly because they would not want that particular job.  This has been a feature of "sweatshop" criticism for years.  Underlying much of the critique is the feeling that "I could never imagine working for $2 a day" so it must be bad.  Of course you can't imagine it, and neither can I -- as Americans we fortunately have many better choices.  But for someone in Vietname whose family has been subsistence farming for generations for less than a $1 a day in back-breaking work where harvests can fail and the whole family perish from starvation, a $2 a day factory job might seem like a gift from heaven.
  2. It is not clear to me why the employers of these older folks are at fault.  The author asserts that no one else will hire these folks, that this is their only choice -- "Few have chosen this life."  If this is so, why place the blame on the only folks willing to hire these people?  I can understand if Amazon were luring people out of comfortable professional jobs on false pretenses that this would be unethical, but why are they to blame if they hire the otherwise unemployable?  I would think that makes them a hero.
  3. It strikes me that 20 years ago, authors like this one were writing pieces about age discrimination and how terrible it is that no one will hire old people.  Now we learn the opposite, that companies are terrible for hiring them.  Forty years ago the author might have been writing about how stultifying middle American suburbs and corporate life were, but now we learn that folks who choose to be nomadic and try some alternative need to go back to the suburbs.
  4. I honestly have no idea what this even means: "We live in a culture where if your number didn’t come up, you’re a bad person, you’re lazy, you should be ashamed of yourself. It eats away at people. It makes them more exploitable."  Let me tell a story.  I do not hire managers from the outside -- everyone I promote to manager has to have worked for me at least a year as a front-line camp host.   Some of the folks that get promoted were managers in their former careers, but most never were.  In fact, I have many managers who never even considered that they could ever manage people, and suddenly discover at the age of 65 or 70 that they can do it.  Seeing this happen is the greatest joy in my job.  I don't know how to reconcile this with the author's statement.
  5. The author wants to blame this all on the 2008 financial crisis, but I guess that is confusing.  I know it took a long time for folks to get jobs back who lost them, and I don't want to minimize the pain of that, but she implies this is a lot about people losing all their savings.  "I talked to one couple, Barb and Chuck. He had been head of product development at McDonald’s before he retired. He lost his nest egg in the 2008 crash and Barb did, too."  I have no doubt this sort of thing happened, but frequently?  All our investments took a hit in 2008 and 2009 but almost everything is higher now than in 2008.  It would have taken some heroically bad choices (or a lot of leverage) to lose absolutely everything,
  6. The one thing I think the author and I would agree on is that the current retirement system is unsustainable.  However, I think we would come to vastly different conclusions.  She says, "We saw in the 1980s a shift from pensions to 401(k)s; that was a raw deal for workers. These retirement plans were marketed as an instrument of financial freedom, but they were really transferring risk from the shoulder of the employers to the backs of the workers."  This is only partially true.  If one is working at Sears with a traditional pension, one likely has way more risk right now (with Sears teatering on bankrupcy and your savings effectively invested all in one company) than if one had a 401(k) invested in the S&P500.  However, I would argue that what is broken in the retirement system is the assumption that everyone has a right to a 30 year mostly-healthy end-of-life vacation.  When pensions were first started, people did not live much longer than they worked.  Now they do.  Good!  But our retirement system and our expectations for it have not changed.  One only has to look at the State of Illinois to see the end game of these mismatched assumptions.
  7. (added as an update):  To the point about "exploitation".    Imagine a person in a small town with a home and she works in the local factory, really the only major employer in that small town.  If she thinks she is getting hosed at work, what can she do?  She can certainly quit, but then she likely must sell her house, find a new place to live, move to a new city, etc.  Basically, she has high job switching costs and thus probably would have to put up with more cr*p before she would leave.  Now imagine our work campers.  I once had an employee tell me that I had to treat him well, because he had wheels on his home and could leave any time.  And he was right.   Work campers, being more mobile, have much lower job switching costs.  Economically, doesn't this make them less, rather than more, vulnerable to exploitation?
  8. Note, when asked to point to true exploitation (rather than just less-than-ideal jobs) who is the one example she can think of:

You write that sometimes the Nomads are exploited. How? 

I filed a Freedom of Information Act request with the Forest Service and learned that some of their workers aren’t getting paid for all their hours. They weren’t allowed to invoice.

A few years ago one branch of the Federal government, the Department of Labor, decided that it was a morally urgent to make sure everyone working in a Federal campground operated by a private company like mine should make at least $10.15 an hour, and imposed this special minimum wage.  And we complied.  But then another branch of the Federal government, the US Forest Service, decided that it could now run the campgrounds cheaper themselves because they could staff it with volunteers and not pay this minimum wage.  Apparently it is not morally urgent for them to pay the minimum wage.  While the USFS sometimes pays hosts a stipend, this stipend, as the author notes above, is well below even state minimum wages and certainly well below the campground concessionaire minimum wage set by the DOL.  I find it not at all surprising the best example of true exploitation comes from the government.  However, how much do you want to bet this author asks that we rely on government to eliminate imagined exploitation in the private world?

Postscript:  It reflects classic middle class snobbery to call these folks "homeless".  I have hired nearly thousands of work campers over the years and have yet to meet one who considers themselves to be homeless.  They would say they have a home -- and it has wheels on it.

Reasonable People Will Disagree -- The Tesla Example

Too often people today in public discourse assume that those who disagree with them are bad people, or have bad motivations.  Or at best, they assume others don't have all the facts and have been influenced by some biased media source.

But perfectly well-motivated people with the exact same data can reach stunningly different conclusions.   A while back I signed up for a (free) investing website called Seeking Alpha.  In doing so, they asked me to list some of the stocks I followed, and they send me email alerts when those stocks have new articles on the site.  One of the securities I put in there was Tesla, so I have been watching the flow of articles on this one company.

It has been an amazing exercise!  Most all the authors are working with the exact same data set, in this case the financial reports and public statements of the company.  And each time new information comes out, there is an absolute flood of articles from different authors.  Many of which have completely opposite reactions to the data -- one says its wildly positive for x and y reasons, another says it is wildly negative for z reasons.  The timeline of articles on Tesla is here.

As a disclosure, I was short Tesla until the other day when I covered at the bottom of their big price drop.  Yay!  I finally made money on a short.  I think Tesla is a mess, and its merger with SolarCity borderline corrupt.  My brother-in-law, a successful entrepreneur in the tech space, thought the merger was brilliant and part of a grand strategy with Musk playing chess when everyone else is playing checkers.

Though It Would Benefit Me Greatly, the Proposed Pass-Through Entity Tax Cut Is A Bad Idea

In the most recent version of a tax "reform" proposal in Congress, there was a provision for a reduced personal income tax rate on income from pass-through entities.  A pass-through entity is usually an S-corporation or an LLC, where the entity fills out a corporate tax form but pays no income taxes -- instead the income passes through to the individuals who own the entity, and taxes are paid on the individual return.  This was a great innovation because it provides an alternative to the double taxation of income that still exists with traditional C-corporations  (ie tax is paid by the corporation on income and again on the same income when it is passed through as capital gains or dividends to the owners).

I own an S-corp and would benefit greatly from a reduced tax rate on S-corp pass through income.  But I oppose it.  The basis of this tax proposal is a familiar one -- there is some type of economic behavior that Congress thinks is either meritorious or counter-productive, and there is a great urge to tweak the tax code to promote or hinder these behaviors.  We get sold on the idea that owning a home is better than renting and thus we have the mortgage interest deduction.  There are thousands of such tweaks in the tax code, and most have little to do with economic reality and more to do with some special interest rent-seeking with Congress.

Someone in Congress thinks it's good that business people own small businesses and they should get a lower tax rate.  That's me, so thanks. But we end up with craziness, exactly as we do every time Congress tries to pick winners and losers.  Here would be effective tax rates (corporate + individual) for income earned in different ways under the new plan:

  • The lowest rate would be for income to a passive investor in a pass-through
  • The next lowest rate would be for income to an active investor in a pass-through -- yes, from a tax point of view it is less meritorious to actually work at the pass-through entity than just collect checks.  The logic is that part of one's pass-through income is for "labor" and thus needs to be taxed at the higher regular income tax rate.  How anyone can separate how much of my profits are from my labor and how much is from -- what?  unicorns? -- I have no idea
  • The next higher rate would be paid on passive income from a C-corporation like ExxonMobil, which would be taxed at the corporate rate and then taxed at the dividend rate (currently 15%) on the individual return but the combination would likely be less than the maximum personal rate.  For people without a lot of other income, this might be the highest taxed activity.
  • The highest rate would be for people simply working and earning income, assuming they are in the upper tax brackets.

All of this makes zero sense, or to the extent it makes sense to anyone is based on economic theories that likely don't hold a lot of water.  It reminds me of the old efforts to distinguish between the deserving and undeserving poor when giving out relief.  Every person in Congress seems to have a personal vision of deserved and undeserved income.  Just because the current folks have me in the deserving category doesn't mean that the next batch won't put me in the opposite category.

I think the entire corporate tax system needs to be junked.  The amount of effort that goes into compliance, and perhaps more importantly, the number of distortions is creates, make finding an alternative well worth the effort.  My tax plan has always been:

  1. Eliminate all deductions in the individual income tax code except for a single personal deduction
  2. Eliminate the corporate income tax.
  3. Tax capital gains and dividends as regular income.
  4. Eliminate the death tax as well as the write-up of asset values at death

Corporate income all eventually passes through to individuals as capital gains or dividends, so eventually they do get taxed.  The same is true of inherited assets -- because they would not get written up in value at death, they would still trigger large capital gains once tapped by those who inherit the assets.  As far as rates are concerned, I actually don't see a strong need for a flat tax -- I can live with the progressive rates we have now.

I have heard people of late saying that we can't eliminate the corporate income tax because foreign investors would never get taxed.  First, they would get taxed, just in their home country.  And second, who cares?  There have got to be a lot of things worse than a rush of foreign capital into the US.

The Irony and Internal Contradiction of Passive Investment Management

My relatively snarky post on hedge fund fees and passive management got a lot of response, including a few of challenging emails from friends and acquaintances.  So I wanted to cover a few followups here.

One of the interesting features of passive investment management is that it doesn't work if everyone does it.  I vaguely remember there is some name for this in the game theory world but I can't for the life of me remember.  Anyway, passive investment is based on the theory that the market for financial products is relatively transparent and efficient.  While one stock will certainly perform better than another, it is almost impossible (or at least really expensive) in a mostly-efficient market for a regular investor, or even an average fund manager, to parse this out.  As a  result, high fees or expenses one might incur to find these opportunities generally don't pay for themselves, and it is better to just invest in a broad basket of securities and accept the average market return.

But note that this is predicated on the assumption that someone, somewhere is actively managing.  Someone must be looking for good stocks and bad stocks and buying the former and selling the latter.  Without these folks actively managing, it would not be an efficient market.  [I am reminded at this point of the old joke about a man walking down the street with an economist.  The economist steps right over a $100 bill on the sidewalk without stopping.  The man asks the economist, "why didn't you stop and pick up that money?" and the economist answers, "in an efficient market it can't really be there."]

I remember a while back reading economic research about shopping.  What percentage of customers have to be active price-shoppers to make a market efficient?  I personally don't price shop for the small stuff.  If I need a bunch of cheap bulk stuff, I just run to Wal-Mart or Costco and buy it with confidence I am getting a pretty good price.  But why can I do that?  Because I trust these large corporations to honor their promise for low prices?  Hah!  No way.  What I trust is that there are people who clip coupons and price every dang item to the penny, and it is these folks who keep Costco and Walmart honest.  Government interventionists like to talk about the free rider problem all the time, but most all of us are free riders on these hard core shoppers.

The same is true with us passive investors.   I like to get snarky about the fees certain active investors charge, but I am still dependent on their work.  And I don't particularly doubt that there are hedge funds and private equity firms that make consistently above market returns, but I do think they are a minority.  I would equate it to max-contract players in the NBA.  No one doubts Lebron James merits a max contract -- any of the teams in the NBA would sign that deal in five seconds.  But a max deal for, say, Chandler Parsons?  Joakim Noah?  The problem with hedge funds is that the few of these folks who merit the two and twenty max contract have very likely been closed to new investors for years, in the same way it is impossible to get LeBron James to play for Memphis.  It is frustrating for me to see public and private institutions chasing yield and continuing to pay 2 and 20 to folks with an unproven algorithm and a marketing plan.  If I am going to pay 2 and 20, its more likely to be to someone in private equity or an LBO fund who is doing more than stock picking.  That's because I do think that stocks are generally well-valued on the market based on their current management, investment plans, culture, etc.  But they may contain opportunities for smart people who can come in and, for example, apply different management and culture and strategy to the people and assets.  A box that is half Kale and half candy corns might not sell for a good price because no one wants the combination, so value can be created splitting it up.

A couple of other thoughts that came up in discussions since yesterday:

  • I am willing to believe that passive investing looks so good vis a vis active investing because central banks have inflated assets and compressed volatility.  If all the boats are rising with the tide of state actions that are raising the tide, then one is less likely to be fussy about which boat he is on.  What's the point of value investing when the market treats stocks as commodities?  But I can certainly see that in markets like the late 70's or pre-market-boom early 80's that stock pickers might have had more room to differentiate themselves.
  • I am also willing to concede that passive investing may turn out to be a terrible trend for corporate governance.  If all your shareholders are just holding your stock as part of a basket of 500 stocks, who is going to hold you accountable?  It is very awkward for a Vanguard agitate for changes in a company, even when they might be the largest single shareholder.  Also, ironically, passive investing may be opening the door for single lone wolf activist investors to impose their will on companies, sometimes to the other shareholders' detriment.  If one person with 5% cares a lot and the other 95% are passive, that one person might be able to raise a lot of hell.

As a final note, I am a screaming hypocrite on the whole passive investing thing, since with most of my net worth I am the ultimate in active investors.  I have most of my savings in one company, the one I run.

Confirmation Bias and the Morningstar Story in the WSJ

Like many folks, including Mark Perry, I would tend to agree with the following statements

  • Past performance is not a very good indicator of likely future performance
  • One should generally eschew managed funds in favor of low-cost index funds

However, I think a lot of folks who believe these same things are applying confirmation bias when looking at the data in a recent WSJ story on Morningstar.  Morningstar analyzes mutual funds and rates them based on their past 1/3/5/10-years performance in relation to other funds of the same type.  Funds in the upper quintile of past performance get 5 stars, the next quintile gets 4 stars, etc.

Morningstar is sort of coy about whether the ratings are supposed to have predictive value.  They will say that of course they only measure past performance, but there would be no way to sell these ratings to folks for millions of dollars (as they do) without there being some implication the ratings were at least partially indicative of future performance.

So the WSJ did something interesting -- they went back 10 years and took all the 5 star funds and looked at how they have done since (as measured by Morningstar itself with its star ratings).  So how many 5-star funds ten years ago actually had 5-star performance over the subsequent years, and so on.  And it turns out that a lot of the 5-star funds have not performed very well.  This is a good reminder to us all.

BUT.  Look at their own data:

Yes, the 5-star funds from 10 years ago only average 3 today.   Everything regresses towards the mean, as we random walk folks might expect.

But the 5-star funds did better than the 4, which did better than the 3, which did better than the 2, which did better than the 1.  This actually understates the difference, because many of the lowest performing funds in the lower star categories closed in this 10 year period, so are not in the final metrics, which likely raises the scores of some of the lower buckets because they dropped out (59% of the 1-star funds closed or merged in this period while only 22% of the 5-star funds did so).

This is actually -- to someone who doesn't really buy into the whole stock-picking thing -- a pretty impressive achievement.  I challenge you to take stocks or bonds or mutual funds of roughly the same type and divide them into 5 buckets, rank the buckets by expected performance, and actually have this ranking hold for 10 years.

Keynesian Economic Stimulation, White Collar Edition

Yet Again, Forgetting the Mix

I like reading Zero Hedge, though their laudable cynicism about government and financial markets sometimes edges into conspiracy theory.

Anyway, I wanted to highlight something in a post there today about BLS data.  Various writers at the site have claimed for years that government economic data is being manipulated.  I am not sure I buy it -- I distrust government a lot but am not sure their employees could sustain such a fraud over months and years.  And besides, once you manipulate data one time to juice some metric, you have to keep doing it or the metric just reverses the next month.   Corporations that play special quarter-end inventory games to increase reported sales learn this very quickly.  Where there are apparent errors, I am much more willing to assume incompetence than conspiracy.

The example this week is from the BLS payrolls data, and I will quote from the article and show their chart:

Another way of showing the July to August data:

  • Goods-Producing Weekly Earnings declined -0.8% from $1,118.68 to $1,109.92
  • Private Service-Providing Weekly Earnings declined -0.1% from $868.80 to $868.18
  • And yet, Total Private Hourly Earnings rose 0.2% from $907.82 to %909.19

What the above shows is, in a word, impossible: one can not have the two subcomponents of a sum-total decline, while the total increases. The math does not work.

Certainly this is an interesting catch and if I were producing the data I would take these observations as a reason to check my work.  But the author is wrong to say that this is "impossible".  The reason is that these are not, as he says, two sub-components of a sum. They are two sub-components of a weighted average.  Total private average weekly earnings is going to be the goods producing weekly average times number of goods producing hours plus service producing weekly average times the number of service producing hours all over the total combined hours.

From this I hope you can see that even if the both sub averages go down, the total average can go up if the weights change.  Specifically, the total average can still go up if there is a mix shift from service providing to goods producing hours, since the average weekly wages of the latter are much higher than the former.  I will confess it would have to be a pretty big jump in mix.  The percent goods producing hours would have to rise from 15.6% to almost 17%, which strikes me as a very large jump for one month.  So I am not claiming this is what happened, but people miss the mix changes all the time.  I had to explain it constantly back in my corporate days.   Another example here.

I Think I Am A Macroeconomics Denier

Microeconomics generally provides a powerful set of tools that have proven useful and successful predictors of how things work in the world.  But I am not sure I trust anything at all from macroeconomics.  Sure, I am fine with work about what contributes to or hinders wealth creation over long time periods -- Ricardo and Adam Smith and Julian Simon and Deirdre McCloskey and that sort of work.  But I am not sure macro is capable of any useful predictions on the 5-20 year scale.  Perhaps it is like climate and trying to isolate output effects of changing one input when millions of other variables are changing is simply impossible for us at this time.  Perhaps the stakes of macro, since it drives major public policy and government spending and regulator decisions, are simply too high for objective work.  I don't know, but I don't trust any of it.  Particularly when so many of the current recommendations for increasing near-term prosperity contradict what we know to have driven long-term prosperity.