Brooks on US Class Struggles

Thanks Barry! Highly recommended:


Today we find out what the Fed is planning to do about this:

How the mortgage market will react when the Fed halts its MBS purchase program remains a significant question.  I have a hard time believing private sector demand will suddenly rise to offset the Fed’s departure and prevent a noticeable price decline.

‘At the end of March, the Fed is also expected to end its purchases of mortgage-backed securities. At some point later, it will start selling those securities. Earlier this week, aides on Capitol Hill said that in questioning Mr Bernanke lawmakers would probably focus on the end of the support for the housing market, which has shown some signs of stabilisation but continues to struggle because of high foreclosure rates, prices that are still falling, and a glut of unsold homes.

Some economists have warned that the end of the Fed’s mortgage purchase programme could raise mortgage rates and stifle any nascent rebound in the housing market. Supporters of the plan believe that it will only marginally lead to an increase in rates, and is a necessary step towards normalisation of US mortgage markets.

“The question is whether the private markets will be able to pick up the slack,” said one aide, who said that lawmakers would focus on the issue because it is what matters most to voters.’


Here is an interesting argument from Jeremy Grantham (and my response):

“Let’s start with the Investment Industry component. It is so obvious in this business that it’s a zero sum game. We collectively add nothing but costs. We produce no widgets; we merely shuffle the existing value of all stocks and all bonds in a cosmic poker game. At the end of each year, the investment community is behind the markets in total by about 1% costs and individuals by 2%.

And the costs have steadily grown. As our industry’s assets grew tenfold from 1989 to 2007, despite huge economics of scale, the fees per dollar also grew. There was no fee competition, contrary to theory. Why?

a. Agency problems – we manage the other guy’s money,


b. Asymmetric information – the agent has much more

information than the client.

Clients can’t easily distinguish talent from luck or risk taking. It’s an unfair contest, nothing like the fair fight assumed by standard Economics. As we add new products, options, futures, CDOs, hedge funds, and private equity, aggregate fees per dollar rise. As the layers of fees and layers of agents increase, so too products become more complicated and opaque, causing clients to need us more.

As total fees in the past grew by 0.5%, we agents basically reached into the clients’ balance sheets, snatched the 0.5%, and turned it into income and GDP. Magic! But in doing so, we lowered the savings and investment rate by 0.5%.  So, we got a short-term GDP kick at the expense of lower long-term growth. This is true with the whole financial system. Let us say that by 1965 – the middle of one of the best decades in U.S. history – we had perfectly adequate financial services. Of course, adequate tools are vital. That is not the issue here. We’re debating the razzmatazz of the last 10 to 15 years. Finance was 3% of GDP in 1965; now it is 7.5%. This is an extra 4.5% load that the real economy carries. The financial system is overfeeding on and slowing down the real economy. It is like running with a large, heavy, and growing bloodsucker on your back. It slows you down…”


Although, in principle, I accept that the financial sector creates nothing (tangible) but carries a significant cost to the “real” economy, I think this investment manager might be selling the industry short in several ways.  Here’s a slightly different telling of a similar tale:

It is widely accepted that governments do not allocate resources as efficiently as private actors.  The failure of the Soviet Union clearly demonstrated that the allocation of capital, in other words the quality of investment decisions, has an immense impact on the growth and health of the “real” economy.  Now consider how to best allocate resources within a capitalist economy: how should a private financial system connect savers with borrowers?  Simple commercial banks were an early step, offering low rates of return on deposits by extending credit to businesses and financing mortgages.  These banks were better positioned to vet their borrowers and allowed the pooling of risks, making the investments palatable for America’s everyman.

Now fast-forward quite a few decades.  Are these local banking outfits well equipped to choose between investing in a biotech startup or an infant electric car company?  Doubtful.  In contrast, venture capital companies, private equity firms and investment banks are better suited to making these complex choices.  These organizations cost more to sustain as their employees are, necessarily, highly intelligent, motivated and well-educated individuals.  Opportunity cost mandates a very high wage but it seems intuitive that these well compensated organizations add a great deal to our real economy by allocating resources more efficiently than would otherwise be the case.  Similarly, it could be argued, that hedge funds create value by helping to properly price assets and, thus, more efficiently allocate resources (ever heard the phrase “the smart money”?).  To me, this logic can most easily be understood by likening the financial system to the brain of the real economy.

Now here’s where I start to agree with Grantham:  As I describe above, it’s the job of these organizations to know more than we do.   Considering they are bright, well educated people who spend their lives thinking about these questions, I’m sure they’ve got an edge.  This immediately creates a gaping information asymmetry.  How do I compare 2 mutual funds?  Not like I compare 2 bags of frozen peas, that’s for sure.  A tech mutual fund looked great alongside a contrarian competitor from 1994-1999.  How should I have known the doom-sayer was the superior product all along?  And further, how should I know how much to pay either of these clowns??  This is just the beginning of the information problems that distort the markets for financial services and may, ultimately, lead to the leaching effect Grantham describes.

This diagnosis means that, in my mind, the solution is not to hold these new financial organizations in contempt but instead to implement strong and well thought out policies to increase transparency.

“Deep in the president’s budget released Monday—in Table S-8 on page 161—appear a set of proposals headed “Reform U.S. International Tax System.” If these proposals are enacted, U.S.-based multinational firms will face $122.2 billion in tax increases over the next decade. This is a natural follow-up to President Obama’s sweeping plan announced last May entitled “Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas.”

The fundamental assumption behind these proposals is that U.S. multinationals expand abroad only to “export” jobs out of the country. Thus, taxing their foreign operations more would boost tax revenues here and create desperately needed U.S. jobs.

This is simply wrong. These tax increases would not create American jobs, they would destroy them.

Academic research, including most recently by Harvard’s Mihir Desai and Fritz Foley and University of Michigan’s James Hines, has consistently found that expansion abroad by U.S. multinationals tends to support jobs based in the U.S. More investment and employment abroad is strongly associated with more investment and employment in American parent companies.

When parent firms based in the U.S. hire workers in their foreign affiliates, the skills and occupations of these workers are often complementary; they aren’t substitutes. More hiring abroad stimulates more U.S. hiring. For example, as Wal-Mart has opened stores abroad, it has created hundreds of U.S. jobs for workers to coordinate the distribution of goods world-wide. The expansion of these foreign affiliates—whether to serve foreign customers, or to save costs—also expands the overall scale of multinationals.

Expanding abroad also allows firms to refine their scope of activities. For example, exporting routine production means that employees in the U.S. can focus on higher value-added tasks such as R&D, marketing and general management.

The total impact of this process is much richer than an overly simplistic story of exporting jobs. But the ultimate proof lies in the empirical evidence.

Consider total employment spanning 1988 through 2007 (the most recent year of data available from the U.S. Bureau of Economic Analysis). Over that time, employment in affiliates rose by 5.3 million—to 11.7 million from 6.4 million. Over that same period, employment in U.S. parent companies increased by nearly as much—4.3 million—to 22 million from 17.7 million. Indeed, research repeatedly shows that foreign-affiliate expansion tends to expand U.S. parent activity.

For many global firms there is no inherent substitutability between foreign and U.S. operations. Rather, there is an inherent complementarity. For example, even as IBM has been expanding abroad, last year it announced the location of a new service-delivery center in Dubuque, Iowa, where the company expects to create 1,300 new jobs and invest more than $800 million over the next 10 years.

This is true in manufacturing, too. Procter & Gamble calculates that one in five of its U.S. jobs—and two in five in Ohio—depend directly on its global business.

Compared to the rest of the world, U.S. corporate tax rates are sky-high and our system of corporate taxation is highly complex. The current U.S. federal statutory corporate tax rate of 35% is the highest among all 30 Organization for Economic Cooperation and Development countries, far above the OECD average of about 23%. Raise the international tax burden on U.S. multinationals by limiting foreign-tax credits, for example, and you will further reduce their ability to compete abroad. This, in turn, will reduce employment and investment in U.S parent companies.

Making it harder for U.S. multinationals to create U.S. jobs would be bad policy at any time. But it would be especially detrimental now because of how dramatically the private sector of the U.S. economy has contracted in the face of this recession.

Since the slowdown began in December 2007, private-sector payrolls have fallen precipitously. Today there are 2.4 million fewer private-sector jobs than 10 years ago. Moreover, in all four quarters of 2009, gross private-sector investment fell so low that it did not even cover depreciation. For the first time since at least 1947, the U.S. private capital stock shrank throughout an entire year.

The major policy challenge facing the U.S. today is not just to create jobs, but to create high-paying private-sector jobs linked to investment and trade.

Which firms can create these jobs? U.S.-based multinationals. They—along with similarly performing U.S. affiliates of foreign-based multinationals—have long been among the strongest companies in the U.S. economy.

These two groups of firms accounted for the majority of the post-1995 acceleration in U.S. productivity growth, the foundation of rising standards of living for everyone. They tend to create high-paying jobs—27.5 million in 2007.

Consider that in 2007, the average compensation per worker in these multinational firms was $65,248—about 20% above the average for all other jobs in the U.S. economy. These firms undertook $665.5 billion in capital investment, which constituted 40.6% of all private-sector nonresidential investment. They exported $731 billion in goods, 62.7% of all U.S. goods exports. And these firms also conducted $240.2 billion in research and development, a remarkable 89.2% of all U.S. private-sector R&D.

To climb out of the recession, we need to create millions of the kinds of jobs that U.S. multinationals tend to create. Economic policy on all fronts should be encouraging job growth by these firms. The proposed international-tax reforms do precisely the opposite.

International trade and investment policies are especially important to these firms. Passing the already negotiated trade agreements with Colombia, Panama and South Korea—and stopping trade barriers against key partners like China—are critical to increasing U.S. exports and related investment and jobs. If we are going to achieve the president’s State of the Union aspiration to “double our exports over the next five years,” we need to start now.

To help close looming fiscal deficits, the nation needs spending restraint and pro-growth sources of tax revenue. But Monday’s proposals are far from that. These tax increases would destroy jobs in some of America’s most dynamic companies.

Mr. Slaughter is associate dean and professor at the Tuck School of Business at Dartmouth, research associate at the National Bureau of Economic Research, and senior fellow at the Council on Foreign Relations. From 2005 to 2007 he served as a member of the White House Council of Economic Advisers.”


Hayek on Economics

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.’’ -F.A. Hayek