Category Archives: business economics

Burt Malkiel vs.John Cochrane on Investment Managers

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In the Journal of Economic Perspectives, Malkiel writes,

The major inefficiency in financial markets today involves the market for investment advice, and poses the question of why investors continue to pay fees for asset management services that are so high. It is hard to think of any other service that is priced at such a high proportion of value.

Cochrane writes,

After all, active management and fees have survived 40 years of efficient-market disdain. Economists who would dismiss “people are stupid” as an “explanation” for a pricing anomaly that lasts 40 years surely cannot use the same “explanation” for the persistence of active management. Economists who think the evidence favors lots of “inefficiencies” in the market are even less well placed to deplore active management. They should conclude that we need more, or at least better, active management to They should conclude that we need more, or at least better, active management to correct the market’s inefficiencies. Their puzzle is the inability of existing managers correct the market’s inefficiencies. Their puzzle is the inability of existing managers to pick low-hanging fruit. to pick low-hanging fruit.

I suppose that one can believe that there are a lot of inefficiencies in the market and also believe that active managers are so bad at finding these inefficiencies that they actually make things worse.

Anyway, read the whole essay.

Connecting Household Balance Sheets to PSST

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Interesting comment found by Glenn Reynolds. From Jeffrey Levin:

If you dig around and research start-ups you will find that the majority of start-ups are funded by second mortgages or HELOC draws. Due to the housing crash, that equity is just not there for the vast majority of people looking to start up a new business. Its one of the large reasons why commercial credit expansion has been so moribund. Without getting off the ground from seconds or HELOC’s all those startups that would have made it past year 1 and then been able to obtain standard commercial business loan never got off the ground and thus never graduated to commercial loan financing. You have to walk first before you can run. Startups don’t start in the commercial loan department (at least most of them don’t).

Recalculation means discovering new patterns of sustainable specialization and trade. Doing so requires entrepreneurial trial and error. As Levin points out, the stereotypical 20-year-old in a garage is actually atypical. Most entrepreneurs are like I was, forty years old and risking accumulated wealth. If my wealth had suddenly been halved in 1993, I doubt that I would have started a business in 1994.

And whose wealth got crushed by the housing crash? According to a paper by Edward Wolff, as cited in the WSJ blog:

The big drop in home prices between 2007 and 2010 meant a 59% loss in home equity for people under 35, compared with just 26% for people generally. That meant a massive loss of wealth, or “net worth” — what people own minus what they owe. People ages 35-44 saw a 49% fall in home equity.

Thanks to Mark Thoma for the pointer.

Wesley Mouch Update

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Veronique de Rugy writes,

In 2009, Fisker received a $529 million federal loan from the Department of Energy’s ATVM program. According to the New York Times, two years after receiving the loans, the company repeatedly missed production targets and other deadlines. They’ve now fired 75 percent of their workforce and hired bankruptcy advisers. It has not built a car since July 2012. That lead the DOE to suspend their support, after having guaranteed $192 million of the $529 million loan. Like Solyndra, taxpayers will foot that bill, minus the $21 million that the government managed to seize from the company’s cash reserves.

At the time that the loan was made, I hailed it.

Forget a carbon tax. Forget cap and trade. Steven Chu is going straight to picking winners and losers.

Two months later, I was still ecstatic.

The American people are being forced to participate in a venture capital fling in which they take most of the down side and none of the up side. And it is not being debated. Nobody has to come before the public and explain themselves. If you call yourself a progressive, are you proud of this?

If there were any justice in the world Steven Chu would be occupying a cell with Bernie Madoff.

The Minerva Project

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David Brooks mentions it. InsideHigherEd describes it.

While MOOCs are basically supersized lectures offered to tens of thousands rather than hundreds of students, Minerva wants to use learning analytics to scale up Oxbridge-style tutorials to seminar-size online classes taught by professors who can work remotely from any location in the world.

…This, Nelson says, will avoid the limitation of the in-person lecture — namely that whatever is said just “vanishes into thin air.”

Thanks to Tyler Cowen for the pointer.

This sounds interesting. I was hoping to create a virtual seminar when Nick Schulz and I used Google+ hangouts. Here is where we discussed Charles Murray’s book Coming Apart.

I liked the seminars when I was at Swarthmore College. Each week the seminar met, one or two students would be assigned to write short papers to be the center of discussion. For example, I once was assigned a paper on the “cobweb model,” in which farmers base next year’s output on this year’s price. After much painful thinking, I denounced this model as irrational. On my own, I located John Muth’s paper, but I could not follow the math. What I came up with on my own instead was essentially the hypothesis of perfect foresight. It turned out, unbeknownst to me, that right at that time the topic of “rational expectations” was about to take the economics profession by storm.

The other characteristic of Swarthmore that I also have championed is the outside examiner. That is, the professor who puts together the syllabus and leads the class is not the same as the professor who puts together the assessment and grades the students.

I hope Minerva is successful with the idea of virtual seminars. I think that the risk is that it is positioned in a sort of no-man’s land, in between the backward model of existing universities and some more radical model of self-directed education that will emerge over the next decade. On the latter, look at these Unschooling Conferences, such as the Trailblazer gathering. Right now, these conferences signal the participant’s weirdness (as Bryan Caplan would predict), but if that should tip….

Chris Peterson is a Minerva skeptic.

If Minerva has higher standards then Harvard, than how is a student who can’t get into Harvard supposed to get into Minerva?

Read the entire rant. I, too, am skeptical. I remember Chris Whittle’s big education venture, called The Edison Project. It was pretty much all hat and no cattle, as they say in Texas. I was wary when he hired Benno Schmidt of Yale for a lot of money. I think if you are going to be an outside force disrupting education, you need to be an outside force. Somebody who has achieved prestige in the existing system is less likely to have the drive and originality to change it.

If I had a lot of VC money to do a project to execute a higher education start-up, I would consult with creative, unhappy professors at low-prestige places to mine their ideas. That said, I would not put them onto the management team. Unhappy people are unhappy people, so I would go with a non-academic management team to keep things sane. You can get inspiration from crazy, unhappy people, but they don’t do well in organizations.

Speaking of organizations, Henry Brighous writes,

While Fisman and Sullivan don’t really comment on this – they simply go on to describe the other kinds of coordination that AA undertakes – it’s hard for me to see how firing an employee simply for explaining how the internal process works to good effect could be efficient. It doesn’t provide any clear, useful incentives to improve overall efficiency. Nor is it conducive to a happy and productive employee culture. The simplest explanation is that Mr. X got fired because his bosses were self-aggrandizing *****s, who saw any public commentary as potential insubordination to be ruthlessly punished, even if this made for a more dysfunctional organization.

To get the context, you have to read the post, and perhaps read the book that he is discussing.

I remember when a project manager at Freddie Mac organized a session where team members could air their gripes. When she had heard all of the complaints about the stupidity and disorganization of the higher-ups, she said told the group that they should be happy that Freddie Mac wasn’t perfect, because if it was already perfect none of them would have jobs.

Indeed, one way to think of an organization is as a mountain of dysfunction. The job of managers at all levels is to try to chip away at that dysfunction. Maybe Henry is correct that Mr. X got fired because his bosses were jerks, but maybe Mr. X got fired because instead of chipping away at the dysfunction, he was contributing to it. I am not saying that I think he should have been fired. I have no idea. Corporate soap opera is complicated.

An Interesting Abstract

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The paper is by Ross Levine and Yana Rubinstein.

We use the classification of the self-employed into incorporated and unincorporated to separate between “entrepreneurs” and other business owners. Using data from the CPS and the NLSY79, we find, in contrast to a large body of research, that entrepreneurs earn much more per hour and work many more hours than their salaried and unincorporated counterparts. Moreover, the incorporated self-employed have distinct cognitive and noncognitive traits: they are more educated, and even as teenagers, they score higher on learning aptitude tests, exhibit greater self-esteem, and engage in more aggressive, illicit, risk-taking activities. And, these traits are much more important for entrepreneurial success than they are for success in other employment activities.

The press has picked up on the part about teenage propensity for illicit, risk-taking activities. Doesn’t describe me as a teenager.

Hospital Charges

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Steven Brill has gotten the health-technocrats very excited. For example, Uwe Reinhardt writes,

hospitals are free to squeeze uninsured middle- and upper-middle-class patients for every penny of savings or assets they and their families may have. That’s despite the fact that the economic turf of these hospitals – for the most part so-called nonprofit hospitals

Pointer from Mark Thoma.

Solve the puzzle:

1. Itemized charges on hospital bills are very high. This is most obvious for items that you can buy yourself in a drugstore or supermarket.

2. Relative to these outrageous markups, profits at for-profit hospitals (and at “so-called nonprofit hospitals”) are not very high.

The explanation is that hospital costs are mostly overhead, meaning that they are not tied to billable services or events. The janitors who clean the halls and rooms once a day (or more)? Overhead. Record-keeping, billing, computer systems, communications? Overhead. Fancy medical equipment? Overhead. Nurses and other staff? For the most part, overhead.

Because most of the cost in hospitals is overhead (or fixed cost, in economic parlance), its allocation across billable items is arbitrary. That is why “tough negotiation” by Medicare does not really reduce overall health spending. Instead, it means that overhead costs have to be shifted somewhere else, including onto those who happen to be affluent but uninsured.

What would happen if we followed the prescription of Reinhardt and others, to force hospitals to bill everyone else at Medicare rates? Hospitals would either stop taking Medicare, drastically cut back on services (reduce janitorial service to once a week), or close altogether.

I am not saying that the business practices of doctors and hospitals are beyond reproach. But claiming that there is a free lunch in medical care from just paying providers a lot less money is unhealthy demagoguery.

The Role of Banks

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1. I write,

Franco Modigliani and Merton Miller point out that the real assets in the economy (fruit trees, oil wells, office buildings, and so on) are all owned ultimately by households. That fact is not changed by the way that financial claims are rearranged into debt and equity. As Miller was fond of putting it, “No matter how many slices you cut, it’s still the same pizza.”

Read the whole thing. It seems as though I constantly come across folks making broad generalizations about what to do about banks that are not grounded in an understanding of what banks do. My essay is an attempt to address that problem. It was provoked by receiving a new book by Anat Admati and Martin Hellwig.

2. Evan Soltas writes,

I can estimate that the average hour worked in the financial industry generates nearly 30 times the average per-man-hour profit in the rest of the economy. That’s up from six times the average in 1964.

This could very well be a question of global comparative advantage, but I find that hard to believe on the basis of the employment figures. It seems substantially more likely, rather, that the financial sector’s profitability comes from the implicit and explicit subsidies of a market with high barriers to entry.

Pointer from Phil Izzo.

Keep in mind that the interesting fact is the increase in the relatively profitability of the financial sector. I think this creates quite a puzzle.

Have barriers to entry increased? Not in any obvious way. Much of the infamous deregulation that took place since the 1960s was designed to increase competition, which should have reduced profitability (Gary Gorton even argues that we need to reverse that, to increase profitability in finance in order to give banks an incentive to hang on to their franchises). We got rid of restrictions on interstate banking. The erosion and repeal of Glass-Steagall were hailed at the time as allowing commercial banks and investment banks to compete on one another’s turf.

Has the subsidy increased? That is a more difficult question. But I do not immediately see how it has.

If one thinks in terms of natural forces, for an industry’s profits to increase, one needs some of the following:

1. An increase in demand.

2. An increase in efficiency.

3. Enough barriers to entry to maintain profit margins.

I suspect that (2) is very important. Off hand, would not finance benefit more than other industries from information technology?

I would tell a story in which the main barrier to entry in finance is the value of reputation. In other industries, innovation creates opportunities for upstarts. In finance, it is more likely to create opportunities for those few incumbent firms that adopt technology quickly and intelligently, because upstarts cannot establish reputations rapidly enough. Thus, one might expect to see a big expansion of profits in the industry as a whole, concentrated in a relatively few firms.

Incidentally, this model may fit higher education going forward. If the Internet creates opportunities for tremendous increases in efficiency, then the “profits” may accrue to universities with strong reputations who adopt technology quickly and intelligently. I would prefer to see competition from upstarts, but first someone must find a way to overcome the reputation advantage of the incumbents.

Two Essays on the Modern Political Elite

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1. Megan McArdle on Mandarinization. Read the whole thing. Trying to excerpt is frustrating, but I’ll use this:

And like all elites, they believe that they not only rule because they can, but because they should. Even many quite left-wing folks do not fundamentally question the idea that the world should be run by highly verbal people who test well and turn their work in on time. They may think that machine operators should have more power and money in the workplace, and salesmen and accountants should have less. But if they think there’s anything wrong with the balance of power in the system we all live under, it is that clever mandarins do not have enough power to bend that system to their will. For the good of everyone else, of course. Not that they spend much time with everyone else, but they have excellent imaginations.

This is an issue that I have been mulling for quite some time, and my thinking is very similar to hers. I believe that our modern elite is more insulated than American elites from the past. The movie Lincoln portrays a President much more exposed to contact with ordinary people than a modern President. And I believe that Franklin Roosevelt really understood how he differed from the typical citizen, so that he could talk with people rather than talking down to them. In contrast, Barack Obama strikes me as an elite liberal bubble-person.

Like Megan, I believe that I am more familiar with the Mandarin class than I am with the rest of America. But I still think that somehow I am less insulated than the elite pundits and policy makers.

But perhaps the biggest difference that Megan and I have with the Mandarins is that we are skeptical of the wisdom of the Mandarins. I am no populist. But looking at the elites close up, I see a lot of blemishes.

Another issue is the desire to affiliate with power. If a Mandarin encounters a powerful person, the Mandarin’s instinct it to ingratiate himself or herself. My instinct is to try to knock the person down a notch. That is in fact one of my most deeply-ingrained personality characteristics, one which I had to consciously stifle when I worked in organizational settings.

2. Angelo Codevilla on the court party vs. the country party.

Thus by the turn of the twenty first century America had a bona fide ruling class that transcends government and sees itself at once as distinct from the rest of society – and as the only element thereof that may act on its behalf. It rules – to use New York Times columnist David Brooks’ characterization of Barack Obama – “as a visitor from a morally superior civilization.” The civilization of the ruling class does not concede that those who resist it have any moral or intellectual right, and only reluctantly any civil right, to do so. Resistance is illegitimate because it can come only from low motives.

Codevilla’s essay is mostly about the inability of Republican leaders to forsake the court party. Actually, I think that one should be skeptical of Codevilla’s framing. It is empty to complain that “the people” are not represented by party leaders. That is true of all parties, at all times. I do not think that those of us with strong libertarian or conservative leanings are going to be saved by a populist uprising. Instead, we fact the daunting prospect of attempting to change the dominant views among the elite.

Ezra Klein Stumbles Over the Truth

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He writes,

In general, politicians are overworked and understaffed. They’re traveling constantly, buried under too many meetings and constituent requests, and working desperately to stay one step ahead of whatever they’re getting yelled at about that week. …however well or poorly the health-care reform effort turned out, the one thing that people on both sides agree about is that it didn’t go according to anyone’s plan. Almost nothing does, and that’s because there usually isn’t much of a plan, or because the plan that did exist was quickly overtaken by events and no one had the time to really update it.

Pointer from Tyler Cowen.

Mr. Klein, if you were to take a job in business, you would discover the same thing. Executives are overworked and understaffed, buried under too many meetings, etc. Plans are quickly overtaken by events, etc. In fact, Mr. Klein, even technocrats and regulators are subject to human frailty and organizational dysfunction.

However, I have confidence that Mr. Klein will pick himself up and go on advocating Washington wonkery as if nothing had ever happened.* Continue reading →

Some Institutional Knowledge

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Tomasz Piskorski and Amit Seru write,

the organizational capability of servicers could have played a very important role in determining the rate of modifications and foreclosures during a financial crisis — and such capability takes a long time to build.

The policy wonks thought that they could implement a mortgage refinance program just by snapping their fingers. In real organizations, planning, testing, and training are necessary.

I could have warned policy makers about this (indeed, I did, at a Congressional hearing). In my forthcoming online housing course, I plan to discuss the business processes involved in mortgage lending. I think that this is important information for policy makers to have. However, you will not see academic economists interested in these sorts of details. Piskorski and Seru seem to have stumbled onto reality by way of the data ex post, rather than through industry experience. This puts them way ahead of folks like Joe Stiglitz and Martin Feldstein, who style themselves as experts on housing finance but who I regard as ignoramuses on the topic.

At best, I hope to interest some mid-level government staffers and research assistants in my course. If they can communicate up to the policy makers, maybe the ignoramuses will do less damage.