A Monetary Policy Critique
Jeffrey Hummel has produced a critique of the Bernanke management of the Fed in the form of a book review. Please read “The New Central Planning” a review of Ben Bernanke’s book, The Federal Reserve and the Financial Crisis. The review appears on page A13 of The Wall Street Journal, Friday, March 29, 2013. This review is a MUST READ.
Intersection of Wall Street and Main Street
The Third Way has produced a document that purports to explain the importance of capital markets. The importance of these markets lies in the link between the Streets: Wall and Main. The purpose of this post is to provide a competitive but much shorter essay on this important topic. In a nutshell, firms need injections of funds for various purposes: to build plant and buy equipment, to undertake research and development (R&D) as well as marketing campaigns, and so on. At the same time, individuals with funds need a way to place those funds . . . to put those funds to work.
Investors
The individuals who are called investors hope to make a return from placing their funds with firms. They place their funds through intermediaries such as a retirement fund or a mutual fund and of course brokers who all inhabit Wall Street. The individuals either buy equities or bonds (or derivative securities which we will explore later). An equity position represents ownership in the firm. A bond is a debt that the firm has. Equities and bonds have different rights to or claims on the income and the assets of the firm. In the first place, a bond has a claim on a stream of interest payments that are usually well-defined as well as a principal payment or payments. If the firm fails, the bond represents a claim on whatever remains of the firm’s assets that is of higher priority than the claims of the owners. In contrast, the owners have a claim on the residual income or what is left over after paying the bond holders and the other creditors. As a result, it is often thought that the equity holders hold riskier positions than bondholders and therefore receive a greater expected return called the equity premium. One contrary thought is that the bond holders often face greater inflation risk or interest rate risk. That is, when inflation increases and interest rates rise, the value of most bonds decline. This kind of risk requires compensation too.
Firms
The firms called corporations sell equities, called stock or shares, through IPOs (Initial Public Offerings) or Seasoned Offerings. Firms buy equities by entering the market and simply buying their own equities back. Similarly, firms may sell bonds or float a bond issue and they may enter the bond market to buy their own bonds back. Just as individuals employ specialist intermediaries to operate in the market for firm ownership and debt, firms also use intermediaries such as investment bankers who also inhabit Wall Street.
Wall Street
Wall Street is the place where the people who live on Main Street and the firms that produce on Main Street meet, through their intermediaries, to do some very important things. They decide together in markets just how much of a firm will be represented by equity and how much will be debt. They also decide together what the prices are. That is, interest rates for bonds are determined in this marketplace. Dividend policies are set in this environment too, where dividends are the periodic payments to the owners of the firm.
Markets for Existing Bonds and Stocks
One might ask, “Why do we need a market for stocks or bonds that are already created?” Well, you can’t just leave the investors high and dry, can you? As time passes, investors will want to change their portfolios because of changes in their lives and because of expectations about changes in the lives of the firms in which they invest. This need gives rise to markets in which existing stocks and bonds are bought and sold, or “traded.”
The Meaning of Prices
The prices of stocks and bonds that emerge in these markets reflect the investors expectations for these firms as well as their expectations for the general economic environment. More specifically, the market for existing stocks produces prices based on their dividends now and their growth or prospects for dividends in the future. Stock prices are enhanced by good news regarding the prospects for a firm such as a new market opening up for their products. Stock prices are suppressed by bad news such as an increase in corporate income taxes, with the US having the highest corporate tax rates in the developed world. Investors are continually looking out for stocks whose prices do not embody all the relevant information. Of course, if they find such a stock, their buying and selling efforts should eliminate the problem of under or over pricing.
Stock prices, in turn, become signals for firms. For example, if the price of a firm’s stock is rising, the managers are likely to conclude that they might well expand, because they can easily finance the expansion through the sale of more stock. The causation could well go the other way, however. That is, the price of the stock may be rising because of coherent expansion plans that the management has projected. Similarly, a reduction in interest rates might suggest to management that they may want to emphasize debt financing over stock offerings. The bottom line is that the prices that one observes on Wall Street have consequences for the people and firms on Main Street.
There are a number of financial instruments that are based on debt and equity instruments. Futures markets allow people to take positions that can potentially protect their portfolios from losses. Alternatively, futures provide a way to speculate about price movements up or down. Derivative securities allow financial engineers to deconstruct rather mundane collections of securities, like mortgages, into parts that behave rather differently than the original securities, like different risk groupings or tranches. These new derivative securities are extremely useful. For example, they provided a mechanism for the country to work out from under the effects of the S&L crisis. Those same derivatives have been incorrectly blamed for the implosion of real estate finance in 2008. Instead, the problem lay with the incredibly poor quality of the underlying mortgages, especially the high loan to value ratios.
Wall Street and Main Street Divergence
So far, it sounds like Wall Street and Main Street are joined at the hip: if firms’ profits increase on Main Street, their stock prices increase proportionately on Wall Street and vice versa. But is this true? In fact, it is not necessarily true. For example, if something in the economic environment changes to lower the rate of return, then people will have to pay more for stocks to get a given income from stocks. So what could lower the rate of return in the economy? Well, an increase in corporate taxes could do this. What happens then? Holding corporate income constant, stock price . . . curiously . . . might rise. This point may very well address current market activities. That is, the current stock market highs could be a symptom of bad news on Main Street. People in this country, and in other countries, are casting about trying to find reasonable investments. In doing so, they are bidding up the prices on Wall Street without affecting the incomes of corporate entities. They are lowering the rate of return.
Software Patents, A Proposal
A court of appeals is contemplating reform of software patents right now. The worst case scenario would be that good ideas would be driven out of the patent system and into trade secrets. Trade secrets are extremely inefficient in comparison to patents. They promote industrial espionage and reverse engineering. They delay the exploration of new ideas by those who would push the innovation envelope further. In contrast, patents spur innovation by revealing all regarding past, patented innovations.
My proposal is that reform can come by way of more precision in defining terms that are commonly used in deciding whether something is patentable. The terms are novel, non-obvious, non-abstract, and non-mathematical.
Novel
A patent should be considered novel if whatever is claimed in the patent has never been done before . . . regardless of whether the thing has been done with or without computers. That is, something that is done without computers should not be patentable with computers. On the other hand there are things that are simply impossible to do without computers, although one might be able to do some part of them with pencil and paper. That is, the time that would be required to do some computations by hand would be hundreds or even thousands of person years. In contrast, computers might be able to do the calculations in seconds. Thus, it is novel to be able to acquire results in a timely manner because of the use of a computing machine programmed for the purpose. Such things should be patentable.
Non-trivial, non-obvious
A patent is not obvious if an expert in the field would have to read, or at least glance at, the patent in order to figure out how the thing is accomplished. One of the problems that has put the patent office in a bad light over the last decade and a half is the granting of patents for trivial innovations.
Non-abstract
For the purpose of patents, the term abstract should refer to an idea without a practical application. So a thing is non-abstract if it has a practical application. The term abstract has other meanings in other contexts. However, one should not muddy the patent waters by using these other meanings in the context of patents. For example, the essence of something may be abstract in another context, but it surely should not be considered unpatentable as a result.
Non-mathematical
Evidently, you cannot patent a mathematical function. Fine, but you should be able to patent a practical application that relies on a mathematical function. While all practical applications are not business applications, it should be that business applications are considered to be practical applications. New algorithms and the use of mathematical functions should be patentable.
Criticism of the patent office
It is easy to criticize the patent office. In fact, it is hard to find a more officious organization and one that is less service oriented. However, this office has a tough job. It should serve the people with regard to approving new patents while, at the same time, protecting the intellectual property of existing patent holders. So there is an inherent conflict here.
What Entitlement to Address First
Let’s start with the easiest entitlement to deal with. This is social security. Instead of increasing the retirement age, let’s go back to the beginnings of social security. I do not believe that it was initially intended to be a welfare program. Furthermore, many social security recipients do not believe that it has become a welfare program. They think they have earned the right to receive the payments they receive. However, this is not the case on average. So what I propose is to turn the social security program into a financially sound annuity program. In order to pull this off, I suggest a new and a specialized type of government bond. Of course, such a program could be phased in or introduced only for people of a certain age or less, say 55. I like annuities and hope that social security can be made coherent.
Guns and Hammers
Gun issues are front and center in the news. The social engineers who seek to address gun issues are like the proverbial man with a hammer to whom everything seems like a nail. Of course the statists believe that it is more regulation that will reduce gun violence. The gun lobby believes that armed officers in schools would solve the problem. The psychiatrists think that we need to be more attentive to mentally ill people. I hope that the economists would think about what the costs and benefits might be for any proposed solutions. I’m not sure that we have heard from the architects yet, but surely it is obvious that we don’t want schools to have entrances that encourage shooters to shoot their way in. Perhaps steel doors at entrances and atriums for recess are good ideas. Those who decry the immoral behavior exhibited in computer games are quick to point out that the mass murderers might be emulating the violent aspects of these games. Similarly, those who do not like the tone of movies from Hollywood gloat over the inconsistency of the denizens of Hollywood being horrified by the mass murders while blithely producing films that glorify similar violence.
So what kind of ideas are emerging from this babble? Well, the statists are pushing such things as limiting the size of magazines and eliminating rifles that look like assault weapons. This has been tried before and no data has emerged that suggests that gun violence decreased with the regulation or increased with the ending of the regulation. So it appears that the purpose of this regulation would just be a sharp stick in the eye of gun enthusiasts who enjoy going to the range and shooting a target rapidly and repeatedly.
One of the big ideas is that individual to individual sales, whether at gun shows or through newspaper advertisements, should involve checks of the buyers’ worthiness. This would be relatively easy to achieve for long guns at gun shows, but more difficult elsewhere. However, this would essentially close down sales of pistols where there are waiting periods except sales to dealers. What would be the problem if the government would require that all auto sales had to be to dealers? Of course, the seller’s price would suffer. The same is true for guns.
There has been quite a bit written lately about gun free zones. These zones would include theaters that do not permit concealed-carry and cities like Chicago where regulations are already very extensive. Some observers have noted that gun violence is actually higher in gun free zones. Statists will argue that the higher violence is simply the result of not having sufficiently extreme restrictions. Critics will point out that it appears that those who carry out gun violence appear to be purposefully selecting gun free zones.
Some in the prosecutorial community have begun to talk about the vigor, or lack of it, in prosecuting gun crimes. But of course, this will not deter the insane individual who will commit only one gun crime . . . but a big one. On the other hand, this might partly address the larger problem of drug related shootings.
One of the recent mass shootings was apparently stopped because the gun jammed. Perhaps this suggests that only poor quality guns, prone to jamming, should be allowed.
Let’s keep in mind that the largest category of the 30,000 shooting deaths per year is suicides. What would you like to do about that? Do you prefer suicide by prescription drugs? Refusing hydration?
Is the Unemployment Rate Fraudulent?
There have been claims by Jack Welch of GE and others that the drop in the unemployment rate to below 8% is election fraud, so let’s take a look at the BLS data. First we will look at the unemployment rate through time. Next, we will look at employment through time. A more detailed look is available by considering the month to month change in employment next. Finally, we will look at the labor force participation rate.
As we can see in the graph directly below, the recent decrease in the unemployment rate to below 8% seems to fit the pattern of the last 3 years or so. That is, there has been a slow decline in unemployment. So the unemployment rate itself is not terribly surprising, although many analysts had thought that the unemployment rate had bottomed out. Apparently not so.
Unemployment Rate
Employment has been rising as can be seen in the graph directly below. But even though employment has been rising, it has not reached levels achieved in 2008.
Total (nonfarm) Employment
The change in employment this month is a bit of a surprise, however. Note in the graph below that there are precedents for the huge increase, but the precedents are few and far between. That is, January of 2012 almost comes up to the level this last month. Otherwise, you would have to go back to January of 2003 to find an increase of the same magnitude. This is the source of the doubts that have arisen regarding the unemployment data. In other words, this data point is highly unusual and was not expected. We cannot check this data point, but we will be watching for this next month. What would we expect to see? A much lower number.
Month to Month Change in Employment
Going back to the first graph, a person might ask what makes it possible for the unemployment rate to be declining in such a lackluster economy. The answer is that labor force participation is declining: people are leaving the work force as seen in the graph directly below. This rate had been stabilized at approximately 66% for the several years prior to the Obama administration. But now it is between 63% and 64%. Furthermore, it appears to be on a path to decline further. This is not a good thing.
Labor force participation
End Medicare?
The Democratic Party election machinery, especially SEIU, is asserting that various Republican congressmen and women have voted to end Medicare as we know it. While this is substantially untrue, we could ask whether this a bad thing? The elderly needed health care insurance because health care insurance is generally tied to employment. Retirement often cuts that link, so along came Medicare to fill the void. But can we conceive of an alternative?
What we really need, in an age in which people both switch jobs more frequently and grow old is private insurance that is for a lifetime: insurance that gets started before most pre-existing conditions get started and lasts until the end, insurance that cannot be cancelled. Of course, we need the features of this insurance to meet other specifications as well. But we do not need Medicare at all.
What are the specifications needed for lifetime private insurance.
1. Very large natural groups. A natural group is one to which people belong naturally and cannot join or leave by choice. For example, all people born in Indiana would be a natural group.
2. Choice in terms of the nature of insurance policies. People in a group should be able to choose whether they want high deductibles or low, health care savings accounts or not, and so on.
3. Prices of health care insurance held down by competition for business in these large natural groups.
Focusing on health care insurance alone does not directly address the cost of medical care. That is a story for another time.
For an outline of insurance and cost reform issues, see my post on the subject.
Fed to buy Chevy Volts?
It has been revealed that the Fed is going to be buying mortgage backed securities in the latest version of QE, I guess this makes QE III. The point is that the Fed imagines that there is still trouble in the mortgage backed security industry. Well, there is trouble on other fronts as well. For example, GM is having trouble selling Chevy Volts, their electric car. So why in the heck doesn’t the Fed buy and park Chevy Volts?
The point is that there is a beauty to limiting the Fed open market operations to government bonds. This limits the mischief that the Fed can get into. That is, they can ratify terrible fiscal policy, but that is the extent to which they can screw up the economy. Now the Fed seems to have opened a new front. It appears that they feel free to meddle in any industry that, in their view, deserves their help.
Bernanke is presiding over the end of Fed independence, because the flood gates have been opened. Other industries will now look to the Fed to fix their problems.
If we ever get back to the days when the money multiplier meant something, I suggest that the Fed should stick to trying to achieve a single goal, price level stability. Furthermore, I suggest that the Fed should stick to a single asset class: government bonds.
To whom do we owe that?
Decades ago we were told that government debt was not a problem, because we owed it to ourselves. This point cannot be made today. We owe about 50% of the debt held by the public (that is, people) to foreigners. We owe over 30% of the total debt to foreigners. Owing it to others may constrain future decisions on what to do with the debt. For example, some may argue that we should inflate in order to reduce the impact of the debt. Can you imagine the impact on the foreign central banks that hold much of this debt? Can you imagine how they will squeal? Of course, I would squeal too. Would you?