Archive for Money

Index Funds

It’s a general guideline that people who do not follow the market obsessively should invest in index funds. Compare to mutual funds, they are lower cost, and over time tend to perform about as well, particularly when costs are taken into account. Compared to investing in individual stocks, they are much lower risk, because they are more diversified. Also people who do not follow the market obsessively tend to be extremely bad at timing their moves in and out of the market.

However, investing in index funds only makes sense if you believe that the overall stock market is going to go up over time. The New York Times has a nice graph showing the S&P 500 return on an annual basis since 1920 compared with inflation. There are plenty of time spans where the S&P 500 did not keep up with inflation—the dark red areas. Note that in the light red the index did keep up with inflation, but the average return was less than 3%. The green areas are relatively infrequent.

What this tells us is that the stock market tends to increase slightly faster than inflation on average, and that there are big chunks of time where it does not. But why should the stock market increase faster than inflation at all? While clearly the stock market often has nonsensical prices for individual stocks, these seem unlikely to persist across the whole market for decades at a time. But growing faster than inflation over a long period of time implies that money is coming in from somewhere. We have to assume that it is not the case that people are increasingly pulling out their savings to invest in the stock market, so the money must be being created. Normally creating money tends to lead to inflation over time, but here we see the stock market growing faster than inflation. So it seems to me that the money must be coming from a slow but steady increase in the size of the overall economy, presumably due to increased productivity.

This means that you should invest in index funds if you believe that the economy is going to continue to grow. It also means that, realistically, you can not expect a large return over time. The economy has historically grown, but it has not grown all that much faster than inflation. You should certainly take that into account if you expect to retire on your savings. In particular it’s easy to trick yourself into looking at the absolute values of your projected savings without taking inflation into account.

It’s also interesting to consider that while the growth of the economy does over time mean that there is more money to invest, there is no rule which says that that money must be invested in the stock market. That is historically what has happened. Why should we expect it to always happen in the future? The short-term market has become a mugs game, in which professional traders with high-powered computers are going to outdo any ordinary person. The long-term market is full of established companies with executives who work with directors to siphon off ever-increasing salaries and build short-term stock pops at the expense of the long-term management of the company. I don’t see any signs that these problems are leading most investors to avoid the stock market, but it seems possible that it could happen—at least as possible as having housing prices drop across the entire country for the first time ever.

So what should you do with your money? I think the main thing to do, assuming you don’t care to follow it obsessively, is to not count on it to grow fast. There are a lot of very safe investments you can make, such as Treasury Inflation-Protected Securities (TIPS). It may be a comfort to know that you won’t lose money.

And what if you don’t have any money to invest, as is true for the majority of people in the U.S.? Then you’ll need to plan to live on Social Security; it’s not much money, but it’s much better than nothing. There are few jobs with pensions any more, and existing pensions are under heavy threat. Or, you could just never retire; at least you’ll be helping the economy grow for everybody else.

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Future Payments

One of the ways that pure capitalism fails is an inability to price limited resources. There is a real sense in which oil, a limited resource, is almost certainly worth more today than people are paying for it. It seems likely that people in the future will be aghast at the way we are wasting this precious resource, one that has taken millions of years to create, by simply burning it to drive a few blocks to the grocery store. Those people in the future would gladly pay far more than $100 a barrel, and their bids should drive the price up. Unfortunately, those people do not yet exist, and their bids don’t count.

Companies can take future pricing into account, of course. However, future prices will always be taken at a discount, due to uncertainty and because it’s better to have money in hand. Also, companies are run by people, and few people take a truly long range view: few people care much about what a company will be like in 150 years. Those people who do take a long range view are rarely chosen to be in charge of company decisions.

Of course there are no pure capitalist societies. Real societies address this issue via some sort of regulation, such as taxing the resource to increase its price, or regulation to limit its use, or a cap-and-trade and system which does both. Not that the U.S. is doing any of those things for oil, but at least there is a possible answer to this flaw of capitalism, an answer that relies on some sort of government.

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Healthy Expenses

The long-term budget forecast for the U.S. federal government looks dire. This is almost entirely due to health care costs.

People talk about social security going bankrupt, but that is actually easy to fix with relatively minor tweaks, such as increasing the income limit for which people pay social security taxes, and/or increasing the retirement age. These are compromises which even the deadlocked federal government should be able to make in order to keep old people out of absolute poverty.

Health care is a different kettle of fish entirely. Social security is a fairly straightforward actuarial problem for which we have a lot of good data. Barring some significant change in, well, health care, we can predict fairly well the rate at which people will die. We can also predict fairly well how much people will pay into the social security system. Therefore, while there can be small shifts from year to year, our predictions for social security spending and income are fairly accurate.

The cost of health care in the future, however, may shift radically. An expensive new treatment which has a good effect on a common disease will cause a large increase in health care costs. Conversely, a new cheap replacement for an existing expensive therapy will cause a large decrease. The health care field has changed radically in the last 100 years. It is very likely to continue to change radically in the next 100 years. Any estimate of future costs is an educated guess.

And it’s not just a matter of technology. Some estimates indicate that for most people in the U.S. some 25% of the total health care spending over their entire lives will occur in the last few months of life. Reducing that would clearly have a huge effect on future health care spending. One can imagine a change in society in which people are more willing to end their lives in a relatively inexpensive hospice with relatively inexpensive pain medication, rather than fighting on via increasingly complex interventions. This would require a change in general attitude, and would also require a change in the medical profession, for which both the Hippocratic Oath and the financial incentives encourage heavy intervention. So it’s not a likely change. But it is clearly a possible one.

So, given the uncertainties, why the long-range pessimism? It’s because we, as a society, feel very uncomfortable watching other people die for lack of health care. Thus we pass laws saying that a hospital emergency room can not turn away patients. And we create programs like Medicaid and Medicare which pay people’s health care costs. When the government is spending money on people, there are some natural ways to control the spending. For example, we could set a lifetime limit on spending per person. However, that would in effect kill some chronically ill people, and we aren’t willing to do that. Or, we could let the government negotiate prices with the vendors, and let capitalist incentives encourage people to find cheaper ways to keep people healthy. However, due to what can be described as, at best, regulatory capture by industry, or, at worst, simple bribery of legislators, the government is not permitted to negotiate prices for certain aspects of Medicare coverage. Or, we could simply let the government set up hospitals and clinics as is done in many other countries, while still permitting private alternatives, and thus control pricing directly. However, in the U.S., aside from the fairly effective V.A. system only available to veterans, that is considered to be a disincentive to medical advances, although I don’t personally see why that would be.

Because we are unwilling to adopt relatively straightforward approaches to limiting health care spending, we have set up a perverse market incentive. Rather than letting health care providers compete on quality and price, they compete only on quality. On average, the highest quality vendors will tend to have the highest price. On average, the best known and most desirable vendors will be able to charge the highest price. Since the government has no effective mechanism for controlling price, they will pay that highest price. That holds true even though the U.S. system uses insurance companies as an intermediary for health care costs. Insurance companies extract revenue from the stream of health care spending; they don’t significantly shift its direction.

The basic fallacy of democracy is that people will always be willing to vote themselves benefits for which they do not have to pay. The fallacy generally does not hold because people are not really that irresponsible. However, when it comes to health care, the benefits are beyond price, the costs are paid after you die, and health care vendors have every interest in confusing the issue so that they continue to earn all available money. The long term prognosis is frankly bad.

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In private e-mail I got a pointer to one of the real goals of the Fed’s quantitative easing, one that we’re also seeing in other countries reactions to the Fed’s plans: to weaken the dollar in order to improve the U.S. trade deficit. This is a more plausible goal than the stated ones. By making it cheaper to borrow money in the U.S., the Fed is encouraging investors to borrow in the U.S. and invest the money abroad—the carry trade. This will tend to drive up prices abroad and in particular tend to drive up foreign currency relative to the U.S. That will make U.S. exports cheaper, and thus tend to reduce the U.S. trade deficit. This will tend to make U.S. exporters hire more people, improving the economy in the U.S.

This won’t work with China, of course, because the Chinese government controls their currency levels. But it will work with most of the other countries the U.S. is running a trade deficit with. Unless, of course, they respond in some way. The trick for them will be finding a way to respond which does not involve increasing their own deficit unsustainably and does not run them afoul of WTO rules.

It’s still a gamble by the Fed, but at least it’s one that might work. The biggest risk would seem to be a steady increase in subtle trade barriers, which will tend to hurt the entire world economy. There is a real sense in which China started the game of subtle trade barriers, and this may be the U.S. response.

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Quantitative Easing

The Federal Reserve Bank is about to undertake another round of quantitative easing, by purchasing up to $600 billion worth of U.S. Treasury bonds. The Fed gets to make up their own money—they don’t have to get that $600 billion from anybody else—so this is a way of expanding the overall money supply. The intent is to increase the price of U.S. Treasury bonds, thereby lowering their yield and making it more attractive for people with money to seek other forms of return. Seeking other forms of returns means investing elsewhere, and in particular it means making loans to businesses which use the money to create jobs.

On paper, there is no way that this can work. The problem with the U.S. economy right now is not a shortage of available money. In fact the interest rate on loans is quite low. The interest rate is so low that companies like IBM are selling bonds directly in order to borrow money at a low interest rate. In other words, this move by the Fed isn’t going to encourage IBM to invest any more: IBM can already get all the money it needs.

It’s small businesses which are having a harder time getting loans. They’re not having a hard time because the banks don’t have money to give them. They’re having a harder time because the banks are being more stringent on their loan requirements. The Fed is hoping that by making investing in Treasury bonds even less worthwhile, banks will start making more small business loans in order to increase their profits. This isn’t going to work for the big banks, which are scared because they still don’t know how much they have at risk during the slow moving unwinding of bad mortgages. They’re going to hold onto their cash. It could work for the small banks.

But even the small banks aren’t going to start loaning money to small businesses unless the small businesses start asking for it. And the small businesses aren’t going to start asking for it until people start spending more money. And people aren’t going to start spending more money until they feel that they have enough savings. The savings rate was very low for several years, around 1%, and is now up to a more respectable 6% or so. In the long run, more savings is good for the economy. In the short run, it means that people are not spending money, which means that small businesses are not starting up and hiring people.

What this means is that the Fed is pushing on a string. Increasing the money supply is a very indirect way of creating more jobs. On paper, the newly created money is just going to get saved, mostly by large banks to improve their balance sheets. In the current economy, the way to create jobs is obvious: give people money to spend. You can’t do with income tax cuts, because most relatively poor people—the people who would spend extra money rather than saving it—pay next to no income tax. You could do it with a payroll tax holiday.

Or you could do it with stimulus spending. However, the Fed isn’t doing that, because it can’t. The Fed isn’t allowed to just hand out the money they create. They can only do specific things with it, like buy Treasury bonds. The rest of the government could hand out money, but they are unable to due to political paralysis.

The recent election is not going to help in this regard, as the Republican platform appears to be extending the Bush income tax cuts and refusing to increase spending, neither of which is going to help the current economy at all. (In fact, of course, extending the Bush income taxes is going to increase the overall deficit far more than any plausible spending cuts, so the claims by people like John Boehner to be interested in deficit reduction without clearly describing the compensating spending cuts make no sense.)

So on paper the Fed’s move is going to be useless. It has only one prospect of working: by making it clear to investors that, despite the government paralysis, the Fed is going to keep expanding the money supply until something happens. If people come to believe that, then they will be that much more likely to start spending, companies will be that much more likely to start borrowing, and jobs will start to be created. It’s a very indirect way of working. I don’t personally think it is going to work. But it could happen.

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