End of Year Reading

• Zerohedge summarizes a Bank of America study on the past and upcoming decades of Asian economics and how they impact the US.

  The financial crisis delivered a clear verdict, in our view, on the limits to the Asian growth model. It no longer makes sense to pursue double-digit growth by lending cheaply to the US consumer.
  Yet change would require less reserve accumulation or – put another way – allowing the currency to appreciate against the US dollar, to which it is now effectively pegged. China needs to manage this “exit” carefully. Moving too fast risks a dollar crisis, with a disorderly drop in the US dollar and a spike in US bond yields. Moving too slow risks a boom-bust cycle in China, with capital inflows and strong monetary growth rates putting upward pressure on asset prices and inflation.

• This is an amazing read on China, written by Christopher Hayes at The Nation. One of the summary paragraphs is particularly interesting, and I quote it below, but I strongly recommend you read the entire article.
  

  We tend to view China as posing an alternative and threatening model for the future, one that's by turns seductive and repulsive, the source of envy and contempt. But after a while I wondered if we aren't in some way converging with our supposed rival. China has managed the transition from a repressive, authoritarian, impoverished country to an industrial, corporatist oligarchy by allowing a loud and raucous debate while also holding tightly onto power. Perhaps we are moving toward the same end from a democratic direction, the roiling public debate and political polarization obscuring the fact that power and money continue to collect and pool among an elite that increasingly views itself as besieged on all sides by a restive and ungrateful populace.

• The title says it all: Why market sentiment has no credibility. Good read at FT.
  
• I don't know who John Kozy is, but I like this paragraph he wrote in his article titled, "The Long Decline of the American Economy":
  

  Ideally, companies exist to provide products and services to people. If the products and services are good, the companies prosper; if they aren't, the companies fail. That's risky, so American companies inverted this model. They fed the public the notion, which has rarely been questioned, that a company's responsibility is solely the financial welfare of its stockholders. Products and services are no longer the goal of business; they are merely means to profit. That reducing quality leads to greater profits quickly became evident. One fewer olive in each jar, one flimsy part in a complex device, one inefficient procedure in a manufacturing process, built-in obsolescence, built-in short product life-cycles, engineered high failure rates. The American quality standard became, "Junk"!

• An excellent argument for a surtax on millionaires, which does a good job of countering an argument I myself believe: that unlimited income potential (where a surtax limits said income potential) is a great motivator for innovation, entrepreneurship, and general hard work. Also, I really like the reasons behind the title of the blog.
  

  The third thing it also might change is the pay that CEOs get. For example, if the top tax bracket were 99%, for all income over $5 million, tax opponents always describe this case as having the effect that people will just stop working after they get to $5 million. That's just not an option for the likes of Peyton Manning, however. What Peyton Manning (or any corporate CEO in the same position) would likely do, however, is settle for just $5 million a year, since all income after that goes to the state. Then, once you get a Republican in office, and they cut that 99% top bracket from $5 million-plus to $25 million plus, Peyton Manning will renegotiate his salary up to $25 million, even though he's still playing 16 NFL games a year...
  So, in this case, tax rates down implies total taxes collected from Peyton Manning up but total "production" from Peyton unchanged, but worsening inequality for the economy and less taxes paid for someone else. So, we'd need to look at whether the consumption spending of people like Tiger Woods, CEOs with their corporate jets, and investment bankers is better for long-run economic growth than the spending of the poor, who spend a large chunk of their disposable income on things such as education and health care...
  This is essentially what has happened in the US, and that is why you shouldn't believe it when economists tell you we shouldn't tax millionaires.
  

Reading

• Krugman made a post recently about how many jobs we need and a promotes a plan to do so:
  
  

  The most specific, persuasive case I’ve seen for more Fed action comes from Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics. Basing his analysis on the prior work of none other than Mr. Bernanke himself, in his previous incarnation as an economic researcher, Mr. Gagnon urges the Fed to expand credit by buying a further $2 trillion in assets. Such a program could do a lot to promote faster growth, while having hardly any downside.
  

  When I read this piece, I was a little struck by how casually he used the $2 trillion number. That's a lot of money, and a lot of debt. Thankfully, The Mess That Greenspan Made agrees:
  
  

  Hardly any downside, that is, unless we're in the middle of a long deferred, fundamental change for the U.S. economy in which the credit expansion seen at all levels over the last few decades - government, corporate, and personal - can no longer produce growth.
  
  

• Mish Shedlock points out that the bond market (usually worth keeping an eye on) is starting to worry about our deficit:
  
  

  The so-called yield curve touched 372 basis points, the most in at least 29 years, as the bonds drew a yield of 4.52 percent. The so-called yield curve has widened from 191 basis points at the end of 2008, with the Fed anchoring its target rate at a record-low range of zero to 0.25 percent and the Treasury extending the average maturity of U.S. debt.
  ...
  “The market is continuing to worry about the massive amount of Treasury issuance that’s going to hit the market well into next year,” said Ian Lyngen, senior government bond strategist at CRT Capital Group LLC in Stamford, Connecticut.
  

• JP Morgan is apparently not concerned about anything actually being done with regards to the "too big to fail" issue. No surprise.
  
  

  Overall, we are left with a big bank that is getting bigger.  It has been (relatively) well run by Mr. Dimon, but there are no assurances for the future.  Given that the “Resolution Authority” is at this point a mythical beast – with no potential effect on the problem of “Too Big To Fail” – we should worry a great deal.
  We could set a hard size cap on banks like JPMorgan Chase (e.g., on assets relative to GDP), which could force them to find ways to spin-off businesses – and return to the much smaller and more manageable size of the early 1990s.  There is no evidence this would be disruptive or cause any economic difficulties.  But, for political reasons, this won’t happen any time soon – the size and power of banks like JPMorgan is put to good use on Capitol Hill.
  

• However, Goldman makes a change to its bonus structure. I wonder if this will be beneficial. It's not in line with Dr. Mintzberg's idea of getting rid of bonuses altogether (as the Goldman strategy still presumes stock price is a good measure of corporate performance), but it does feel like a small step in the right direction:
  
  

  With a resurgent Goldman set to award billions of dollars in bonuses — a trove that could rival the record payouts of the bubble years — the bank said that its 30 most-senior executives would be paid in the form of a special stock, rather than in cash.
  

This Isn't Needed Regulation

I'm appalled by what the government is up to right now.
In case you haven't heard, the Pay Czar, Kenneth Feinberg, just started instituting pay cuts at Wall St. firms that used TARP money:

Mr. Feinberg, the Treasury Department's special master for compensation, will lower total compensation for 175 employees at seven firms including AIG, Citigroup, Bank of America and GM, by an average of 50%, people familiar with the matter said. He will also demand a series of corporate-governance changes at the firms, including splitting the positions of chairman and chief executive officer; requiring boards of directors to create a committee to assess risk, and eliminating staggered boards.

Some of that actually sounds not so bad, such as splitting the positions of chairman and CEO. However, this is not the way to go about fixing anything! What is Feinberg trying to accomplish? Here's the best I've found:

Summers said Feinberg's rulings -- which are expected to be publicly released in the coming days -- will ensure taxpayers' interests come before those of shareholders and incumbent management at the beleaguered firms.

Let's do a quick history. First of all, lest we forget, the government forced these companies into accepting bailout money. Some argue that hey, if you take public money, you have to be prepared for public oversight ... but they didn't have a choice! Beyond that, it's not as if there were any particular requirements associated with the TARP money. For example, one way to look out for taxpayers might have been to get the banks taking TARP money to lend more, during a time when credit was/is tight. Did that happen? No. "Geithner did not require the Big Banks to loan money for commercial loans as a prerequisite for additional borrowings from the Fed."
And now Obama & Co. start trying to trim their pay? What are they accomplishing?? All that I'm seeing here is this: Dear Big Banks, if you get in trouble, we'll give you tons of money. In fact, we might even force it down your throats, but at least no matter how bad you screw up you know you won't go under. Then we'll let you do whatever you want with that money and achieve mind-blowing profits during a recession, which will naturally lead to fantastic compensation and plenty of public outrage. And since we used to work on/with Wall Street, we could basically predict all this would happen. And it's kinda messed up that we used to work with you and now we're giving you more-or-less free public money, but hey, that's what friends are for! But look, we'll have to pretend to be totally bewildered and fake some anger at you so the public doesn't tar-and-feather us.
Honestly, as far as I can tell, that's more or less the story so far. Ugh. Instead of focusing on useful policies that might prevent future issues (such as reinstatement of the Glass-Steagall Act, or something similar, which is sadly looking like it won't happen), they do worthless stuff that won't even really have a lasting impact:

Pay is the wrong way to tackle this problem. It’s a lazy, crowd-appeasing, intellectually dishonest approach. The out of line pay is a symptom, and any attempt to treat symptoms as causes is likely to be ineffective, more likely dysfunctional.
...
Now why is trying to control this through pay not such a hot idea? First, one hundred years of performance appraisal systems have proven them to be abject failures (aa 1992 paper by
Patrick D. Larkey and Jonathan P. Caulkin, “All Above Average and Other Unintended
Consequences of Performance Appraisal Systems,” did a brilliant job of dissecting why, but it was too heretical to get published. You can read a few key points here in the section “The Illusion of Meritocracy”). Second, comp systems are supposed to solve what is called a principal-agent problem. You the person hiring someone to work on your behalf wants to make sure they are operating in accordance with YOUR best interests in mind, not theirs.
But what did we learn from 20 years of executive rewards schemes that had lots of equity incentives that would supposedly align the interest of top brass with that of shareholders. We got instead an explosion of CEO pay and companies that are so fixated on quarterly earnings that they are reluctant to invest in growth. How did that come to pass?
BECAUSE THE AGENTS AND NOT THE PRINCIPALS DESIGNED THE PAY SCHEMES!  The foxes were running the hen house. Oh, sure, we had some fig leaves, it was the HR department that hired the compensation consultant, and the board (nominated by the incumbent management) that signed off on it, but it is pretty clear that a comp consultant that did not deliver a CEO-wallet-fattening plan was unlikely to get much repeat business.
And is anything going to be materially different? No. The conventional wisdom is that having employees take a high level of pay as equity is a magic solution, conveniently forgetting that Bear and Lehman both featured very high levels of shareholding among its top management and employees. Feinberg is only intervening in outliers, to collect a few scalps. He is in a very difficult position and is trying to make the best of it.
The financial services industry now has an unimaginably rich deal: privatized gains and socialized losses, and with tons of leverage too, which amps up the apparent profits and hence the pay levels these looters can claim they deserve. The way to attack this problem is to constrain the level of risk assumption. That in turn requires understanding the products and the markets, something the authorities have completely abdicated. With so much “talent” looking for jobs, now would be the perfect time to invest in catching up.

Sorry for the angry, poorly-written rant. And please keep in mind, I'm not exactly trying to defend banks here. In fact, I think I've been quite open on this blog about how immoral they've been and how dangerous they are to our country as they're currently constructed. The point here is, nothing useful is being done to correct this! All this Pay Czar junk is just political maneuvering. Real reform is not happening.

A must-read

Krugman put up a must-read piece at the New York Times. I think it is slanted to the Keynesian school of thought, but it is also an excellent history of modern macroeconomics and how we got to where we are. There are a few paragraphs I want to quote and discuss, but please do read the article in full. It is particularly good for those who want a quick grounding in economic history.

Any emphasis in the quotes below is mine.

1. The birth of modern economics and the Efficient Market Hypothesis
"The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical” economics ... was that we should have faith in the market system."
This is foundational. Note that it relies on rational individual decision-making.
"There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”"
Krugman details much more, but essentially, makes clear that the belief in Efficient Markets had taken hold to such a degree amongst mainstream thinkers and policy-makers, that any thought to the contrary was dismissed out of hand.
"By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.” Since this collapse of the intellectual edifice was also a collapse of real-world markets, the result was a severe recession — the worst, by many measures, since the Great Depression."
I linked an Economist article on this a few days ago. I think what one can see here is the beginnings of a fundamental questioning of Milton Friedman's faith in rational markets. This is a very, very serious question, as a reversion back to Keynes would be greatly at odds with what we've been used to for nearly 20 years now (it's arguable that Bernanke's stimulus is Keynesian, but I do still think that the core belief system of key modern policy-makers leans towards deregulated markets). Also, this is why I have the blog The Mess That Greenspan Made in my list of favorite blogs. =)

2. The Stock Market
It is generally accepted that the goal of a public corporation is to maximize value for its shareholders. This is a principle that I, at least, have never questioned. I am beginning to, however:
"By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.”"
I find this very interesting. How did corporate leaders view the stock market prior to 1980? Was it simply a means to raise cash - in other words, allowing the stock to fund your activity and judge your value rather than forcing your activity so as to increase the stock price? The former seems far more rational to me.
My dad, Pramod Khargonekar, with whom I discussed parts of this article, brings up further points and questions on this topic:
There are some really fundamental questions: Consider a public company such as IBM.
Who owns the company? Legal answer: Stockholders (there are many classes of shares which makes this a little more nuanced. There are also debt holders who have a higher priority in terms of ownership which makes this answer even more complicated. Finally, taking into account externalities, society where the company operates have a legal and societal stake in the company. This is not always acknowledged.)
What is the role of mgt? Flip answer: maximize the value of the company. But what does this mean? Stock price in the next day, week, month, year, ...? Not all stockholders have the same view on this. BoD is supposed to represent the interests of the owners but they are often beholden to the management. Often CEO is also the Chairman of the BoD. The entire area of corporate governance is supposed to deal with this but has been quite dismal in this regard.
Where does the larger society fit into this? Flip answer -- no role. But then when the company creates toxic dumps, we the society pay for it and thus it becomes a subsidy from the nonowners to the owners. Unless the cost of externalities is fully reflected in the taxes paid, this is often in favor of the management of the company.
It is critical to realize that the corporate/government structure is constructed by us: it is not ordained by nature. It operates in the physical world and has humans as players. Behavioral finance, economics is probably the best direction for understanding how these things work and what to do about them for the long term good of the society.

3. Keynesian Economics
Back to quoting more Krugman:
"I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.
This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.
Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .
In short, the co-op fell into a recession."

4. No one could have predicted this!
"Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”
... there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”
Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified.
...In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place."

I leave the rest of the article to you. It makes for great reading.
The key points this article brings up:

• Lack of faith in the Efficient Market Hypothesis (I've brought this up before, and am wondering if we're beginning to see a more serious questioning).
• Too much belief in mathematical models that make for an ideal world rather than modeling the real world.
• A need to incorporate Behavioral Economics more strongly as the field moves forward.

I want to make a post later in further detail on the principle of maximizing shareholder value, how that's currently defined, and how it should be defined. I will quote my dad's note in that again, but expand on some points it makes brief note of (corporate governance and behavioral economics).