Naked Economics (24 page)

Take risk, earn reward.
Okay, now we’ll talk about whether your 401(k) should be in stocks or bonds. Suppose you have capital to rent, and you are deciding between two options: lending it to the federal government (a treasury bond), or lending it to your neighbor Lance, who has been tinkering in his basement for three years and claims to have invented an internal combustion engine that runs on sunflower seeds. Both the federal government and your neighbor Lance are willing to pay you 6 percent interest on the loan. What to do? Unless Lance has photos of you in a compromising position, you should buy the government bond. The sunflower combustion engine is a risky proposition; the government bond is not. Lance may eventually attract the capital necessary to build his invention, but not by offering a 6 percent return.
Riskier investments must offer a higher expected return in order to attract capital.
That is not some arcane law of finance; it is simply markets at work. No rational person will invest money somewhere when he or she can earn the same expected return with less risk somewhere else.

The implication for investors is clear: You will be compensated for taking more risk. Thus, the more risky your portfolio, the higher your return—
on average.
Yes, it’s that pesky concept of “average” again. If your portfolio is risky, it also means that some very bad things will occasionally happen. Nothing encapsulates this point better than an old headline in the
Wall Street Journal:
“Bonds Let You Sleep at Night but at a Price.”
¹¹
The story examined stock and bond returns from 1945 to 1997. Over that period, a portfolio of 100 percent stocks earned an average annual return of 12.9 percent; a portfolio of 100 percent bonds earned a relatively meager 5.8 percent average annual return over the same period. So you might ask yourself, who are the chumps holding bonds? Not so fast. The same story then examined how the different portfolios performed in their worst years. The stock portfolio lost 26.5 percent of its value in its worst year; the bond portfolio never lost more than 5 percent of its value in a single bad year. Similarly, the stock portfolio had negative annual returns eight times between 1945 and 1997; the bond portfolio lost money only once. The bottom line: Risk is rewarded—if you have a tolerance for it.

That brings us back to the Harvard endowment, which lost about a third of its value during the 2008 financial crisis. And Yale lost a quarter of its endowment in one year alone. Meanwhile, over the same stretch of dismal economic circumstances, my mother-in-law earned about a 3 percent return by keeping nearly all of her assets in certificates of deposit and a checking account. Is my mother-in-law an investment genius? Should Harvard have directed more of its assets to a giant checking account? No and no. My mother-in-law always keeps her assets in safe but low-yielding investments because she has a small appetite for risk. She is protected when times are bad; of course, that also means that if the stock market posts an 18 percent gain one year, she earns…3 percent. Meanwhile, Harvard and Yale and other schools with large endowments earned enormous returns during the boom years by taking large risks and making relatively illiquid investments. (Liquidity is the reflection of how quickly and predictably something can be turned into cash. Illiquid investments, like rare art or Venezuelan corporate bonds, must pay a premium to compensate for this drawback; of course, when you need to get rid of them quickly to raise cash, it’s a problem.) These institutions pay an occasional price for their aggressive portfolios, but those bumps should be more than offset in the long run with returns that are a heck of a lot better than a certificate of deposit. Most important, the endowments are different than the typical investor planning for college or retirement; their investment horizon is theoretically infinite, meaning that they can afford some really bad years, or even decades, if it maximizes returns over the next one hundred or two hundred years (although both Harvard and Yale have had to make serious budget cuts lately to make up for lost endowment revenue). Yale President Richard Levin told the
Wall Street Journal,
“We made huge excess returns on the way up. When it’s all over and things stabilize I think we’ll find the overall long-run performance [of the endowment] is better than if we didn’t.”
¹²
I suspect he’s right, but that doesn’t necessarily make it a wise strategy for my mother-in-law.

Diversify.
When I teach finance, I like to have my students flip coins. It is the best way to make certain points. Here is one of them: A well-diversified portfolio will significantly lower the risk of serious losses without lowering your expected return. Let’s turn to the coins. Suppose the return on the $100,000 you have tucked away in a 401(k) depends on the flip of a coin: Heads, it quadruples in value; tails, you lose everything. The average outcome of this exercise is very good. (Your expected return is 100 percent.)
^*
The problem, of course, is that the downside is unacceptably bad. You have a 50 percent chance of losing your whole nest egg. Try explaining that to a spouse.

So let’s bring in some more coins. Suppose you spread the $100,000 in your 401(k) into ten different investments, each with the same payoff scheme: Heads, the investment quadruples in value; tails, it becomes worthless. Your expected return has not changed at all: On average, you will flip five heads and five tails. Five of your investments would quadruple in value, and five would become worthless. That works out to the same handsome 100 percent return. But look at what has happened to your downside risk. The only way you can lose your entire 401(k) is by flipping ten tails, which is highly unlikely. (The probability is less than one in a thousand.) Now imagine the same exercise if you buy several index funds that include thousands of stocks from around the world.
^†
That many coins will never come up all tails.

Of course, you better make darn sure that all those investments have outcomes that are truly independent of one another. It’s one thing to flip coins, where the outcome of one flip is uncorrelated with the outcome of the next flip. It’s quite another to buy shares of Microsoft and Intel and then assume that you’ve safely split your portfolio into two baskets. Yes, they are different companies with different products and different management, but if Microsoft has a really bad year, there is a pretty good chance that Intel will suffer, too. One of the mistakes that compounded the financial crisis was the belief that bundling lots of mortgages together into a single mortgage-backed security created an investment that was safer and more predictable than any single mortgage—like flipping one hundred coins instead of just one. If you are a bank with one mortgage loan outstanding, it could go into default, taking all of your capital with it. But if you buy a financial product constructed from thousands of mortgages, most of them will be fine, which offsets the risk of the occasional default.

During normal times, that’s probably true. A mortgage goes into default when someone gets sick or loses a job. That’s not likely to be highly correlated across households; if one house on the block goes into foreclosure, there is no reason to believe that others will, too. When a real estate bubble pops, everything is different. Housing prices were plummeting all over the country, and the accompanying recession meant that lots and lots of people were losing jobs. The seemingly clever securities backed by real estate loans morphed into the “toxic assets” that we’ve been trying to clean up ever since.

Invest for the long run.
Have you ever been in a casino when someone wins big? The casino operators are just as happy as everybody else. Why? Because they are going to make an extraordinary amount of money in the long run; this is just one minor hiccup along the way. The beauty of running a casino is that the numbers are stacked in your favor. If you are willing to wait long enough—and pose happily for photos as you give a giant check to the occasional big winner—then you will get rich.

Investing has the same benefits as running a casino: The odds are stacked in your favor if you are patient and willing to endure the occasional setback. Any reasonable investment portfolio must have a positive expected return. Remember, you’ve rented capital to assorted entities and you expect to get something back in return. Indeed, the riskier the ventures, the more you expect to get back, on average. So the longer you hold your (diversified) investments, the longer you have for probability to work its magic. Where will the Dow close tomorrow? I have no clue. Where will it be next year? I don’t know. Where will it be in five years? Probably higher than it is today, but that’s no sure thing. Where will it be in twenty-five years? Significantly higher than it is today; I’m reasonably certain of it. The idiocy of day trading—buying a stock in hopes of selling it several hours later at a profit—is that it incurs all the costs of trading stocks (commissions and taxes, not to mention your time) without any of the benefits that come from holding equities for the long run.

So there you have it—the sniff test for personal investing. The next time an investment adviser comes to you promising a 20 or 40 percent return, you know that one of three things must be true: (1) This must be a very risky investment in order to justify such a high expected return—think Harvard endowment; (2) your investment adviser has stumbled upon an opportunity still undiscovered by all the world’s sophisticated investors, and he has been kind enough to share it with you—please call me; or (3) your investment adviser is incompetent and/or dishonest—think Bernie Madoff. All too often the answer is (3).

The fascinating thing about economics is that the fundamental ideas don’t change. Monarchs in the Middle Ages needed to raise capital (usually to fight wars), just as biotech startups do today. I have no idea what the planet will look like in one hundred years. Perhaps we will be settling Mars or converting salt water into a clean, renewable source of energy. I do know that either of those undertakings would use the financial markets to raise capital and to mitigate risk. And I’m positive that Americans will not have become thin and healthy by eating only grapefruit and ice cream.

M
any years ago I took a vacation with a group of friends. As the sole academic among the bunch, I was the object of mild curiosity. When I explained that I was studying public policy, one of my peers asked skeptically, “If people know so much about public policy, then why is everything so messed up?” On the one hand, the question was idiotic; it’s a bit like asking, “If we know so much about medicine, why do people keep dying all the time?” One can always come up with clever rejoinders a decade later. (At the time, I mumbled something like “Well, it’s complicated.”) I might have pointed out that in the realm of public policy, as in medicine, we have achieved some pretty good wins. Americans are healthier, richer, better-educated, and less vulnerable to economic booms and busts than at any time in our history—the recent economic downturn notwithstanding.

Still, the question has stuck with me for years, in large part because it hints at an important point: Even when economists reach consensus on policies that would make us better off, those policies often run into a brick wall of political opposition. International trade is a perfect example. I am not aware of a single mainstream economist who believes that international trade is anything less than crucial to the well-being of rich and poor countries alike. There is just one small problem: It’s an issue that literally causes riots in the streets. Even before the violent antiglobalization protests in places like Seattle and Genoa, agreements to expand trade, such as the North American Free Trade Agreement, caused ferocious political battles.

Meanwhile, pork-barrel legislation sails through Congress, lavishing money on small projects that cannot possibly be described as promoting the national interest. For nearly forty years, the federal budget included a cash payment to American mohair farmers. (Mohair comes from the Angora goat and is a wool substitute.) The mohair subsidy was created in 1955 at the behest of the armed forces to ensure a sufficient supply of yarn for military uniforms in the event of a war. I won’t quibble with that.
But the military switched to synthetic fibers for its uniforms around 1960.
The government continued to give large cash payments to mohair farmers for another thirty-five years. The mohair subsidy was eventually eliminated when it became the poster child for pork-barrel politics and was doomed by its sheer absurdity.

And then, when the rest of us turned our attention elsewhere,
it came back.
The 2008 farm bill includes subsidies for wool and mohair producers for the crop years 2008 to 2012. How does this happen?

It is not because the mohair farmers are enormously powerful, well funded, or politically sophisticated. They are not any of those things. In fact, the small number of mohair farmers is an advantage. What the mohair farmers have going for them is that they can get large payments from the government without taxpayers ever really noticing. Suppose there are a thousand mohair farmers, each of whom gets a check from the federal government for $100,000 every spring, just for being a mohair farmer. The farmers who get that subsidy care a lot about it—probably more than they care about any other government policy. Meanwhile, the rest of us, who pay mere pennies extra in taxes to preserve an unnecessary supply of mohair, don’t care much about it at all. Any politician with a preference for job security can calculate that a vote for the mohair subsidy will earn the strong support of the mohair farmers while costing nothing among other voters. It’s a political no-brainer.

The problem is that mohair farmers aren’t the only group lining up to get a subsidy, or a tax break, or trade protection, or some other government policy that puts money in their pockets. Indeed, the most savvy politicians can trade favors with one another—if you support the mohair farmers in my district, then I’ll support the Bingo Hall of Fame in your district. During my days as a speechwriter for the governor of Maine, we used to refer to the state budget as a Christmas tree. Every legislator could hang an ornament or two. I currently live in the Illinois Fifth Congressional District, the seat held for decades by Dan Rostenkowski (and later by Rahm Emanuel). We Chicagoans can drive around the city and literally point to the things that Rosty built. When the Museum of Science and Industry needed tens of millions of dollars to build an underground parking garage, Dan Rostenkowski found federal funds.
¹
Should taxpayers in Seattle or rural Vermont have paid for a parking garage at a Chicago museum? Of course not. But when I took my children to the museum last weekend in a downpour, I was delighted to be able to park indoors. That helps to explain why Dan Rostenkowski, not long out of federal prison, can still command a standing ovation at political gatherings in Chicago.

The stimulus bill passed by the Obama administration during the depths of the financial crisis was a giant legislative Christmas tree. I will argue in the next chapter that the stimulus was a reasonable thing to do under the circumstances. No sane person, however, would have designed that particular bill, which included funding for things ranging from “green” golf carts to a polar ice breaker. Yes, the process that has generated decades of cash payments for mohair farmers is alive and well. Let’s talk about ethanol, a corn-based gasoline additive with putative environmental benefits. Gasoline blended with ethanol is taxed 5.4 cents less per gallon than pure gasoline, ostensibly because it burns more cleanly than pure gasoline and because it lowers our dependence on foreign oil. Of course, neither scientists nor environmentalists are convinced that ethanol is such a great thing. A 1997 study by the General Accounting Office (which later changed its name to the Government Accountability Office), the nonpartisan research arm of Congress, found that ethanol had little effect on either the environment or our dependence on foreign oil. The ethanol subsidy had, however, cost the Treasury $7.1 billion in forgone tax revenues. Worse, ethanol may actually make some kinds of air pollution worse. It evaporates faster than pure gasoline, contributing to ozone problems in hot temperatures. A 2006 study published in the Proceedings of the National Academy of Sciences concluded that ethanol does reduce greenhouse gas emissions by 12 percent relative to gasoline, but it calculated that devoting the entire U.S. corn crop to make ethanol would replace only a small fraction of American gasoline consumption. Corn farming also contributes to environmental degradation due to runoff from fertilizer and pesticides.
²

But to dwell on the science is to miss the point. As the
New York Times
noted in the throes of the 2000 presidential race, “Regardless of whether ethanol is a great fuel for cars, it certainly works wonders in Iowa campaigns.”
³
The ethanol tax subsidy increases the demand for corn, which puts money in farmers’ pockets. Just before the Iowa caucuses, corn farmer Marvin Flier told the
Times,
“Sometimes I think [the candidates] just come out and pander to us,” he said. Then he added, “Of course, that may not be the worst thing.” The National Corn Growers Association figures that the ethanol program increases the demand for corn, which adds 30 cents to the price of every bushel sold.

Bill Bradley opposed the ethanol subsidy during his three terms as a senator from New Jersey (not a big corn-growing state). Indeed, some of his most important accomplishments as a senator involved purging the tax code of subsidies and loopholes that collectively do more harm than good. But when Bill Bradley arrived in Iowa as a Democratic presidential candidate back in 1992, he “spoke to some farmers” and suddenly found it in his heart to support tax breaks for ethanol. In short, he realized that ethanol is crucial to Iowa voters, and Iowa is crucial to the presidential race. Since then, every mainstream presidential candidate has supported the ethanol subsidy, except one: John McCain. To his credit, Senator McCain generally opposed ethanol subsidies during his presidential runs in both 2000 and 2008. While Senator McCain’s “straight talk” is admirable, let us remind ourselves of one important detail: John McCain is not currently president of the United States. That would be Barack Obama—an ethanol subsidy supporter.

Ethanol is not a case of a powerful special interest pounding the rest of us into submission. Farmers are a scant 2 or 3 percent of the population; even fewer of them actually grow corn. If squeezing favors out of the political process were simply a matter of brute strength, then those of us who can’t tell a heifer from a steer should be kicking the farmers around. Indeed, America’s right-handed voters could band together and demand tax breaks at the expense of the lefties. And we could really have our way with those mohair farmers. But that’s not what happens.

Economists have come up with a theory of political behavior that fits better with what we actually observe.
When it comes to interest group politics, it pays to be small.
Gary Becker, the same University of Chicago Nobel Prize winner who figured so prominently in our thinking about human capital, wrote a seminal paper in the early 1980s that nicely encapsulated what had become known as the economics of regulation. Building on work that went all the way back to Milton Friedman’s doctoral dissertation, Becker theorized that, all else equal, small, well-organized groups are most successful in the political process. Why? Because the costs of whatever favors they wrangle out of the system are spread over a large, unorganized segment of the population.

Think about ethanol again. The benefits of that $7 billion tax subsidy are bestowed on a small group of farmers, making it quite lucrative for each one of them. Meanwhile, the costs are spread over the remaining 98 percent of us, putting ethanol somewhere below good oral hygiene on our list of everyday concerns. The opposite would be true with my plan to have left-handed voters pay subsidies to right-handed voters. There are roughly nine right-handed Americans for every lefty, so if every right-handed voter were to get some government benefit worth $100, then every left-handed voter would have to pay $900 to finance it. The lefties would be hopping mad about their $900 tax bills, probably to the point that it became their preeminent political concern, while the righties would be only modestly excited about their $100 subsidy. An adept politician would probably improve her career prospects by voting with the lefties.

Here is a curious finding that makes more sense in light of what we’ve just discussed. In countries where farmers make up a small fraction of the population, such as America and Europe, the government provides large subsidies for agriculture. But in countries where the farming population is relatively large, such as China and India, the subsidies go the other way. Farmers are forced to sell their crops at below-market prices so that urban dwellers can get basic food items cheaply. In the one case, farmers get political favors; in the other, they must pay for them. What makes these examples logically consistent is that in both cases the large group subsidizes the smaller group.

In politics, the tail can wag the dog. This can have profound effects on the economy.

Death by a thousand subsidies.
The cost of Dan Rostenkowski’s underground parking garage at the Museum of Science and Industry is insignificant in the face of our $14 trillion economy. So is the ethanol subsidy. So is the trade protection for sugar producers, and the tax break for pharmaceutical companies with operations in Puerto Rico, and the price supports for dairy farmers. But in total, these things—and the tens of thousands of others like them—
are
significant. Little inefficiencies begin to disrupt the most basic function of a market economy: taking inputs and producing goods and services as efficiently as possible. If the government has to support the price of milk, the real problem is that there are too many dairy farmers. The best definition I’ve ever heard of a tax shelter is some kind of investment or behavior that would not make sense in the absence of tax considerations. And that is exactly the problem here: Governments should not be in the business of providing incentives for people to do things that would not otherwise make sense.

Chapter 3 outlined all the reasons why good government is not just important, but essential. Yet it is also true that when Congress turns its attention to a problem, a lot of ornaments end up on the Christmas tree. The late George Stigler, a University of Chicago economist who won the Nobel Prize in 1982, proposed and defended a counterintuitive notion: Firms and industries often benefit from regulation. In fact, they can use the political process to generate regulation that either helps them or hobbles their competitors.

Does that sound unlikely? Consider the case of teacher certification. Every state requires public school teachers to do or achieve certain things before becoming licensed. Most people consider that to be quite reasonable. In Illinois, the requirements for certification have risen steadily over time. Again, that seems reasonable given our strong emphasis on public school reform. But when one begins to scrutinize the politics of certification, things become murkier. The teachers’ unions, one of the most potent political forces in America, always support reforms that require more rigorous training and testing for teachers. Read the fine print, though. Almost without exception, these laws exempt current teachers from whatever new requirement is being imposed. In other words, individuals who would like to become teachers have to take additional classes or pass new exams; existing teachers do not. That doesn’t make much sense if certification laws are written for the benefit of students. If doing certain things is necessary in order to teach, then presumably anyone standing at the front of a classroom should have to do them.

Other aspects of certification law don’t make much sense either. Private school teachers, many of whom have decades of experience, cannot teach in public schools without jumping through assorted hoops (including student teaching) that are almost certainly unnecessary. Nor can university professors. When Albert Einstein arrived in Princeton, New Jersey, he was not legally qualified to teach high school physics.