Productivity, Wages, and Asset Inflation

Dean Baker has a very interesting piece trying to make sense of why, with headline productivity so high since the mid-nineties, wages have not kept pace. Dean Baker begins…

Most economists view productivity growth as being the key to rising living standards through time. The basic story of productivity in the post-war era is that growth was rapid in the years from 1947-1973, but then slowed sharply over the years from 1973-1995. Productivity growth then ticked up again in 1995 and has been relatively rapid since 1995.

1995, huh. That was quite a year according to this article by Aaron Krowne. Aaron argues that in 1995, an obscure loosening of US bank reserve requirments, and an abandonment by the Greenspan Fed of a “virtual gold standard”, gave rise to an era of unprecedented growth in broad money. In my own mind, 1995 corresponds to about the beginning of the “asset economy”, when wealth accumulation from capital gains rather than wage or business income became an unusually important driver of the US economy. Hmmm.

I have an monetarist intuition about wages during this period. Suppose that under certain circumstances fast money supply expansion results in asset inflation rather than goods inflation. Goods prices remain stable, the economy seems to grow at a moderate clip, but asset prices grow far faster than GDP. Sellers of productive capital (tractors, factory equipment, etc.) as well as workers then have to compete with the financial sector for investable funds. As expectations of asset appreciation increase, more investors choose to purchase stocks, homes, hedge funds, oil, or gold than to build factories, open businesses, and hire workers. Of course stocks have to be backed by firms, and homes have to be built, but on the margin, investment dollars are diverted from direct deployment as productive capital to purchasing paper assets via financial intermediaries. The net effect is a reduction of the “velocity of money” in the real investment sector, reducing input prices while at the same time diminishing future capacity. Input prices include wages.

In an environment where capital is drawn to appreciating financial assets, workers and vendors of productive capital have to make price concessions relative to productivity in order to attract funding. Rocketing asset prices should be expected to reduce the bargaining power of workers, and to exert downward pressure on their wages.

UPDATE: Shamed by Greg Mankiw and some awful grammar, I’ve performed major surgery on this post, prettying things up and dropping a long digression from the main point. (I’ll insert the original version into the comments for posterity). 2006-10-08 03:11 am EET


By the way, Dean Baker’s piece offers a very different, but quite interesting explanation for the divergence between wages and productivity. He adjusts productivity growth by subtracting out growth in depreciation costs (which cannot go towards wages) and taking into account the diversion between consumer inflation (by which real wage grwoth is reckoned) and the GDP deflator (by which real productivity is measured). Since consumer inflation has been higher than broad GDP inflation, even wage earners who do see their wages of growing in proportion with GDP would see their “real” wage lagging, because they disproportionately buy goods that have gotten more expensive. Read the whole thing.

Pegging Real Exchange Rates: A Synthetic Tariff?

Mystery-blogger knzn packs an avalanche of insights into a very brief discussion of why China’s policy of puchasing dollars to peg its nominal exchange rate has not led to real appreciation via inflation in China. knzn is quite critical of Charles Schumer and Lindsey Graham, who’ve written an op-ed in the Wall Street Journal (via Mark Thoma) today in defense of a proposal that amounts to a faint and distant threat of tariffs on Chinese goods. I am broadly sympathetic to Schumer and Graham’s proposal, despite considering myself a staunch free-trader, and I think their point largely stands, despite problems that knzn and Greg Mankiw highlight. I hope he will forgive me for abusing his insights in support of a position he may not much like. Here’s knzn:

China today is a special case for several reasons. First, there is a rapid flow of workers into the industrial sector, and this flow is helping to prevent the inflation that might ordinarily attend an undervalued currency. Second, much of China’s foreign exchange intervention is sterilized, which is to say, China is making attempts to slow down domestic sources of demand to compensate for the foreign demand occasioned by its weak currency. Third, China’s government is effectively running a very large surplus, which also tends to slow down domestic demand. Fourth, arguably, China is following policies that encourage a high level of private saving, which also tends to slow domestic demand.

knzn whizzes through this like it was nothing, but there’s a ton of interesting stuff here. knzn’s first reason is conventional wisdom, fine as far as it goes, and as the vowelless one notes, “if China has a lot of workers available to do these jobs, whereas the US has only a few (relatively speaking), why shouldn’t trade be set up to create jobs in China rather than the US?”

But knzn’s second point left me standing naked on the shoreline in wonder. Countries that manage their exchange rates are supposed to sterilize their interventions. It’s like Central Banking 101. If China’s central bank prints Yuan to buy dollars, it’s got to borrow some of those Yuan back to avoid flooding the market with newly printed Chinese bills, right? knzn is having none of it, and of course he’s absolutely right to note that sterilization is just a fancy word for what central banks do when they want to restrain domestic demand to avoid inflation. What I considered central bank prudence, knzn considers cheating, “[S]terilized intervention, might reasonably be considered an unfair trade practice (and probably a foolish practice as well).” Central banks may “naturally” want to prevent their exchange rate policy from causing inflation, but doing so in effect pegs the real, rather than nominal exchange rate. While pegging nominal exchange rates need not impede trade balance adjustments (because those adjustments can occur via changes in the price level), pegging real exchange rates blocks trade adjustment entirely.

knzn’s third point is also a shocker. He notes that China is “effectively” running a large surplus. But hold the phone. Isn’t China running a significant fiscal deficit? Well, yes, if you consider only tax revenues. But, if you consider a consolidated income statement that includes China’s central bank, China’s deficit would be dwarfed by the piles of foreign currency flying into the vaults, net of sterilization costs (and even net of significant presumed valuation losses). So is knzn is right to refer to this as “a very large surplus, which also tends to slow down domestic demand”? I think he’s only half right, in a very subtle way.

Imagine that China did no sterilization, and purchased dollars with freshly printed Yuan to maintain its peg. This would maximize the surplus achieved by China’s government (including central bank). But it would also be a very loose, a stimulative monetary policy that might provoke inflation, as China’s central bank would be increasing the money supply dramatically. An unsterilized peg then has two paradoxical and countervailing effects, amounting to a stimulus and tax at the same time. It taxes holders of domestic currency, by increasing the cost in local money of forign goods (an upward shift in the supply curve for imports). But it stimulates domestic demand for all goods. The net effect is almost certain inflation of the price of imported goods (relative to the price that would prevail without intervention), but a mix of real GDP growth (to the degree that there is “slack” in the economy ) and inflation in the domestic economy.

Now let’s put all this together. If China were simply pegging its currency without sterilizing, it would stimulate demand for nonimported goods and services, but it might also stimulate inflation, permitting real exchange rate adjustment. But, by adjusting the degree of sterilization, it can seek a sweet spot that grows unsterilized money at a level chosen to maximize real GDP without provoking inflation, preventing real adjustment. The net effect is a synthetic tariff, raising the price of foreign goods while stimulating the domestic economy and providing revenue to the state. It’s no wonder that China’s trade partners object.

Would “Cash, please” amount to protectionism?

The very excellent Mark Thoma, under the title “Avoiding Protectionism“, quotes a very orthodox article from The Economist (subscription req’d). From that article…

The developed economies as a whole will still benefit hugely from trade with emerging economies. Increased competition and greater economies of scale will boost the growth in productivity and output. Consumers will enjoy lower prices and a greater variety of products, and shareholders will enjoy higher returns on capital. Although workers will continue to see their pay squeezed, they can still gain as consumers or as shareholders… [G]lobalisation is benefiting America’s economy… But in practice the average family has not seen such a gain because much of it has gone to those at the top or into profits. This explains the lack of support for globalisation from ordinary people. Unless a solution is found to sluggish real wages and rising inequality, there is a serious risk of a protectionist backlash. Rather than block change, governments need to ease the pain it inflicts in various ways: with a temporary social safety-net for those who lose their jobs; better education to equip workers for tomorrow’s jobs; and more flexible labour markets to encourage the creation of new jobs… More controversially, governments may need to redistribute the benefits of globalisation more fairly through the tax and benefits system.

As long-time readers may know, this sort of rehash of the “free trade” catechism makes my blood boil. Why? Because I am deeply, pro-free-trade and proglobalization, and this sort of palaver threatens to discredit these important projects for a generation, when the current nightmare masquerading as free trade unwinds. As Brad Setser has noted, what is at issue is not the globalization per se, but the form that globalization is now taking that is the problem. Under this globalization, not some Econ textbook idealization, The Economist‘s case simply does not hold. For example:

Consumers will enjoy lower prices and a greater variety of products, and shareholders will enjoy higher returns on capital. Although workers will continue to see their pay squeezed, they can still gain as consumers or as shareholders.

These statements have simply been untrue, empirically, for American workers in the last five years, and the future looks even bleaker. Despite remarkable efforts of Wal-Mart and heavily subsidized Asian exporters, the median US worker has not seen lower prices, relative to the value of her labor. Living as a typical American has grown more expensive, when measured in median-worker-hours, not less, despite that worker’s apparently increased productivity. And this during a period in which supply chain innovations and an artificially strong dollar (vis Asia) have blown strong, disinflationary headwinds. Should the US dollar reprice, the road will only get harder.

The median worker, having been unable to benefit from globalization as a consumer, can hardly be expected to do so as a shareholder. A rising real cost of living implies less savings, or what we observe in fact, dissaving. At the same time workers are losing the purchasing power of their labor, they are losing the ability to participate in increasing returns to capital.

I could rant on and on about the patronizing incoherence of The Economist piece. [*] But enough. Let’s get to the root of the problem: This globalization has proceeded in a manner that violates the assumptions of the traditional (and correct!) case for free trade. The problem is not that emerging market labor is “too cheap”, or that “the global capital-labor ratio” has shifted. It is that advanced countries, especially the United States, are not paying for the goods and services received with the current provision of goods and services in exchange, but instead with promisary notes that may or may not be honored in real terms. The real-economy case for free trade is based on the idea of each nation producing as much and as best as it can in the domains in which it has comparative advantage, and exchanging that production for what others produce well. The exaggerated use of credit in international exchange (visible in the stockpiled reserves of emerging market central banks and national investment funds) has turned this case on its head. Rather than shifting production in “advanced economies” to align with changing comparative advantage, credit-based globalization encourages a retreat from tradables production altogether, as no real goods or services need be exchanged to receive tradables from elsewhere. The traditional case for free trade is simply not compatable with a regime in which some countries persistly provide, and others persistently accept, credit in exchange for real goods and services.

Which leads me to the question that serves as the title of this essay. Advanced economies don’t necessarily need tariffs, or subsidies, or any of the traditional arsenal of policies that fall under the rubric and epithet of “protectionist”. All they need to do is insist, to others and to themselves, on “paying cash, not credit”. Although intuitive, this formulation is strictly speaking meaningless, since modern money is a form of debt. Perhaps a better way of stating this is that advanced economies should, in fact make broadly balanced trade a non-negotiable policy objective, not as a form of protectionism, but in order to uphold the assumptions and preconditions required to ensure that free trade is beneficial.

A balanced trade policy could, and might sometimes need to be, enforced through measures that look atavistically protectionist. But not usually. Policies like the one Warren Buffet has proposed would be reasonable. Or the US Fed’s famous “dual mandate” could simply be expanded to a “triple mandate”, in which balanced trade is an explicit objective. When Americans, directly or via governments, are buying too much on credit from trade partners — when US trade is deteriorating out of balance — the Fed should increase the cost of taking on more debt. (In the short run, that might conflict with the Fed’s other mandates. But in the long run, full employment requires an economy that produces tradables sufficient to pay for wage-earners imports.)

Free trade is a great idea, when it is real goods and services being traded, rather than promises which will either be painfully kept or painfully broken. We should give it a try.


[*] Okay, okay. One more rant. The article quotes a prestigious economist to the effect that education offers “advanced country” workers no protection, noting, “This may help to explain why the real median wage of American graduates has fallen by 6% since 2000, a bigger decline than in average wages.” But it concludes with that usual bromide of a suggestion, “better education to equip workers for tomorrow’s jobs”, in its litany of nonsolutions. Aaargh!!!!
Update History:
  • 19-Sep-2006, 8:30 p.m. EET: Took out some wordiness (“dishonest palaver” becomes palaver; “enormously important” becomes important).

Greg Mankiw’s “The Savers-Spenders Theory of Fiscal Policy”

Greg Mankiw, Harvard prof, former CEA chair, and most importantly famed econblogger wrote this very fine paper several years back. Though there’s a bit of math, overall the paper is very common-sensical, and quite readable. Here’s my favorite bit:

Proposition 3: Government debt increases steady-state inequality.

Although… government debt does not affect the steady-state capital stock and national income, government debt does influence the distribution of income and consumption in the savers-spenders model… A higher level of debt means a higher level of taxation to pay for the interest payments on the debt. The taxes fall on both spenders and savers, but the interest payments go entirely to the savers. Thus, a higher level of debt raises the steady-state income and consumption of the savers and lowers the steady-state income and consumption and the spenders. The spenders, however, already had lower income and consumption than the savers (for only the savers earn capital income). Thus, a higher level of debt raises steady-state inequality in income and consumption.

This is a very straightforward argument: The government borrowing today to tax tomorrow is a non-event, if the monies not taxed today are all invested at a return that precisely covers the deferred taxation. But if “savers” invest the funds not taxed while “spenders” consume more than they would have, the savers are left unaffected but the spenders are left worse off when the bill comes due. (In Mankiw’s model, savers are not unaffected, but positively gain, as higher current consumption by spenders and government yields rising returns to savers, who invest and earn more than they otherwise would have.)

Given all the recent sturm und drang over inequality and the degree to which it can be accounted for by public policy, I’m surprised that this argument hasn’t featured more prominently. Given the United States’ current fiscal policy and the concern over inequality today, you’d think the idea of deficits exacerbating inequality would really bite.

Some comments:

  1. The effect that Mankiw describes would be lagged: deficit spending now yields greater inequality over time.
  2. It is somewhat insidious, in that deficit spending today increases consumption equality today, as typically poorer spenders consume more than they otherwise would, and live more like wealthier savers.
  3. To counteract this effect, having a progressive tax system isn’t enough. A government that causes inequality through deficit spending would have to increase the progressivity of taxation in proportion to its borrowing in order to undo the increased inequality. Progressivity here would mean adjusting effective tax rates paid by cohorts. (The proportion of total taxes paid by spenders would increase even without policy changes, as a reflection of growing inequality.)

I’d love to see Mankiw extend his model to include not only domestic spenders and savers, but also foreign savers not subject to many US taxes. Also, if monetization of government debt is permitted as an alternative to (or a form of) taxation, how would that affect the relative wealth of domestic spenders, domestic savers, and foreign savers?

Note: Mankiw issued a minor correction for this paper, though it does not affect the argument discussed above.


Some Recent(-ish) Inequality Posts

Beyond spite and envy…

Some of the best and brightest econbloggers are having a debate on whether there are negative externalities associated with wealth inequality, and whether these might merit government intervention to remedy. Unfortunately, the debate has gotten lost in a colorful, but unhelpful, discussion of “spite” (on the part of rich people) and “envy” (on the part of the poor). However entertaining this may be, it quite misses the point.

Very large wealth inequality has a huge, tangible negative externally in all existing political systems that has nothing to do with idiosyncratic emotional reactions. Wealth inequality leads to large, utility-destroying errors in public policy.

In the real world, under democratic capitalism, stalinist communism, feudal monarchies, you name it, there is a strong correlation between actual wealth and political power. (Under some systems this might be masked by differing institutions of wealth and property, but facts on the ground proved Comrade Stalin to have a nicer car than Comrade Sven.) Correlation is not causation: In some systems political power precedes wealth, and in others wealth brings with it the capacity to garner influence. Nevertheless, the relationship is strong, everywhere. The wealthy always have disproportionate political power.

Wealthy people — and I mean the best intentioned wealthy people, not the corrupt — make political decisions to improve the world as they see it. The greater the degree of wealth inequality, the greater the difference between the world those at the very top experience and the experience of the vast majority. This leads to errors in judgement, policy changes that improve the world the rich live in while harming the world that the not-so-rich inhabit, and very large utility losses when the not-so-rich are numerous. The best intentioned of the wealthy may try to mitigate this by reading, thinking about the less fortunate, etc. etc. But these exercises are a poor substitute for experiencing the world as most people experience it, and suffering the consequences of poor leadership directly. And power correlates with wealth much more than it correlates with diligence and skill in understanding the world beyond ones own experience.

Utility losses due to misguided generalizations of their own experience by the wealthy and powerful may be inevitable. But quantities matter. A society in which “the wealthy” represent a large fraction of the population who live not to differently from the less wealthy will make fewer and less costly errors than one in which a realtively small, very wealthy group lives very differently from the rest.


From the great spite and envy debate…

Wealth & Money — Some Thoughts

It is always worth remembering that wealth is not about what you have, it is about what you do. Dollars, cents, and bars of gold are only shadows of the past, that to a greater or more often lesser degree help today’s wealth open a door into tomorrow’s. Economists forget this, and treat wealth as quantifiable and money as a store of value, when in fact value must be recreated every day. A nation’s “stock of wealth” may be fifty trillion dollars, but wait and see how little wealth $50 trillion buys if that nation slows in the dance of producing and serving to meet its own wants and the wants of others.

Money is key to wealth for individuals and firms in a healthy, stable economy. Money is irrelevant to the wealth of societies at large. Economists err when they measure a society’s “real wealth” by agglomerating the prices of things and adjusting for an slippery quantity called inflation. Real wealth is about matching the production of goods and services, or their sustainable acquisition through trade, with the very diverse wants and needs of people. Refracting these questions through the a fiction of dollars and cents provides analytical convenience but not accuracy.

Private Equity & Dividing By Zero

I’ve been pulled from a period of post-nuptial dissolution and lassitude by an astonishing article in yesterday’s Wall Street Journal on private equity buyouts. It describes a simple game. Private equity firms persude creditors fund highly leveraged buyouts. The bought-out firm then takes on more debt to quickly pay large sums to the private equity firm, its new owner and manager, in the form of management fees and dividends.

Consider Intelsat. According the the WSJ article, private equity investors put up $515 million, while creditors footed the remaining $5.5 billion to purchase the communications satellite business. Within two years, the private equity investors had extracted more than $576 million in fees and dividends, while still retaining full ownership of the firm. Now that’s a good position to be in. After two years, while the underlying firm was struggling, renegging on promised employee benefits, and showing a negative net worth, it’s owners had already earned 5.75% annual returns on their stake and recovered their capital in full, while still retaining control of the company and claim to any future profits it might earn! Alluding to a previous post, this is a deal right on the dotted line. For zero net investment, the private equity firm gets to gamble taking all the profit and growth a 3 billion dollar firm can generate, or walking away from the table with a bit of bad publicity and the unwinding of some legal entities.

It’s easy, as is apparently the German custom, the think of private equity firms as “locusts”. But this is capitalism, and people are supposed to figure out ways to exploit unusual opportunities. It’s not the sharks who are feeding, but the rare, bloody meat floating in the water that’s the problem here.

There’s an old math cliché that you can prove any proposition so long as division by zero is permitted. I think a finance version of this cliché would be that anything is possible if there’s a mispricing in any market that can’t undone by its exploitation. Credit markets for the past half-decade have matched this description. Central banks have held money cheap, despite unprecedented and every growing use of borrowed funds by everyone from strapped consumers to eager-to-please businesses to multibillion dollar investment funds. In unmanipulated markets, the orgy of borrowing that has characterized the last few years would have led naturally to tighter rates. Thanks to the US Fed, the People’s Bank of China, the freewheeling dollar lending of petrostates, and of course the Bank of Japan, that hasn’t happened. Money has been nearly free. Banks have had to compete mercilessly for the privilege of lending for any interest at all. Risk has been so sliced and diced and sold and apparently “managed” by the derivatives boom that many creditors have been made comfortable with positions that in the past would have looked like laughably bad deals for them. Global interest rates have been fixed by the behavior of central banks collectively and state-affiliated investment funds at absurdly low levels.

The current private equity boom is largely a means of exploiting that mispricing. The underlying businesses that are bought and sold are means to ends. It is not what they do, what new efficiencies or synergies or what not that can be introduced that matters. It is how well their assets can be used to justify continual leveraging, how cheaply they can be bought, how good a story can be told to keep the terms of borrowing from becoming too onerous even while cash is sucked from the firms by equityholders, that matters most. The underlying business then becomes a lottery ticket. If a firm can, in the course of doing a deal, build a really great company, put together several firms and take advantage of synergies, improve underlying efficiencies, then the value of all those improvements is pure profit for the private equity fund. Leveraged buyers have every incentive to try to build and improve the companies they float through. But in a world of artificially cheap credit, taking underperforming companies and turning them into great ones becomes secondary, gravy. An arbitrage opportunity is better than any risky investement. The first order of business for a rational private equity fund would be to find target investments through which to exploit mispricings in credit and risk can be efficiently exploited.

Of course this will all come apart, rather soon I hope. If collective state behavior does change (a very big if) and the era of absurdly cheap money ends, many of these heavily leveraged deals will go south, and we’ll have a predicatable wave of Enron-like scandals, as firms go bust, private equity funds write off their investments, and creditors sue them for fees and dividends they extracted from retrospectiovely insolvent companies. If central banks around the world are determined to keep money cheap, if China keeps ramping its exports and lending away all the proceeds for next to nothing, if the petrostates keep buying up dollar debt with all their oil proceeds, if the Bank of Japan and US Fed get spooked by the prospect of recession and hold rates low, we can put off much of this unpleasantness, but with much worse eventual consequences.

After all, it is not liquidity or interest rates or equity deals that matter in the enterprise of human wealth. It is the business of producing real goods and services. A world in which nominal wealth becomes detached from real production, and bound instead to cleverness in manipulating the machinery of high finance, is a world in which financiers will have an ever larger share of a progressively smaller pie.

Blame Avoidance: Understanding the Bernanke Fed

I think it’s very simple.

They know something bad is going to happen. It could be a deflationary recession, it could be out of control inflation. In a world awash in liquidity and debt, in which the US Fed has limited effective control over the quantity of money and the quality of claims, either possibility is plausible.

The Fed doesn’t want to be blamed. Feds are historically blamed first for pushing interest rates too high (causing a deflationary recession), and second for letting inflation get out of hand. So, the Fed’s first priority is not being blamed for acting too aggressively and causing a recession. They can avoid blame by pausing the rate hike cycle, if it seems decent to do so, or by moving 25 bp per meeting, if inflation numbers run high. That “measured pace” is now a kind of default, not a blame magnet, and anyway, it’s a Greenspan Fed strategy, so if contiguous 25 bp moves precede a recession, most of the blame goes to Bernanke’s predecessor. But the Fed also doesn’t want to be blamed for failing at its core mission of keeping inflation under control. So, in “jaw-jaw” mode — speeches, informal comments, etc. — Fed officials come off as hawkish, hoping to maintain their credibility as inflation fighters, and thereby reduce self-fulfilling expectations of increased inflation.

This is a fairly optimal strategy for avoiding blame. If a recession hits, blaming the Fed for being too aggressive will have limited traction. After all, the Fed only continued its predecessors policy of gently tightening, and only when inflation numbers clearly forced continued tightening. Blaming the Fed because Bernanke talked about inflation numbers exceeding his comfort levels in some speech is not going to take. The formal record will be one of very measured interest rate rises, and very moderate statements and minutes. If there’s a recession, it won’t be the Fed’s fault. If inflation continues to pick-up, the Fed can try to maintain its credibility by talking tough and continuing the 25 bp hikes. If the Fed really is “behind the curve” on inflation, and prices accelerate, eventually they might be blamed. But that involves incremental and subtle attributions of blame. They can always, actually “shock the market”, if things get out of hand and the blame for inflationary pressires gets palpable. But much better to threaten to do something radical (deniably, through third parties and rumors) than to take the risk of actually doing something, until something absolutely must be done, and the risk of serious blame can no longer be avoided.

I do think some kind of bad economic period is inevitable, though whether it looks like recession or stagflation or just modest inflation and sluggish real growth is uncertain. I’m not sure that I blame the Fed for avoiding blame. But I do blame the Greenspan Fed, and current administration, and the ossification of economic ideas into stale ideologies over a longer period of time, for getting the US economy into an obvious, big mess, while the best and brightest debated whether a garbage dump wasn’t the optimal outcome if something resembling a market happened to produce it.

Leveraged fund optionality and the “least cost bearer of risk”

Traded financial derivatives, it is often claimed, permit markets to find the “least cost bearer of risk”. But if this is true, what exactly does it mean? Who are the least cost bearers of risk? Highly diversified investors with very strong balance sheets? It’d be natural to think so. But think again. Perhaps the least cost bearers of risk are aggressivley speculative investment funds intentionally leveraged to the point where the potential upside is very large, and the corresponding downside triggers bankruptcy.

Recall that any leveraged, limited-liability entity can be understood as a call option. If a business owes the bank $1M, but its assets — including the present value of expected future profits — are worth less than that $1M, it can declare bankruptcy. Its owners hand over all assets to the bank, and walk away without paying off the loan. On the other hand, if equityholders believe the business is worth more than a million, they pay off the bank, or rollover the loan, depending on the operation’s current liquidity and available investment opportunities. Thus, the value of this entity to equityholders can be described by the red curve below.

Investments whose returns are like options have an unusual property. Usually, investors hope to minimize risk and maximize returns in their investment choices. But the expected return of an option increases with the risk (or volatility) of the underlying asset. Consider the case of an idealized entity operating entirely on borrowed cash. It holds $1M in assets, all borrowed, no owners equity. On the graph above, it sits at the point where the dotted line intersects with the red line. Suppose equityholders had a choice, hold the million dollars cash, or flip a coin in a bet that either doubles their money or loses it all. An unleveraged, risk-averse investor always prefers sure cash to a fair coin-flip. But a very leveraged investor who has the option of shifting costs to the lender, takes the coin-flip. If she loses the flip, she loses nothing, the lender takes the cost. If she wins, she’s turned other peoples’ money into a cool million for herself.

A 100% leveraged entity is a zero-cost bearer of risk. The downside of any potential investment is immaterial. Only the probability-weighted magnitude of the expected upside matters. A 100% leveraged entity prefers volatility to safety, even if the “average” outcome of a gamble is not particularly good. Even if the coin in the previous example were rigged so that the fund loses 2 out of 3 flips, equityholders still prefer to play than to hold cash. Since creditors bear the losses, the only cost to a bad gamble is the opportunity cost of better gambles that might otherwise have been undertaken.

In the real world, very few entities get to borrow all their assets, hold all gains, but walk away from any losses by defaulting. It’s a great deal for the borrowers, but a crappy one for lenders, who strive to prevent these kinds of perverse incentives from arising. Lenders typically require borrowers to hold significant equity. A typical borrower sits at the intersection of the red and green lines. At this point on the curve, equityholders absorb most losses, as well as any gains on their investments, and the possibility that some of their losses will be borne by lenders if they lose absolutely everything is unlikely to be particularly relevant. Also, business bankruptcy often exacts nonmonetary costs that mitigate predatory behavior by borrowers. Controlling equityholders of failing businesses lose reputation, their jobs, see their friends lose jobs and retirement security, face lawsuits, etc. Finally, lenders often protect themselves with “covenants” that remove control from equityholders as the degree of business leverage increases, to prevent borrowers from taking big chances after they’ve borne great losses.

But, nevertheless, the world is a diverse place, with lots of different kinds of businesses and creditors. While very few entities enjoy 100% leverage, some businesses fall much closer than others to the dotted line on the graph above, some businesses have more non-monetary costs associated with bankruptcy than others, some businesses have more restrictive covenants than others. Leverage is no longer as simple a concept as funds borrowed from a diligent local bank. Bonds can be sold to the public, to naive foreign investors, to foreign central banks. In markets awash with liquidity, borrower reputation may substitute for balance sheet due-diligence in the decision to extend credit.

The trading of financial derivatives is supposed to transfer risk exposure to its least cost bearer. In light of the foregoing discussion, what might a least cost bearer look like? As we’ve seen, entities that are nearly completely leveraged, that fall near the dotted line on the graph above, face a low, or even negative, cost to bearing risk! This is counterintuitive, since these are the sorts of entities that face the greatest likelihood of bankruptcy. But that is exactly the point. Bankruptcy transfers the cost of risk gone bad to others. The least cost bearer of risk is an entity with few nonmonetary costs associated with failure, and a reputational or strategic capacity to take on leverage without surrending its ability to take risk. It should be no surprise to anyone following financial markets that this sounds a lot like a highly regarded hedge fund. Think Long-Term Capital Management.

The point of this essay is that LTCM-style meltdowns are not aberrations, but are a rational, structural consequences of a financial system in which the returns of some entities have high optionality, offering the possibility of high-returns for a low sums put at risk of total loss. LTCM should not be regarded as a failure or lapse of judgement on the part of its managers or investors. Its failure was a “normal accident”. Assuming independence of returns across investments, the rational investor should diversify her holdings among a very large number of funds with LTCM-style leverage and high appetites for risk, as these offer far superior return to risk than traditional investments. Many, perhaps most, of these investments would go south, and end up worthless. But the returns on the high-leverage, high-risk funds that succeed will much more than make up for these setbacks. On average, lenders bear most of the risks and equityholders enjoy most of the gains. It’s a good deal for investors.

If highly leveraged funds are good deals for investors, than hedge-fund managers ought to be competing to create them. (We’ve not touched on the much maligned “2 & 20″ fee structure of many hedge funds. That adds additional optionality to hedge fund incentives, but it is only icing on the cake.) Funds should be competing to maximize their leverage without compromising their capacity to take-on risk, leap-frogging one another down the slope of a graph towards that dotted line. Speculative derivative positions often offer both risk and leverage in convenient packages whose “rocket-scienceness” helps to obscure both aspects, and make it possible for a fund to take on yet more.

Of course there is a problem here. Somebody ends up bearing all the risk that leveraged funds can write off via defaults. What is rational behavior for each individual fund or investor may turn out not to be so rational, if failures turn out to be correlated rather than mostly independent. If several funds default away large losses, the funds’ creditors may in turn default, wiping out other funds’ gains and increasing the likelihood of futher defaults. In a typical “tragedy of the commons”, rational behavior by investors and managers can lead to a systemic crisis.

Update History:
  • 12-Jun-2006, 10:am p.m. EET: Changed “tragedy” to “crisis” in last sentence to avoid double-use, and removed the overdone word “grave”. Fixed two spelling errors.

Free trade, or the first few hits are free?

What was that famous Adam Smith quote, the one that made the case for free trade better and more concisely than ever before, or ever since?

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor.

What is prudence in the conduct of every private family, can scarcely be a folly in that of a kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.

But, you know, the “prudent master of a family” does not engage his tailor and buy his shoes on credit, for prolonged periods of time and with no forseeable means of repayment. Debt securities do not represent the produce of our industry. Sometimes the wisdom of crowds is not found in central-bank manipulated markets, but in the messy kinds of preferences expressed by voters in elections.

I’m all for free trade. But what many businesses and economists refer to as free trade, in this real world circa 2006, is not trade at all. Trade implies two parties exchanging value. I’m a long-time, knee-jerk anti-protectionist. But at this moment, I don’t know who to be more afraid of: US politicians catering to paleolithic economic xenophobia, or economists who’d describe as “free trade” the United States’ growing addiction to goods and services it cannot pay for and the nation’s ongoing, humiliating “soft default” on debts public and private via real depreciation of the dollar.

A man standing in line at a soup kitchen is involved in a voluntary transaction between two parties. He may think he’s outsmarted the guy with the ladle, working the system, getting something for nothing. But that man in line at the soup kitchen is neither admirable nor prudent, and it is that guy with the ladle who holds the power. The problem with a free lunch is that it may not be there tomorrow. And a free lunch, however long it lasts, is not free trade.


This rant was inspred by a post by the very excellent Mark Thoma.