Wednesday, February 24, 2010

Understanding the Pharmaceutical Industry

So I recently had a long debate with a friend about my argument regarding the dangers of a monopsony in negotiating drug reimbursement costs. He did eventually come around, but I am posting the salient arguments here:
The initial claim was that Pharma has been the most profitable sector of the last decade (ahead of even oil and finance), and that the only people who take a hit by allowing Medicare to negotiate drug prices are the shareholders of the companies, and they are secondary to consumers. To support this, the arguer cites profit margin data on large drug companies - PFE, MRK, JNJ, etc - Net Income over Revenues. These are consistently in the Mid 20 %s, which seems to clearly be a high margin business, so pressuring those margins won't affect incentives.
My response, slightly edited for a blog audience:
"You're referring to pharma as big pharma. I'm referring to pharma as the margin on a drug from the beginning of the "drug creation process", which includes pharma killed earlier in the supply chain.
Let's walk through the pharma supply chain, and you'll see where I'm going with this, and why exact numbers are very hard to come by, but they're way smaller than you think they are.
Basic research and initial innovation happens in a number of places: universities, foundations, major pharmaceutical companies, and startups and entrepreneurs.
This research then moves onto the initial commercialization stages. If the basic innovation happens at a major pharmaceutical company, they develop it in-house; if the basic innovation happens elsewhere (as a large and growing portion of it does), it then goes to a startup.
Startups are capitalized with venture capital and bank loans. These startups generally lose a ton of money as they work to develop their one or two big horses.
Almost all of these startups fail long before we hear about them. A few manage to demonstrate clinical relevance, and once they have done so, these startups partner or are bought by big pharma companies, who inject massive sums of capital to help further commercialize the drug and get it through the tremendously expensive (many hundreds of millions of dollars) FDA approval process. Note that the cost of trials for FDA approval does not scale equally with the revenue/profit potential of the drug - something with 1/100 the potential market doesn't cost 1/100 the amount to take to trial.
Large pharma can do this because they a) can contribute tons of capital and b) can spread the substantial risk of FDA approval over lots of drugs. Thus, there are tremendous economies of scale in large pharma, which is why there are so few large pharma companies. They still face a lot of risk on individual drugs, rely on 4 or 5 drugs for all of their revenue (from a pipeline of many hundreds of drugs over the years) and when a drug doesn't get late stage approval, the stocks often drop 10, 15% in a day (and I've seen 40, 45%, or even higher).
The small pharma companies aren't often public, and when they are, they lose a ton of money and have midget market caps. Any statistics you're looking at are going to be isolating the large pharmaceutical companies only and market-cap-weighting the numbers (instead of weighting by actual book capital), which means the margins you're citing, 25%, are subject to colossal levels of survivorship bias and calculation error. The return expectation of creating a new drug from the get-go are tiny, possibly negative depending on what you're looking to treat, and certainly way less than 25% margins. It's impossible to "show you numbers" because private companies aren't subject to reporting with the SEC, but if you lower the expected profit of a drug from the get go, that doesn't stop with large pharma - that cascades through the supply chain. [Note: I later actually do cite some real numbers to approximate]
These large pharmaceutical companies then go and sell the drugs to consumers via insurance companies at rates negotiated individually with each health insurance company or organization. For this reason, large health insurance companies can receive drugs for cheaper than small health insurance companies. Foreign governments can negotiate prices WAY down, which is a major reason for the gap between foreign countries and the US in terms of drug costs. The pharmaceutical companies don't love it, but there's nothing they can do, and they still proceed with drug development because the US is a large enough market that they can still make money. Thus, incremental margins from US health insurance companies are substantially higher than those from foreign health insurance companies.
If the US pressures margins down, watch how that flows through the rest of the supply chain. All of a sudden, drugs aren't as profitable. Individual drugs are still tremendously risky and lowering potential profits doesn't equivalently reduce the cost of FDA approval, which means that big pharma necessarily has to be choosier about which drugs it purchases from small companies  - cholesterol, ED and baldness meds still get bought because the conditions are common and the potential number of customers are huge (they can become tentpole drugs, which provide those juicy 25% margins for large pharma) , so even if margins drop, they're still profitable on a units basis. Perhaps drugs treating rarer diseases, or commodities like vaccines, no longer have the margins to meet the risk-reward, return on invested capital guidelines that every major pharmaceutical company has when deciding what to buy.
Venture capitalists no longer fund startups in those areas because they no longer have a profitable exit strategy because big pharma isn't buying. Similarly, bank loan interest goes up, making them harder to get. Thus, the small companies no longer are able to start up. The basic researchers no longer have anyone to commercialize research on rarer diseases. On net, you have less research overall, and much less diversity in research. Innovation goes down and focuses on just the super profitable drugs at the exclusion of others. If you think this is a problem now, it'll only get worse.

It can get better, however, with some very simple policy regarding foreign healthcare monopsonies. You can see that America functionally subsidizes the world's medical costs, but you can't remedy that by simply forcing pharma companies to take lower margins, because that affects what the companies buy. The more useful way of dealing with it is to prevent foreign countries from exercising market power, so that pharma companies can spread development costs over a larger base of customers, bringing US costs down and raising the artificially-low foreign costs. You can do this by striking a nuanced form of reimportation that becomes legal when pharma cos and foreign insurance companies renew their contract - by universalizing the market, the pharma company has the power to walk away from individuals because the opportunity cost of a sh**ty deal goes up. This forces foreign insurance companies to cooperate.
Of course you don't actually want any reimportation to happen for security reasons, just the credible threat, which is why it's got to be such a nuanced policy and it's why it's difficult.
There are plenty of "bad" responses to this, but a smart one is "then negotiate prices down on things which are drugs for large numbers of people, and don't negotiate prices down on things that are small numbers of people". This is an economically legitimate argument with a few problems: firstly, do you really want to create any artificial disincentives to research drugs that affect a lot of people? Secondly, drugs for rarer conditions also tend to be drugs for more serious conditions and are thus very expensive for someone who has high medical costs already... do you really trust an elected bureaucrat with the power to negotiate some and not all drug prices when the political temptation to negotiate all drugs is so tempting?
Florida homeowner's insurance is an actual, living case study of what happens when you give politically motivated bureaucrats the power to decide premiums, payouts and risk. It started out fine, but political temptations got too large after a few years. Designed initially as the insurer of last resort, it has become the largest insurance provider in Florida, and although the government has put a tax on every property insurance that goes directly to capitalizing this insurance in addition to premium revenue, in the case of a big hurricane, the state will be put into a Greece-style fiscal crisis that makes California, Illinois, Michigan, etc. look like a joke and will probably require a massive Federal bailout and significant cutting of services. The Florida state legislature tried to raise insurance premiums, but Governor Crist, a certifiable idiot, blocked them.
(this gets way more interesting when you start talking about the health insurance companies, esp in light of the de facto price controls that Obama announced he wanted to include via commission in this week's version of the bill... needless to say, I'm not a fan).
I'm a fan of health insurance for all, and I'm a fan of trying to improve medical quality for reduced cost (hospital infections are a great place to start cuz they should be really, really simple), but if you don't consider the whole healthcare system as an interconnected ecosystem, you're going to cause a lot of unintentional trouble.
I'm not saying, btw, that big pharma won't keep profits up if you pressure prices - I'm saying that they'll focus on drugs that affect large numbers of people at lower per-pill margins (like viagra or lipitor) and less on drugs that either make no money anyway (most vaccines) or affect small numbers of people at higher per-pill margins (like drugs for rare cancers) because you can't easily pressure down the number of people, but per-pill prices can get pressured down easily. So innovation as a whole goes down, because the payoff is lower, but the impact is disproportionate among types of drugs. No matter whether big pharma takes this in-house or purchases R+D from outside, the cascade happens the same way, with the same negative consequences.
Actually, I thought of a way to approximate "true" margins - factor in acquisition costs for big pharma, because those are functionally r&d but they aren't treated properly in profit because goodwill isn't amortized. It's easier to calculate on a cashflow basis... It doesn't match up perfectly w revs but it should be close enough for a no backlog, no warranty, low working capital industry like big pharma. From morningstar, here is an approximation over the last 10 years (cash flow data is lumpy, so long terms smooth them out better):
1999-TTM (Operating CF - Investing CF)/Revenue
Pfizer,  16.4% (I started with PFE and AMGN cuz PFE, JNJ and AMGN are the best run companies in the space, and JNJ isn't comparable because of their large consumer goods segment)
Amgen: 17.0%
AstraZeneca: 13.8%
Bristol Myers Squibb: 12.6%
Allergan: 5.8%
This is just big pharma - if you think that big pharma pressures little pharma into taking lower expected returns for less uncertainty (which is absolutely the case) this margin for pharma as a whole goes way, way down - you're looking at under 10% overall cash margins. On a risk adjusted basis, there isn't a ton of room for pressure before they start cutting back.
These take me a while to calculate (they do overweight recent history ever so slightly but not significantly), but my source is, so if you're interested in other companies, you can find it there (again, with the exception of JNJ, because of their consumer goods division), but you can see that once you factor in acquisitions for R+D, these companies' margins drop sharply from the lofty mid 20%s you see on income statements.
There are places you can probably pressure to reduce drug costs, however. I think almost every major drug rep agrees that legalizing advertising for drugs has been mixed at best - the US used to illegalize drug commercials til the early-mid 90s, then legalized only "there exists a treatment for your condition, ask a doctor what it is" ads, and then legalized "buy viagra!" ads... the first legalization was important, because it got people to realize they didnt have to live with their condition. the second, however, massively ramped ad spending and actually didn't help spread usage that much... but every pharma co has to do it because all of their competitors are doing it, and if they don't they'll be relatively victimized. It's a prisoner's dilemma. If you wanted to argue that the US should make direct advertising illegal and only allow "there exists a treatment" ads, that's something I could get 100% on board with. Advertising to doctors is harder, but you could also do a lot of regulating on exactly how drug companies are allowed to advertise to doctors - something else I could get 100% on board with.
You have made a good point that the pipelines could dry up under these types of circumstances, by the way, because to an extent, they are. Bush cutting funding for stem cell research ("the next frontier") didn't help, certainly, and organizational inertia is probably part of the problem as well, but a lot of it is on the "basic research" side - nobody's really coming up with anything that gets through the FDA anymore (that includes universities and startups as well as the research components of big pharma). Foreign country margin pressure could produce this exact effect, as I've mentioned before, and that's one strong remedy. Reducing the cost of seeking FDA approval and make the FDA better at assessing drugs - that's another strong remedy. I don't know what the perfect solution is (who does), and perhaps this is somewhere economic policy could help with scientific research.

Tuesday, February 23, 2010

Health Insurance Antitrust Exemption and the sharing of Actuarial Data

I don't like health insurance companies having antitrust protection. At all. For the most part, I'm anti-market power (whether exerted by the government in the form of public option or overregulation, or by private corporations).
However, one strong benefit of insurer antitrust protection is that it gives health insurance companies a route to sharing their actuarial data, which is very important for competition. If companies knew that any competitor could just jump in, grab their actuarial data, and improve on it, they wouldn't make it available to anyone. This, ironically, would actually serve to WORSEN competition because it becomes an issue of "whoever has the best actuarial data gets all the customers in the long run, and can then negotiate lower rates and keep everyone out". So the sharing of actuarial data actually keeps the market more competitive, and eliminating the antitrust provision could make things worse (and no, the government can't reach a good conclusion by enforcing antitrust provisions when the co with the best data does force everyone else out, because in that case, the company will just do enough to comply with regulation, as opposed to continually improving operations.)
This actuarial data is also critical for any serious research into healthcare costs. I don't know, but I wouldn't be surprised, if this data was also used by Medicare.
Thus, if you're going to lift the antitrust exemption, you need to somehow force insurers to keep sharing their actuarial data. This should be simple enough policy, but it's important, and I guarantee Obama and the Dems in Congress are forgetting it.

The newest iteration of Obamacare

I have three big things to add to this article:
Firstly, replacing the tax on high-value health insurance with a capital gains tax replaces a revenue source that would slow healthcare cost growth with a revenue source that will slow economic growth. That is a very, very bad change.
Secondly, creating a review board to reject "unreasonable" rate increases (ie, those that are actuarially fair but politically unpopular) can take 2 scenarios:
1) it doesn't block any rate increases, so it just becomes a black swan political risk for insurers that makes premiums a little bit higher (to account for future risk)
2) it starts blocking rate increases, serves as price controls (anyone wanna check the history of price controls? I'd challenge you to name a single time that price controls have ever worked), and leads to 2 concurrent dilemmas: 1) health insurance plans refuse to cover new people, pull out of a number of states, and perhaps even liquidate, reducing competition and access, and leading to a government run monopsony medical plan that will crush innovation and lead to a lot of doctors or potential doctors exiting the field, and 2) health insurance plans refuse to cover a single new treatment that doesn't cut costs, functionally permanently ending our search for cures to things like cancer, diabetes, heart disease, etc.
Is that a world you want to live in? One where medical costs skyrocket (increased demand and decreased supply), wait times explode, economic growth slows down and new diseases aren't cured (and if you believe that innovation can happen in the presence of price controls, I'd challenge you to read any one of the bajillions of studies that has demonstratively shown that the single biggest driver of increased healthcare costs is new, expensive treatments. As they say, dying is cheap and treatment is expensive)
The sad thing is that there are so many better ways to achieve healthcare for everyone and slowed growth in healthcare costs.
Thirdly, if you have earnings power, America is possibly the highest tax regime in the world, and certainly one of the top few highest tax regimes. This will only get worse as the national debt continues to grow (and btw, this healthcare bill will be deficit expanding - it's only "deficit neutral" via accounting tricks with the timing of revenues and costs, and a Medicare "doc fix" that won't happen). One of the principal reasons to stay in America as a high earner is that the cost-independent quality of healthcare here is very, very good (US morbidity and mortality rates for most major diseases are tops in the world).
If America loses that healthcare advantage while also increasing taxes, do we see brain drain?

Monday, February 22, 2010

Corporate management and efficiency

This was a fascinating set of conclusions (original report here:
Firstly, the US has the best quality-of-corporate-management scores by a significant margin. Germany is second, Sweden is third, Japan is fourth, and down the line it goes.
Robin Hanson interprets:
  1. Firms with "better" management practices tend to have better performance on a wide range of dimensions: they are larger, more productive, grow faster, and have higher survival rates.
  2. Management practices vary tremendously across fi rms and countries. Most of the difference in the average management score of a country is due to the size of the "long tail" of very badly managed firms. For example, relatively few U.S. firms are very badly managed, while Brazil and India have many firms in that category.
  3. Countries and firms specialize in different styles of management. For example, American firms score much higher than Swedish firms in incentives but are worse than Swedish firms in monitoring.
  4. Strong product market competition appears to boost average management practices through a combination of eliminating the tail of badly managed firms and pushing incumbents to improve their practices.
  5. Multinationals are generally well managed in every country. They also transplant their management styles abroad. For example, U.S. multinationals located in the United Kingdom are better at incentives and worse at monitoring than Swedish multinationals in the United Kingdom.
  6. Firms that export (but do not produce) overseas are better-managed than domestic non-exporters, but are worse-managed than multinationals.
  7. Inherited family-owned firms who appoint a family member (especially the eldest son) as chief executive officer are very badly managed on average.
  8. Government-owned firms are typically managed extremely badly. Firms with publicly quoted share prices or owned by private-equity firms are typically well managed.
  9. Firms that more intensively use human capital, as measured by more educated workers, tend to have much better management practices.
  10. At the country level, a relatively light touch in labor market regulation is associated with better use of incentives by management.
This may explain a number of things:
Firstly, this may explain why corporate compensation is so much higher in the US - when all of your competitors are well managed, you had better be well-managed, too.

Secondly, this should make everyone very skeptical of top-down management, and somewhat concerned for the well-being of US banks. (More concerning points on this come from the Economist, with a hat tip to Mankiw: The Obama administration labor policy as it concerns the stimulus has meant that the infrastructure portions have cost about 15% more than they would have, which means that the tax payer is getting 15% fewer jobs for the money and 15% fewer roads, bridges and schools for the money. This goes along with a bunch of other irrational but popular union-favoring policies). One Australian (former NZ treasury official, current hedge fund manager) believes that Fannie and Freddie could fully repay the government within 5 to 8 years, with interest, if the government stays out of their way (, but it's possible Congress could call for their liquidation. You get the idea.
Finally, we need to strengthen corporate boards of directors and align them with non-majority public shareholders, at least for deciding "who gets to be the CEO". Nepotism is well known as a major efficiency drain, and just because it tends to be less of a problem in America than anywhere else doesn't mean we should stand still on it.

Sunday, February 21, 2010

Antibiotic resistance

The use of indiscriminate antibiotics in our food supply is causing all sorts of problems with antibiotic resistance, etc. Much of this problem comes from other countries, but ours is just as guilty.

Of course, the problem is that our low food prices are partially because we can use antibiotics, and thus pack animals closer together when we raise them (some have moral issues with this also, for understandable reasons).

If we wanted to avoid the catastrophes associated with antibiotic resistant diseases, what would we have to do?

a) research more antibiotics. This should be a continual process. This could be done pretty easily with our tax code and NIH grants - Making large percentages of R&D tax-deductible, funding research, etc.

b) ban the use of antibiotics in animals who aren't sick (testing would be necessary).

What happens then?

Testing would be expensive, as would disease verification. It would also be more expensive to raise animals in general.

Meat would increase in price, leading vegetables higher in price as people substituted. How could we mitigate food prices?

The easiest way to fix this would be to substitute vegetable production for meat production, but a lot of the land isn't convertible.

A better way may be a "long-term contracts" route - much of the arable land in America is already farmed. In South America, it is also farmed, but far less efficiently. Equipment in exchange for guaranteed food supplies at preset prices for an extended period of time would actually be valuable. That, and convincing Americans to eat a vegetarian meal or two per week. Vegetables are still more cost effective than meat, so we'd spend the same amount on food.

Thursday, February 18, 2010

Revisionist history about interest rates in the 2000s, and the effect of gasoline on the US economy

Yes, the Fed held down interest rates too low for too long in the 2000s. Hindsight, however, is 20/20, and people were more aware of this possibility than you'd think.
Bill Miller's October 2005 investor letter (found here: cites oil and interest rates as constraints on the US economy. Without the benefit of seeing what happened between October 2005 and February 2010, he could not link them properly. But in hindsight, we can. 
On oil, he points out "the experience of dramatically higher gasoline prices and the prospect of paying much more for heating oil this winter have kept investors worrying about the impact on consumption spending" and says that "we have good evidence that $70 oil or higher puts global growth in jeopardy" based on the evidence already accrued (remember, this was before the true froth in the oil bubble). He believes that the incredible constraint that high oil prices play in the world economy will serve as an effective governor on oil prices, because at that point, the marginal cost per barrel of production was about $40. His projection that oil wouldn't go higher was wrong, but taking his observations a tiny step further, the fact that oil kept rising so much meant that the economy could never seriously heat up in the presence of low rates, so we had to keep interest rates lower than we should have. We can look back and understand that these low rates offset an economy constrained by oil prices, but facilitated a housing bubble.
In fact, his commentary indicates that the Fed was perfectly aware of "froth" in the real estate markets and was having trouble getting real estate speculators to stop. We were aware about the possibility of a housing bubble in October 2005, we were moving to stop it, and intervention wasn't working. He attributes it to investor psychology - probably part of the problem, it usually is - but it's also likely that he underestimates just how badly high oil prices affect the US economy and how badly high oil prices affect long term bond investor psychology and how much we need to lower interest rates to offset this. (note: a high trade deficit weakens the dollar and causes higher oil prices, so this ties in with what I've been writing about, also)
Bill Miller isn't perfect - certainly he was wrong in his projection that ceasing short term rate increases would increase medium and long rates and contain the housing bubble (at that point, it wasn't quite as destructive as it got a couple years later), because he doesn't attribute it properly to energy prices. However, people, including Alan Greenspan, were aware of the problems we faced in real estate and were indeed trying to contain them.
This suggests that as long as our cars use gasoline, we're not going to have the easiest time avoiding crises and competing internationally through economic growth, even if government policy can stay out of the way.
Quotes below on the Fed:

"The Fed has raised the funds rate 11 times and is poised to go to 12 on November 1. It has done so to remove the policy accommodation put in place to counter the bursting of the tech bubble and the ensuing economic weakness emanating from the aftermath of Sept 11, the junk bond collapse, and the corporate scandals. It has also explicitly expressed concern about "froth" in the residential real estate market, and one way to inhibit that is to raise the cost of financing. It has succeeded at the short end, but failed at the long end, resulting in Chairman Greenspan's  "conundrum" of why it is that intermediate and long rates have not risen as they "ought" when the Fed is moving short rates higher...

[Stopping rate increases, resulting in a] rising market will also likely solve Mr Greenspan's conundrum. A pause, or even the signal of a future pause, in the rate increases will awaken the bond vigilantes from their Rip Van Winkle slumbers as they begin to fret about inflation. Falling bond prices will also shake loose those who think bonds have little risk, since they have done so well for so long, and that stocks are risky since they have done poorly. If stocks start to rise, their perceived riskiness will fall, and money will be attracted to equities and away from bonds. The resulting rise in intermediate and long rates will feed back into mortgage rates, slowing if not halting the speculative activity in real estate. That money will likewise move to stocks. Thus the solution to the conundrum is a paradox: to get rates to rise, stop raising rates...

Among the old leaders, the homebuilders stand out, trading at 5 or 6x earnings due the incessant drumbeat about a housing bubble. That industry would benefit greatly from better capital discipline via share repurchase, and some merger and acquisition activity."

Bill Miller on Financial Reform

This letter entertained me (Bill Miller's April 2009 market letter):
In addition to the well-deserved shots at Frank, Dodd, Shelby, Stiglitz and Krugman, it also outlines a) the appropriate goals of financial reform and b) why government regulatory oversight is going to have a lot of trouble improving the banking system over what it currently is. My favorite excerpts below:
"I believe policy with regard to banks remains the greatest risk to market confidence and stability, and therefore to economic recovery. Until the late fall of last year, most efforts to deal with the crisis served only to accelerate it, destroying confidence instead of enhancing it. Think of the pre-emptive seizure of the government sponsored enterprises (GSEs) with the attendant wipeout not only of common shareholders but also the completely gratuitous evisceration of preferred holders. By prohibiting the payment of dividends to preferred holders, the government managed to blow a further hole in the banking system's capital (Fannie and Freddie preferreds counted as Tier 1 capital for banks) and at the same time, to shut down the market for capital raising via the issuance of preferred stock, which had previously been an important vehicle for private capital to invest in banks. The decision to let Lehman fail has been widely derided as a complete disaster...

Policy has improved since then, as it became clear to at least some authorities that policies that wipe out private capital (in obeisance to some idea about moral hazard or some other equally inane supposition) and are punitive to investors in financial institutions are hardly likely to lead private capital to invest in those institutions, which is the stated objective of the policies: to restore confidence so that private capital can do the investing, and not have the government putting taxpayer money at risk.

There are a few who have been voices of reason during this crisis, people who understand how the banking system works and how confidence can be restored. These include Ricardo Caballero, head of the economics department at MIT, Bill Isaac, former head of the FDIC, hedge fund manager Tom Brown, veteran bank analyst Dick Bove, Anatole Kaletsky of GaveKal Research, Eddie Lampert of ESL Investments (and controlling shareholder of Sears), and as usual, Warren Buffett, who in a recent interview pointed out the intellectual vacuity of the favorite new ratio the bears are using to beat up on banks, the tangible common equity ratio. These voices of reason appear, though, to be in the distinct minority, as the other side commands the likes of Nobel Laureates Paul Krugman and Joseph Stiglitz, politicians Barney Frank and Christopher Dodd on the left, George Will and Senator Richard Shelby on the right, most sell side bank analysts, Tom Friedman and a plethora of political and economic commentators in the U.S. and abroad...

...Banks are, broadly speaking, in the business of collecting liquid short-term assets in the form of deposits and turning them into illiquid long-term assets in the form of loans. Not only do they take our liquid assets and make them illiquid (they do retain enough liquidity to meet anticipated demands from depositors for cash), they create many more loans than they have capital to support if too many of the loans go bad. This leverage is about 10 to 1. Since the assets are 10x the capital supporting them, it doesn't take more than third-grade arithmetic to conclude that if the value of the assets they hold fall more than 10 percent on average, they are "insolvent" (the quotation marks are there because the whole argument of those who support some kind of nationalization turns on confusing the different predicate logics of the single term "insolvent")...

The notion of insolvency, as typically understood, means you don't have the wherewithal to meet your obligations as they come due. But that is certainly not the case with the banking system as a whole, or with any major bank. Banks, in fact, are flush with cash, have deposits flowing in, and have $800 billion of EXCESS reserves on deposit at the Fed. Most of the big banks that have reported results recently are profitable... Not surprisingly, the same analysts who expected the banks to report losses in the first quarter dismiss the earnings as due to nonrecurring items, unusual market conditions (very wide spreads) and accounting gains. Of course, when those same conditions led to large losses being reported last year, those losses were considered all too real.

Remarkably, those who so worried about the financial condition of banks have decided that accounting conventions should trump economic reality. Accounting conventions seek to present the financial condition of businesses — they are not themselves that condition. The underlying financial condition of banks depends on confidence and cash flows. The cash flows are robust, the system has record liquidity; it is clear thinking about the accounting that is wanting.

Consider the issue of mark-to-market accounting, which has been the subject of so much controversy. Supporters say it serves the goal of transparency and helps illuminate the true financial condition of the enterprise. Opponents say it does no such thing, just the opposite, in fact, confusing market prices with underlying values, and injecting needless volatility and confusion into bank financial statements.

The irony is that we have been here before: the same arguments were made in the 1930s when for most of the decade banks marked assets to market. As asset values fell, depositors fled, banks collapsed, and the depression wore on. In July 1938, the Federal Reserve bulletin announced that mark-to-market accounting was being suspended, and that bank assets should be valued on long-term safety and soundness, and not daily price fluctuations. That was also the time the uptick rule was instituted to slow down short selling. Coincidence or not, those two policy measures coincided with the end of the vicious bear market of 1937 and 1938. It is eerie how the relaxation of mark-to-market accounting rules a few weeks ago and the announcement that some form of uptick rule would be reinstituted also coincided with the bottom of this bear market. Policies and rules matter.

A couple of other points on mark-to-market: Showing market values, or estimated market values, for assets is a good thing. But requiring bank capital ratios to be adjusted accordingly is not. Leaving aside the current controversy, consider that whenever we have another asset bubble and irrational exuberance returns, banks will have to mark up their assets, no matter how absurdly overpriced they are. It is also telling that the bears appear to want only those assets that can be marked down marked to market. None are calling for buildings built years or decades ago whose value is far in excess of carrying value (as was the Bear Stearns headquarters  building) to be marked up. And none has ever been heard to call for the deposit bases of major banks to be marked to market, which would generate billions of excess capital for those banks if the deposit franchises were carried at market... [Trevor's input for readers who don't breathe banking systems, if they're actually reading this: if you think leverage was ridiculous now, that'll just make things a billion times worse, because you could LEND AGAINST that stuff]

The major design flaw [with government stress testing] comes in that the government has indicated that banks that are currently well capitalized will be required to raise even more capital just in case things get a lot worse, to provide an additional cushion, as the saying goes. This pre-emptive capital raise is exactly backward. It ought to be the case that if things get a lot worse, and banks' capital ratios fall enough, then they will have to raise additional capital. If they cannot do so privately, then the government will need to put more capital in, diluting, perhaps substantially, existing holders. But pre-emptive dilution is the first cousin of pre-emptive seizure, which was so disastrous with the GSEs.

There is another, broader point: here again policy is backward. Capital should be raised in good times and drawn down in bad times. To require capital to be raised pre-emptively creates perverse incentives that work against policy goals. The easiest way to raise capital is not to lend, and to force borrowers to repay when loans come due. Assets decline and capital ratios improve, and we are all a lot worse off as the economy sinks because credit is not available. Keynes made this point in the 1930s: Actions that seem individually rational can be collectively irrational.

It has been reported that the stress tests will also look to see if the banks have the "right" kind of capital, which is taken to mean tangible common equity. This new requirement is conceptually incoherent, despite its now being adopted as the gold standard of capital by sell side analysts and hedge funds who are short. They appear to have persuaded regulators it is important. It is idiotic. The argument is being made that tangible equity is the first line of defense against losses. Other equity, like the preferred equity the government got for TARP (Troubled Assets Relief Program) money, is somehow not as good. But equity is equity. The cash the government exchanged for preferred stock could have been exchanged for common equity, but the government wanted taxpayers to be in senior position to the common shareholder, which seemed sensible then, and still seems so now.

Now, it is being argued that preferred equity should be converted to common, as this will be somehow "better." No one seems to have noticed that no new capital is being created by moving from preferred to common; the equity has just been rearranged (dividends saved do create capital, but only later). It is impossible to understand what economic or political benefit the government gains by moving from a senior to a subordinate position in the capital structure, forgoing substantial dividends in the process. No new equity is created; accounting typology trumps economic reality...

Warren Buffett noted recently that he never looks at tangible common equity in assessing banks' financial strength (and neither should regulators). As he noted, Coca Cola has very little tangible common equity yet is highly profitable and financially strong. You don't make money on tangible common equity, he said, you make it on the difference between your cost of funds and the return on your assets net of credit losses. Losses can be absorbed at banks through loan loss reserves, and through all forms of capital, not just tangible common equity. That is why regulators settled on Tier 1 capital, core capital, and leverage as the way to assess banks, and not tangible common equity. Sound policy would do the same. Changing the rules in ways that make banks seem weaker than they are, or requiring them to raise capital when they do not need to do so, is bad policy and is destructive of confidence."

The US prospects from the Chinese bubble

I have been asked if my hypotheses on China (which almost invariably end in US inflation as China combats the effects of a bubble yet to pop with its massive US Dollar reserves) mean that the economic recovery will be tepid and the US is screwed. I outlined the China problem here:
No, I don't believe so. Although I certainly don't claim to know how to time the market, bubbles have historically had a tendency to persist before popping, and the Chinese government has a strong incentive to force the bubble to persist, both because of short-term political maneuvers and also a hope that it can stimulate Chinese consumption and perhaps lessen the fall. As long as the Chinese bubble remains intact, we're fine.
There's more nuance to it.
If US government policy can stay out of the way of the economic recovery (to be determined - I don't like handing over control of the financial system to a political Treasury department instead of a nonpartisan Fed, I don't like the press for top-down renovation of the US economic system, etc), we'll recover; at the very least, I'd expect much lower unemployment at year end. Consensus still has unemployment at 10% and various gvt estimates at 9.5%. Remember how suddenly unemployment cratered? It's perfectly capable of reversing nearly as quickly, with just as little warning. I'm not saying it'll get back to what it was, but the inventory bounce alone should ramp up production more than consensus believes.
Action by the Obama administration on Chinese trade imbalances could cause inflation via the chain listed yesterday, but we're still at a low level of aggregate demand, so a little (keyword: little) inflation wouldn't kill us, because the Chinese government spending its dollar reserves is no different than the US policy of quantitative easing to stimulate the economy*... action on the trade deficit and real action on cutting government spending could combine to make a) US exports more competitive, stimulating employment, while b) lowering the impact of inflation due to the existence of a savings rate in private capital,** and a beneficial improvement in the currency because the national debt doesn't increase so quickly (and because the trade deficit would be going away).
In fact, I wonder if action on the trade deficit right now would actually work to shrink the budget deficit, because the Chinese government would start quantitative easing for us, and that would allow governments to spend less on things like unemployment benefits, etc. This doesn't work anymore once you're into a recovery, but while it may not be good in the medium term, it'll be beneficial in the short term (free stimulus!) and long term (rebalancing). This assumes, of course, that all of these policies (US cutting trade deficit with import certificates, Chinese spending US dollars to keep development going) happen today - the time lag would remove some of these effects. Still worth thinking about.
*EDIT: Bill Miller supports the concept behind my view of the idea that Chinese spending their dollar reserves won't cause significant inflation while the economy is still weak: "Inflation can only arise if labor or business, or both, have pricing power. Labor is still around 70% of the cost of doing business, and there won’t be any inflation there with unemployment at 9.5% and [when this was written in July 2009,] rising. Capacity utilization is 68%, among the lowest in the postwar period. Businesses will have no pricing power until that number is at least over 80%, a long way away."
**(For econ people, yes, I am asserting that private capital is both more effectual and more efficient than government spending, due to government bureaucracy, but also less inflation-causing, because there's less of it due to a savings rate. The inability to deal with government efficiency in a way that would satisfy the Austrian brick-through-a-window parable is what dooms Keynesianism in my eyes as anything but a highly secondary and supplementary policy when monetarism fails.)
EDIT: more from the inimitable Bill Miller, in his July 2009 market letter:
"Our friends at GaveKal Research³ have reminded
us there is a certain rhythm to the remarks
surrounding recessions and recovery. The
psychological cycle goes something like this: first
it is said the fiscal and monetary stimuli are not
sufficient and won’t work. When the markets start
up and the economic forecasts begin to be revised
up — where we are now — the refrain is that it is
only an inventory restocking and once it is over
the economy will stall or we may even have a
double dip. Once the economy begins to improve,
the worry is that profits will not recover enough
to justify stock prices. When profits recover, it is
said that the recovery will be jobless; and when
the jobs start being created, the fear is that this
will not be sustained."

Wednesday, February 17, 2010

A Detailed Mechanism of Inflation in China, and How to Respond

EDIT: The simplest version of this story (still not super simple, but generally simpler) I wrote here:

You may find it easier to start with this before proceeding.

The bottom half of the rest of this post is mine. The top half of the rest of this post is from a piece written by Patrick Chovanec, an economist at Tsinghua (a university in China).

Chovanec's is easily the best description of the potential for Chinese inflation I've ever seen. (I apologize for quoting so much, but it's really a masterpiece). I've added my own comments and extensions at the bottom.
"when the PBOC buys dollars, at a fixed exchange rate, to accumulate as reserves, it issues RMB.  Ordinarily that would mean the supply of RMB in circulation would increase, and if the economy remains the same size, each unit of RMB would buy a little bit less.  That's classic monetary price inflation, as the Monetarists themselves would describe it.

The thing is, China knows that's what will happen and wants to prevent it.  So the PBOC does two things to reduce the amount of RMB in circulation and cancel out the increase in the domestic money supply from its purchase of dollars.  First, it raises the reserve requirement of Chinese banks, and second, it issues bonds — so-called "sterilization bonds" — mainly to the banks in order to soak up even more RMB.  Josh Greenwood, Chief Economist at INVESCO, wrote an excellent paper for the Cato Institute that lays out this process in detail, for those who are interested.  But more to our immediate point, he demonstrates how together the increases in reserve requirements and total bonds issued almost exactly track China's accumulation of reserves.  The PBOC is entirely canceling out the inflationary increase in China's domestic money supply...

The funds — in the form of mandatory deposits and long-term bonds — are basically being requisitioned from China's banks, which in turn are drawing on the savings of Chinese citizens.  They do this in part by selling government bonds, in turn, to the public, and in part by investing their deposits.  In principle these are demand deposits, but in practice, for a variety of reasons — cultural predilection to save, lack of health insurance and other provisions for potential calamity — these funds are locked up in long-term savings.  And the government has a lot of leeway in tapping this large pool of savings, because (1) it owns the banks, (2) it sets interest rates, and (3) it severely restricts the range of other investment alternatives.  The effect of this borrowing is to tamp down consumer demand, not unleash it.

But as Greenwood notes, "monetary sterilization," as the process is known, is not the perfect antidote to inflation it appears to be.  Maintaining a below-market rate for the RMB, which is the whole point of the exercise, fuels the growth of the export sector...So either you get monetary inflation, by expanding the money supply, or you get "overheating" from over-incentivized exports, but one way or another you eventually get inflation."

[He cites Krugman earlier on the mechanism by which an export sector fuels inflation... I know I rail on Krugman a lot, but he is very knowledgeable about trade. The argument:
Consider the real exchange rate, defined as RX = EP*/P, where E is the exchange rate measured as the domestic currency price of foreign currency (so an appreciation of the renminbi is a fall in E), P* is the foreign price level, and P the domestic price level. Basic international macro says that there is a "natural" level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy "wants" to get to that real exchange rate.
If you have a floating exchange rate, you get there via a rise or fall in E. But if you have a pegged rate, there's pressure on prices instead. By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy.

However,  exports were an inflationary problem before the crisis, but since then, exports have cratered. So that's not the immediate risk. The immediate risk is the stimulus:]

"My guess — and I don't think I'm alone here — is that without the stimulus, China would pretty much be treading water on GDP.  And by "stimulus," I don't just mean the RMB 4 trillion package in government spending announced in late 2008.  I mean the more than RMB 10 trillion (USD $1.4 trillion) lending boom led by Chinese banks, of which only 2 trillion went to fund the "official" stimulus.  Even China's National Bureau of Statistics says that this lending boom dramatically expanded the money supply, in a manner that was not cancelled by any sterilization...

Where did this money go?  As I've noted before, China's lending boom evolved over the course of the year.  In Q1, it mainly went out in the form of short-term operating capital loans to prop up struggling businesses.  But evidence suggests those recipients weren't dumb.  Rather than use those funds to manufacture goods they couldn't sell, it appears many borrowers stashed the money in stocks and real estate — which helps account for the astonishing resilience of those markets in the face of last year's slowdown.

By Q2, the picture began to shift, with much of the new lending going into longer term loans, which I interpret as construction and infrastructure projects.  By Q3, the pattern continued shifting, with money going mainly into long-term consumer loans, which I take to be mortgages.  Q4 saw a moderation in lending, but with a continued emphasis on funding construction and mortgages.  There's also plenty of evidence to suggest that a big chunk of business loans to large State-Owned Enterprises (SOEs) made its way into investment in land and real estate development.

I think it's reasonable to say that — besides a big boom in automobile purchases this year — the big growth story in China this past year was construction and real estate.  The government itself, until it began to grow worried a month ago about the prospect of a property bubble, talked up these two related sectors as "key drivers" of growth.  So the picture that emerges is as follows:
  • An ongoing expansion of the RMB money supply to buy dollars (to sustain the US$ peg and support chronic trade surplus, the direct, immediate effects of which are entirely cancelled by "monetary sterilization."
  • An overstimulation export sector which, in principle, can transmit inflationary pressure to the economy, but is unlikely to have actually done so while reeling from the effects of the global slowdown for the past 14 months.
  • A massive expansion of the money supply from an unprecedented burst of bank lending that was channeled mainly into construction and real estate, and to a lesser extent the stock market, accounts for a large part of China's GDP growth over the past year, and was not counteracted by sterilization.
If it's the flow of easy money into certain sectors that's generating all or most of the GDP growth in China, it would not be surprising to find inflationary pressure — whether generated by monetary expansion or "overheating" (or perhaps both, as two faces of the same coin) — initially concentrated in those same "pockets."  You would expect to see asset inflation in real estate (as well as possibly the stock market), and price inflation in key construction inputs such as steel and cement.  Only later would those inflationary pressures potentially reach their way into the rest of the economy and affect consumer prices.  That looks strikingly like what we're seeing in the Chinese economy right now — you could call it "Crouching Stimulus, Hidden Inflation."

Of course, as overseas demand picks up, China's export sector could come back online as a source of inflationary pressure, as Krugman predicts.  But as long as China sterilizes the RMB it issues for dollars, negating the direct monetary effect of the imbalance in payments, its structural overcapacity in exports — sustained, in large part, by the stimulus — will continue to blunt that pressure for some time to come. [This refers to the fact that China has been building more factories and raw material production capacity than world demand can support. This ties into a massive bank overleverage but indicates that exports won't likely remain the problem because supply side issues are addressed]

That's not to say China should be unconcerned.  My worry is that if the expansion in construction and real estate (as well as the flow of money into the stock market), which is generating both the growth and the inflation, proves unsustainable, China could be looking at stagflation.  If you dramatically expand the money supply, and that money goes into unproductive activities that do not produce real wealth, you get the worst of both worlds — inflation without growth. "

The rest of this post is mine.

The logical extension of this discussion is "how long is Chinese growth sustainable in the nature that it has been going"?

China is targeting GDP growth through exports. It prints money to accumulate US dollar reserves in order to make its exports cheap, which increases demand for Chinese goods. The profit from exports then can go into expanding the industrial base. The industrial base is highly inefficient, cost-wise, but it is still substantial, and capacity has expanded so much that, as long as capacity can still outpace demand, I'd argue with any mechanism that suggest short- or even medium-run inflation from demand for low-price Chinese goods over high-priced foreign goods... in other words, while Krugman argues that inflation will happen with a fixed exchange rate because of price equalization, and Chovanec disputes that in the short run, saying that exports aren't high enough to drive up demand enough to move prices, I'm going to go a step farther and say that as long as capacity growth continues in the way that it has, inflation isn't going to be a problem. Additionally, there is enough excess capacity in the market that even if they don't grow capacity, inflation won't be a crushing issue for a while.

Of course, this assumes that capacity can continue to stay high. Clearly, it can't continue indefinitely. I'll come back to this.

If the US or China stops "Chinese mercantilism" and rebalances the Chinese exchange rate, demand for Chinese goods will plummet. A massive number of capital projects will default, the banks will be thrown into disarray, lending stops and WAY more stimulus is required. The Chinese economy stops growing, the money supply explodes, the country endures some lean years with unemployment skyrocketing and commodity and manufactured good deflation from a) loss of demand for capacity expansion and b) overcapacity leading to overcompetition on price, which worsens the default rate. This is a deflation trap (if this doesn't sound familiar, it should... it's not too far from what happened initially in the US, it's just that ours didn't start because of an artificially favorable exchange rate, it started because of an artificially low interest rate).

Of course, there's another step to this. To avoid a very costly deflation trap, the government prints a boatload of money and spends it - both monetary and fiscal policy (in the US, this has been Zero Interest Rates/Quantitative Easing and the dreaded S word, stimulus)... while people disagree on their importance, I think most would agree that up until now, monetary policy has been what has saved us. Either way, you're a) increasing the national debt and b) increasing the money supply.

These steps have a problem. Increased national debt almost certainly means higher interest rates, to compensate from increased default risk. An increased money supply can mean asset bubbles (anyone looking at the price of gold or treasuries?), and eventually, classic monetarist inflation, unless interest rates rise. So you end up with a situation where either a) interest rates need to rise, prolonging the downturn, or b) inflation happens.

Raising interest rates would stunt nominal growth, which would be very, very difficult to do, given their political situation, but it doesn't matter. I would speculate that in an inflation situation, the Chinese government would probably start instituting price controls domestically, and start using its trillions in US currency reserves to purchase goods internationally. The US needs to increase interest rates (nontrivially, because Chinese dollar demand will be insensitive to interest rates) or experience inflation of its own. The US starts toeing the line between stagnation, inflation or both. In a high interest rate situation, China can start using dollar reserves for international purchases and shift Yuan to transfers to people looking to finance their own consumption ("look at the Communist party/Chinese government caring for its people after the villainous West steps in to stop our growth! We will persevere!"). Either way, this doesn't look too pretty for the US.

Thus, China ends up in a pickle and real growth slows down significantly the moment the exchange rate starts slipping.

The exchange rate starts slipping when Chinese government bonds stop being appealing to Chinese citizens, and bank capital requirements can't be raised anymore because they're basically at the gold standard. Chovanec believes that stimulus will cause inflation, but stimulus funds can be mopped up with (long overdue) bank capital requirements when international demand comes back. It's possible, given the stunning size of Chinese stimulus (larger than anywhere else in the world), that China needs to suck up some inflation to absorb the stimulus (higher interest rates are barely an option at this point, because they'd slow down the growth that's propping up their asset bubbles). So yes, China could see some inflation from stimulus, and it's possible that the stimulus alone would be enough to start getting them to draw down their dollar reserves. I don't know that we have any idea how bad inflation would get, so it's hard to make that call.

What can bail out China is consumption - when the Chinese people can consume the extra capacity they have so that the government doesn't need to keep artificially pegging the exchange rate, they can stop pumping Yuan. Of course, they'd have to decrease exports at the same rate they increase consumption, or prices will start rising again, leading to interest rate hikes and recession. This brings us back to the capacity growth problem from the beginning - if capacity dips too low for export demand + consumption, prices go up, and you have interest rate hikes or inflation again. So you need consumption to grow way faster than capacity, while still leaving ample room for capacity. Functionally, what China is doing by shifting exports to consumption is "exporting their inflation" - they deflated our (US and other foreign) prices artificially, largely to our benefit, and are now walking it back down so WE pay more instead of them, and they haven't reduced consumption, so natural resources prices stay unevenly high, depending where capacity has come online.

There are a few outcomes:
1) US intervention on the exchange rate (tariffs, either of a beneficial or destructive kind) causes disaster for China, and helps the US in innumerable ways (as long as the budget deficit can come down with it), although it also causes prices to undergo a one-time spike. Spending of US currency reserves means we see inflation.

2) Unwillingness of Chinese citizens to continue financing the currency peg (but not consuming with the savings - instead, they'd be saving elsewhere), and an inability to keep forcing the banks to hold more, spells disaster for China. The currency peg slips, causing prices to undergo a one-time spike and closing the US trade deficit. Spending of US currency reserves means we see inflation.

3) China successfully walks the line by growing consumption at the same rate it walks down the exchange peg, without causing a consumption bubble. This happens before Chinese citizens aren't willing to finance the peg. Chinese growth slows down to more normal levels of productivity growth, but crisis is averted, and what a development story... meanwhile, the US undergoes a price spike, the deficit is closed, and Chinese consumption sends natural resources prices higher, leading to inflation AND the Chinese still having US monetary reserves to cause us inflation later in the future.

These can be exacerbated by:
1) Chinese stimulus causes inflation internally, leading to increased spending of US currency reserves.
2) Chinese stimulus causes only mild inflation internally, because it's sopped up by capital requirements. Their real estate bubble pops, cratering consumption.

So how does the US get out of this alive?
There are two huge reasons why the US has let China build up such huge US currency reserves.
1) We have a large government budget deficit that we have trouble financing internally because not enough people want to save government bonds. Obama has already talked about giving people tax rebates in the form of government bonds to try and finance internally. A much, much, much better solution is to cut the budget deficit. Pigouvian taxes and government spending are better targets for this for efficiency and economic growth reasons. General tax increases probably won't help the matter much.

2) We cannot provide enough oil for ourselves to run our cars, so we're ok with importing a lot of it. The money we export to buy oil ends up in Chinese hands through trade. Transitioning our auto fleet away from gasoline reduces our demand for oil.

Thus, the prescription for the US is threefold:
1) import-certificate Chinese goods. In the short run, this won't be pleasant, it may have to happen gradually, but as long as China is pegging, we don't have a choice - it just gets worse the longer we wait.
2) move vigorously to get off of gasoline in our car fleet.
3) cut government spending and implement pigouvian taxes

Simple in principle, brutal in practice, but that's how it has to go.

My take on things is (roughly) verified in a paper by my Introductory Macroeconomics professor, Ray Fair.

An appreciation of the Yuan would make US goods more competitive with Chinese goods internally and would stimulate internal consumption. Chinese imports would drop due to recession, so there wouldn't be much help to the US there in the short run. Interest rates go up and inflation in the US happens (partially because our imports go up in price, and partially because the government can't finance its deficit). The net effect is small but we're put in a better situation of stability - as in, the sooner this happens, the less inflation happens.

Of course, what Fair doesn't consider is the idea that the government can reduce wasteful spending at the same rate as the Yuan appreciates. In that case, you'd avoid the interest rate rise, hopefully, and lessen inflation, without actually harming GDP growth much because the multiplier on wasteful government spending is way, way less than 1.

Monday, February 15, 2010

The Canary in the US Debt Coal Mine

I would suspect that it is not a coincidence that this result came in the first auction after the new Obama budget came out, which predicted that we'll carry deficits way, way in excess of anything we've ever done far into the future. Watching an actual Western country default (Greece) with others circling the drain (Spain, Italy, Portugal, Ireland) could not have helped reassure those who think the US debt load makes it vulnerable. (How China ties into this is hard to say, given how uncertain their response will be to their own massive asset bubble).

"1) Direct Buyers: folks who buy straight from the Treasury, typically comprising a minor stake in US debt purchases

2) Indirect Buyers: folks who buy LARGE chunks of US debt, typically Foreign Governments

3) Primary Dealers: banks that HAVE to buy US debt to ensure an auction doesn't fail. You don't want to see a lot of Primary Dealer purchases as this means that those who can CHOOSE to buy US debt DON'T want to.

On Wednesday, February 10, 2010, the US Treasury issued $16 billion in 30-year Treasuries. Here are the buyer data points:


Purchase Amount (%)

Primary Dealers


Direct Buyers

24% (A RECORD)

Indirect Buyers


First of all, we see Direct Buyers hit a RECORD percentage of purchases. This is extremely bizarre and somewhat disconcerting given that we have no way of knowing who these buyers are. For all we know, they could be the Federal Reserve itself or other US Government entities buying "off the radar."

Indeed, on that note, we know that the US Federal Reserve accounted for 11% of the total purchases. Folks, you're not dealing with a healthy debt auction when the Fed accounts for 10% of purchases.

However, far, FAR more worrisome is the pathetic Indirect Buyer takedown: 28%. Historically this number has been more around 40% (Tyler at ZeroHedge notes that the average Indirect purchase of the last four long-term Treasury auctions was 39.9%). To see such a MASSIVE drop off in Indirect Buyers (40% down to 28%) is a MAJOR warning sign that Foreign Governments are no longer willing to buy long-term US debt."

more evidence:

"The bid-to-cover ratio, which measures demand, came in at 2.67. That's below 3.00 at the previous auction...

The yield on the 10-year Treasury note that matures in November 2019 rose to 3.69 percent from 3.65 percent late Tuesday. Its price fell 11/32 to 97 13/32. The yield on the 10-year note is a benchmark for interest rates on mortgages and other consumer loans....

The yield on the two-year note that matures in January 2012 rose to 0.89 percent from 0.84 percent. Its price fell 3/32 to 99 31/32.

The yield of the 30-year bond maturing in November 2039 rose to 4.64 percent from 4.58 percent. Its prices fell 27/32 to 95 23/32.

The yield on the three-month T-bill that matures May 13 rose to 0.10 percent from 0.09 percent. Its discount rate stood at 0.10 percent."

Friday, February 12, 2010

How many people die from lack of health insurance?

Anyone interested in medicine, health insurance, or anything else should read these, not just for the interesting possibility that very few people die specifically from not having health insurance (anecdotes notwithstanding, and we should all be skeptical of taking this result too far - health insurance for everyone is still a good thing, even if it may not save the 20,000 lives a year some claim it will), but understanding WHY these results come up the way they do (major behavioral or other inherent differences between the insured and the uninsured, big problems with patient incentives in health insurance  - medicare/medicaid and private, and issues of healthcare causing disease by spreading infection, etc) is interesting.
(and before you jump on me for bias, Megan McArdle is a libertarian / classical liberal, and she used to write for the economist:
a sample:
"one of the two studies that went into the most commonly cited number--the roughly 20,000 a year figure from the Institute of Medicine and the Urban Institute--found that the highest mortality was not associated with being uninsured, but being on a government health care program. (the other excluded those patients). This was true even after they'd run all their controls.  Given that the bulk of the coverage expansion in both the Senate and the House plans comes from Medicaid expansion, this is a little disturbing.

But how likely is it that Medicaid is killing people?  Possible, I suppose, but not really all that likely.  Medicaid and Medicare patients, too, are not like the broader population.  The authors in fact recognized this fact in their paper, pointing out that these patients have higher rates of disability--but then failed to address the obvious question this raised about their data on the uninsured.
To my mind probably the single most solid piece of evidence is this:  turning 65--i.e., going on Medicare--doesn't reduce your risk of dying.  If lack of insurance leads to death, then that should show up as a discontinuity in the mortality rate around the age of 65.  It doesn't.  There are some caveats--if the effects are sufficiently long term, then it's hard to measure, because of course as elderly people age, their mortality rate starts rising dramatically.  But still, there should be some kink in the curve, and in the best data we have, it just isn't there.

That doesn't mean I'm prepared to say that no one dies from lack of insurance.  The data is messy, and the studies often contradict each other.  Intuitively, I feel as if there should be some effect.  But if the results are this messy, I would guess that the effect is not very big.  At minimum, I think we should be pretty cautious about stating that we know how many people die from lack of insurance.  We don't, and worse, we may never."
"The bigger problem is that the uninsured generally have more health risks than the rest of the population. They are poorer, more likely to smoke, less educated, more likely to be unemployed, more likely to be obese, and so forth. All these things are known to increase your risk of dying, independent of your insurance status.

There are also factors we can't analyze. It's widely believed that health improves with social status, a quality that's hard to measure. Risk-seekers are probably more likely to end up uninsured, and also to end up dying in a car crash—but their predilection for thrills will not end up in our statistics. People who are suspicious of doctors probably don't pursue either generous health insurance or early treatment. Those who score low on measures of conscientiousness often have trouble keeping jobs with good health insurance—or following complicated treatment protocols. And so on.

The studies relied upon by the Institute of Medicine and the Urban Institute tried to control for some of these factors. But Sorlie et al.—the larger study—lacked data on things like smoking habits and could control for only a few factors, while Franks, Clancy, and Gold, which had better controls but a smaller sample, could not, as an observational study, categorically exclude the possibility that lack of insurance has no effect on mortality at all.

The possibility that no one risks death by going without health insurance may be startling, but some research supports it. Richard Kronick of the University of California at San Diego's Department of Family and Preventive Medicine, an adviser to the Clinton administration, recently published the results of what may be the largest and most comprehensive analysis yet done of the effect of insurance on mortality. He used a sample of more than 600,000, and controlled not only for the standard factors, but for how long the subjects went without insurance, whether their disease was particularly amenable to early intervention, and even whether they lived in a mobile home. In test after test, he found no significantly elevated risk of death among the uninsured. "

Thursday, February 11, 2010

Drilling for biblical oil?

I cannot stop laughing. And yes, the moment he mentioned this company, I did pull up my brokerage account with the intention of shorting it.
This company, with a market cap of $100 million (small fry as stocks go, but still not trivial as a business valuation), drills based on biblical texts and "creation science". As in, it reads the Bible, figures out where oil should be based on the Bible, and undertakes multimillion dollar drilling expeditions based on this. People have actually funded this.
There's a pretty funny video on the blog site. Turns out they've actually rung the AMEX opening bell when they IPOed.

Wednesday, February 10, 2010

Welfare incentives

Katie drew something to my attention yesterday: St. Louis and other cities are having a big problem with welfare, because a lot of families spend less on their children than the welfare check provides per child (this is very plausibly mistreatment of kids by parents), so they are incentivized to have many children, as many as a dozen or more.
There are a number of points to this:
firstly, St. Louis does not provide free contraception and abstinence-only education is common, and the cost of a first child is higher than the cost of subsequent children because you need to buy fixed supplies (a crib, for example). It's a safe bet that a number of these people never would have started down this track of many children intentionally if they hadn't accidentally had a first child unintentionally. So reducing abstinence only education for high schoolers and making contraception more available is one excellent possible solution.
Of course, this doesn't solve the current problem, and the solutions aren't pretty.
A policy of "for each additional child beyond three, you get paid less than the normal child allotment if any of them are over a certain age" (where less can be zero, and the age can be anything) has the effect of reducing incentives to keep having children to stay on welfare. By making the age flexible and the payment flexible, you can try and tune it so that you dont have children starving or turning to the drug trade to stay afloat.
Of course, then you have to be willing to enforce that  - can you watch children not be fed enough because they're mistreated by their parents AND the government isn't giving them anything? It's a commitment you have to be willing to make if you want to disincentivize people from riding welfare rolls.
A way to minimize THAT problem is committing to checking on the welfare of children whose parents receive welfare money, and if the children are not receiving good care, committing to putting them in a home that does (of course, foster parents ALSO have terrible incentives that need to be changed, but that's for another post). If you made welfare money for kids contingent upon kids staying in school, that could significantly decrease school dropout rates, but it also creates massive problems with supplying people into the drug trade. You'd have to make this contingent on strong enforcement of drug laws.
It's not an easy problem.

Will we have a jobless era?

From a friend, Eric:

"It's a fascinating article, but in trying to paint a broad, comprehensive picture, I thought a number of underlying contradictions (among the examples) became rather apparent...
Any thoughts? "

My response, slightly edited for a public audience:

I really dislike that article. Every time he makes a historical economic reference, he's wrong (recoveries have gotten longer and longer? that's news to me... unemployment was less of a problem in the 90s? only because of a very artificial overemployment in the dotcom bubble...)
Jobs are always, always, always, the last thing to drop and the last thing to rise. This "recession" started in the stock market in like June or July 2007, but everyone forgets that, because the stock market is usually the first thing to react. Unemployment didnt begin to creep in for almost a year. The stock market recovered, because it usually recovers first. Jobs take the longest to recover. They'll come back.
It's a fair question to ask what level they'll come back to, but this starts getting into policy questions, and not all of them to do with the recession (it IS, however, a fair point to note that it will be better than everyone's expecting)
1) Yes, it's true that people out of work are less employable, meaning it's tough for them to find work. This effect will be there until the next period of intense labor demand pushes employers to hire whoever is available. That will need a little time, but it'll happen eventually
2) yes, the patent system is stifling, and it doesn't help things.
3) we have a minimum wage that's jumped from the low 5's per hour to the mid 7s per hour very, very quickly, which causes businesses to hire fewer low wage workers, especially young ones and minorities.
4) I agree with the frustrating nature of corporate focus on quarterly results, but that's been there for a long, long time - it's nothing new, and it didn't stifle us before. A longer term approach would be helpful, but im not sure what you could do about this.
5) Massive uncertainty around financial reform, healthcare reform and energy/cap and trade - people are holding off hiring to see exactly what these end up. If Obama has his way, all three will contribute to further joblessness. Fortunately, it seems as if the Republican party is actually defending jobs right now by stomping on all three. (Btw, I do think we need reform in all three areas, i just think Obama's version is awful)
6) China's the gigantic wildcard in this. They're in an asset bubble the type and magnitude of which the world has seen exactly twice in the last 200 years - the US in 1929 and Japan in the 80s. Could they learn from the mistakes of the US and Japan? Maybe, but it's going to be a rough landing. The reason this is such a wildcard is that it's going to affect the prices of everything.... i'd expect commodity prices to come down as they slow down development (did you realize that something like 35 or 40% of Chinese GDP is construction, and that a huge percentage of it is literally building random useless shit to inflate GDP?). It's hard to know if the prices of Chinese goods will drop as companies race to try and desperately sell things to finance their debt, or if prices will increase as bankrupt companies close and supply drops. It's hard to know if the US dollar will drop as the Chinese government starts spending like a madman in the country to support the economy and using dollar reserves to support its currency (or at least doesn't need to consume dollar reserves at the same rate, which is functionally the same thing), or if the dollar will strengthen as the Chinese government decides to artificially weaken the Yuan to prolong the period of growth.

Personally? I'm betting lower commodities costs as the Chinese government demands less, but a little bit mitigated because it'll be accompanied by a weakening dollar (for the simple reason that I don't see the US tolerating more Chinese mercantilism in a period of joblessness - I think tariffs, either in a constructive good form (yuan denominated import certificates) or a destructive bad form (traditional tariffs), are coming from an Obama administration that acts very anti-trade).
I don't see the Chinese letting their factories close, which means greater supply of goods, which should mean they're cheaper, except a weakening dollar should make those more expensive. It's hard to know if this makes everything cheaper or more expensive.
On net, if I'm right, what you should see is a) a productivity boost from lower commodities costs, b) a manufacturing boost from a weaker dollar and accompanying c) inflation. The Chinese goods question is an unclear one, and cheapening/more expensive Chinese goods have differential effects on jobs/productivity and overall consumption by the US.
either way, those things point to a better jobs picture down the road. This is, of course, all speculation and because there are so many effects that can cancel each other out, and so much of it is based on policy predictions, that it's highly uncertain. Anyway, the point is that China is a big wildcard - the most likely scenario in my mind is a boost to US productivity and jobs, with a hit to US consumption. But there are ways of adjusting this so that US productivity and jobs go down too.
Given all of that, it's hard to see us entering a new "jobless America" unless we let it be so. treating this all as a static equilibrium, as opposed to a point-in-time picture of a highly, highly dynamic economy, makes that article problematic.
(That said, a while ago, I posted this: and some of that still applies, though I think that it's turned out that some of the beats were cost cutting and some were analysts being behind, so it's not quite as hard hitting a question as it used to be).

On the Volcker Rule about Prop Trading and Bank Size

This article was sent to me by a friend, Rob:

So, I find the debate about the Volcker rule to be interesting for a bunch of reasons.

1) I think the limits on bank size are VERY dumb and actually terrible for the system. I have updated my thoughts on the prop trading aspect as I've thought about them, so see below.

2) The limits on prop trading are mixed. On the one hand, there aren't significant synergies and it may make bank incentives more inline with treating customers well. It does reduce bank diversification, so that you probably see more frequent credit issues when commercial lending is in trouble but prop assets aren't, or vice versa, but it shrinks the size of those crises. So it's a tradeoff of frequency for severity, with perhaps a little bit of incentive push. That's a good thing.

The interesting part is going to be what it means for liquidity. I think day trading is worthless for liquidity (I'm not saying you can't do it  - I know you work with it - just that it has no social value. Neither does Coca-Cola, but so that goes), and restricting HFT and UHFT, in particular, could actually have some very beneficial societal effects in terms of slowing down collapses to give people time to react, and also just leaching less money away from long term investors (in the form of arbitraging their lack of attention to penny-level detail), giving people more incentive to invest. These are the kind of prop bets that Goldman, etc, say they make.

However, if you define some of the stuff banks use on their balance sheet as prop trading, it significantly alters the demand for various credit flows. It's a brilliant and kind of nefarious way for the government to finance a massive deficit to say that banks can only use treasuries, but it comes at the expense of small business loans, mortgage loans, etc, that are important to the functioning of the economy. Remember that the only reason these banks could use that kind of security on their balance sheets was because they were backed by Fannie, Freddie, Ginnie, Sallie and the other GSEs, and thus counted as government loans. US government bonds carry risk, too (though I doubt any default would come in the form of explicit default, but instead on inflation, which doesn't crater banks).

So the Volcker rule is a backchannel way of facilitating a one-shot expansion of the deficit, while decreasing the private sector role of financing and generally just making credit less available, leading to slower overall macro growth. In other words, the Volcker state makes us look like Europe, which isn't a good thing, if it's applied to the longer term bonds that the banks own.

Thus, neither portion of the Volcker rule is actually that appealing as Volcker envisioned it. Volcker's considered a legend because he had the courage to raise interest rates to lower inflation - he's conservative in the "not aggressive" sense and doesn't seem to value macro growth that highly, which is why it was possible for him to crush inflation. I'd argue that's not a prudent approach here.

There are people out there more qualified than me, but it seems to me that the proper response to this financial crisis is:

a) cut down on some bad industry practices - flash trading, probably dark pools, day trading/prop trading in its strictest sense by banks, and HFT and UHFT with some sort of "turnover tax" where you're taxed for turnover in excess of 400% of your highest account value for the year (400% chosen bc earnings are reported quarterly) - outlined here

b) focus on "too interconnected to fail" instead of "too big to fail" - create exchanges for as much as you can (doesn't eliminate interconnectedness but definitely reduces the size of bailouts when they do need to happen), create some sort of counterparty guidelines for banks who lend to each other and cancel derivatives by reselling them to each other, etc.

 c) subject anyone who trades in securities that are allowed on bank balance sheets to leverage or capital requirements - so hedge funds who trade in things that can sink banks can't sink banks as easily, etc.

d) it'd be good to see the uptick rule in place for financial companies, at least - I know shorting is important but when your stock price affects your capitalization and your capitalization affects your survival, there needs to be something in place to prevent abuses.

e) Instead of a bank tax or tobin tax, create some sort of accelerating bailout tax (in the future this could be done with interest rates, but retrospectively it has to be a tax), where companies pay more and more for the bailout money they took the longer they hold onto it. Companies that really, really need the bailouts are going to pay for them, whereas companies just caught up in a crisis dont really get punished for what was not bad behavior. It also delays bank bankruptcies to a point where the system is a little more robust, but still makes them possible, mitigating moral hazard. I won't go into huge detail but i outline it here:

EDIT: More on why defining "prop trading" as anything a bank holds for a long time is a problem: it mitigates banks' ability to offset some very, very uncertain credit risks. I've mentioned this before here, in my post about financial innovation:

and there is a very nice expansion on this by an Australian Hedge Fund manager in his blog:

"Imagine a suburban bank which takes deposits and makes mortgages.

The deposits are primarily at-call and pay a floating interest rate. Legally they bank has overnight money – and if interest rates rose then the next day the customers could (in theory) all withdraw their money and/or ask for a higher interest rate. The bank does not really know what interest rates it will be paying next week let alone in three years.

In reality the customers of the bank are sticky. There is no way that everyone will pull their money in response to a short term rate rise. The funding of the bank is of uncertain duration.

On the asset side the bank lends on fixed rate but refinanceable mortgages. The bank really has no idea how long the mortgages will last. If rates go down they might all be refinanced tomorrow. People might just sell all their houses and repay their mortgages. In reality however the customer are likely to be somewhat sticky. On the asset side the bank has uncertain duration.

This plain vanilla bank has interest rate risk. If rates rise their funding costs will rise relative to their asset yield. If rates fall their assets will refinance. Their funding cost might also fall – but at the moment the funding cost seems pinned by the zero-bound.

Some hedging of interest rate risk here seems entirely sensible. Banks (and more often S&Ls) have failed in the past because they failed to hedge this sort of interest rate risk. However as both the assets and liabilities are of uncertain duration there is no way of knowing just how much hedging is required. There is a choice here – it is a proprietary choice (in that the bank will trade off hedging costs against profits). And there is no easy way to legislate that choice away."

Edit 2:

one response to the Time article above (not this blog post), by a very, very intelligent friend of mine, who also happens to not be a banker or economist (this should highlight some of the challenges that face intelligent financial reform - even very smart people have trouble with the banking system because our banking system, inherently, is very complex, and I'd be willing to bet you that the writer of this is much smarter than most Congresspeople):

"1) I think the companies on question, on the whole profited from the activities ~ however, since the profits were not put aside for the potential rainy days/year to follow, when the downside indeed materialized, some of these institutions were badly hurt. Instead of giving out 70% of profit as bonuses, the companies could have kept them or distributed to shareholders,who might be willing to tolerate the risk of the downside. Although indeed the losses from propriety trading "did in" these banks, it was because there was no cash cushion ~ which was plundered by management, who did not have to worry about any downside as much

2) One argument in the Time article was: ""If companies can't sell stock or bonds as easily as investors would like to buy them, the cost of capital will go up," says James Ellman, president of the money-management firm Seacliff Capital. "That hurts companies' ability to expand, buy equipment and create jobs. GDP grows slower." Well, this is actually precisely what one would *hope* would happen: If the cost of capital is too high to build those new condos *maybe* you shouldn't be building them. If your GDP is growing too fast due to too much liquidity, eventually you'll crash ~ so slower GDP growth is necessary to avoid harsh corrections. "

My response:
"on 1)
i'm not sure you can look at bonuses as an offset for capital structure, because salary is competitive. If they cut salary, talented people go elsewhere and the profits never materialize. It's the result of a system in which a) the demand for good bankers is very high, and the return to having a good banker is way, way above any conceivable cost, b) the supply of good bankers is very low given banking demand, because banking is hard, and c) it's not always the easiest to tell who is and who isn't a good banker because even the very best fail and even the very worst get lucky. This is a recipe for a "keeping up with the Joneses" salary system where banks pay very high salaries to anyone who looks like they could have talent, because the upside if they're right is so unbelievably high and the downside if they're wrong is so much smaller (which still applies despite the financial crisis, btw).

In other words, banking bonuses weren't the cause of the crisis (in fact, BANKING, in general, wasn't really the cause of the crisis, just the most obvious and stupid piece of a complex system to get crushed). Going after the level of banker bonuses will a) not solve any problems at all even if you were successful, and b) won't be successful because finance is very, very mobile and countries have an incentive to compete for financial infrastructure.

You could have "saved up for a rainy day" by lending at higher interest rates, or lending less. That's a competitively feasible way of saving up for a rainy day... but generally speaking, that's not an issue of greed, it's one of incompetence and mismeasurement, which is why it's such a damn hard problem to fix.

on 2)

cost of capital isn't quite what you're referring to.
what Ellman means is that creating friction or reducing the depth of markets (making it hard to sell stocks or bonds, or reducing the number of them available for sale) will mean people will have to pay more for the exact same benefit. The goal is, and should always be, to have the cost of capital stay low.

The situation you're referring to with the condos isn't about the cost of capital, it's about risk management on the return side.

Very generally speaking, the "economic value added" of a project is equal to its return on invested capital minus its weighted average cost of capital.
What this means is that the economic value of a project is the amount you can make on each dollar you invest minus the cost of obtaining each dollar you invest. Most fundamentally, it's revenues minus costs.

Now, if you take something that is entirely debt funded, then your cost of capital is pretty set - it's the interest you pay on your debt. The revenue you can take in, of course, is far more uncertain, and you have to make projections.
What matters to "not building things in the first place" is that spread between revenue and costs, not the level of costs - if you have a high cost of capital, fewer things get built, but the risk of those things defaulting is determined on the revenue side and thus is entirely independent of the cost of capital. So the problem with a condo that defaults is that people didn't understand the potential revenue distribution, and took projects whose potential spread was too small. Raising the cost of capital would make it a smaller problem because less overall (real) economic activity can take place (it's very hard to have a problem if you have sackfuls of cash with nothing to do with them) but that's not really an effective way to deal with the problem. the issue, instead, should be a) estimating that revenue side better so that you can learn more about the profit margin and b) capital structure controls that ensure people don't take margins that are too small and lets them absorb any mistakes they make without failure.
That isn't done effectively by raising the cost of capital."