Opinion

Felix Salmon

Is it possible to hedge tail risk?

Felix Salmon
Jul 13, 2010 16:58 UTC

Pine River Capital Management has just launched a new hedge fund. You’ll like the fee structure: there’s no incentive fee at all, which makes for a welcome change from the standard structure where the fund manager takes 20% of the profits. But you might not like the performance: it’s designed to lose between 12% and 18% per year playing in the options market.

Why would anybody invest in such a product? As insurance: the idea behind the fund is that it will soar in the event of extreme market chaos. It’s a productized form of tail risk hedging, and it gives a pretty good indication of how difficult and how expensive true tail-risk hedging really is. Especially since there’s no guarantee that the fund will actually work as hoped.

Deutsche Bank’s Ken Akoundi has a great 21-page primer on tail risk hedging, which lays out the various options. For those of us who rely on old-fashioned diversification across asset classes, there’s this handy cut-out-and-keep chart:

correlation.tiff

What you’re looking for here is numbers less than zero. At zero, there’s no correlation at all: for instance there’s no correlation between U.S. bonds and managed commodity futures. Less than zero, and you’re likely to at least partially make up in one asset class’s gains what you lose in another asset class: for instance, if you’re long U.S. equities and also long volatility, then when stocks crash and volatility spikes, you’ll do better than if you just held stocks on their own. The correlation between stocks and volatility is very low, at -0.65.

The other asset class which has a negative correlation with stocks is, again, those managed commodity futures — which are not to be confused with commodities themselves. Those have a positive correlation. It’s worth noting that diversifying internationally doesn’t seem to help at all: U.S. stocks have a +0.93 correlation with foreign stocks.

The problem with trying to invest in asset classes like volatility or managed commodity futures, of course, is that it’s expensive and difficult to do so. You can’t just go out and buy an ETF. Deutsche Bank has its own proprietary products, with names like ELVIS and EMERALD, which try to give pension funds the ability to invest in these asset classes, but again it’s hard to know whether they’ll work ex ante. As everybody knows, in a crisis, correlations all tend to zoom towards 1.

So what other options are there for hedging tail risk? Akoundi presents a pretty long list. There are complex things like variance swaps, inflation floor agreements, and tail risk protection indices, but there are also simpler ideas like buying out-of-the-money index puts, or buying credit protection in the CDS market. And then there are the kind of strategies which ask “if there’s a crisis, what’s likely to happen to certain assets”: Akoundi cites as examples the “sovereign risk commodity hedge” of buying calls on gold and puts on oil and aluminum, or the “sovereign risk rates hedge” of buying something known as a  low‐strike receiver swaption in USD.

I’m not a huge fan of these strategies, because they only work if (a) there’s a crisis like the crisis you think might come, and (b) it plays out in the way that you think it will. Crises, of course, have a way of being unexpected, both in terms of where they come from and how they play out. That’s why someone like Peter Schiff could position his investors for the coming crisis, see the crisis materialize, and still lose his investors lots of money.

There’s another way to deal with tail risk, and that’s the Nassim Taleb approach: put 90% of your money in Treasury bills, and then invest the other 10% in options and other instruments which normally go down but which are likely to pay off massively if there’s a crisis or a major spike in inflation. If they don’t, well, at least you still have 90% of your money in Treasury bills. But that kind of strategy is much harder to pull off if the bulk of your money is in stocks rather than risk-free investments.

Ultimately, tail risk is something that’s very expensive to hedge, and attempting to do so might well fail. It’s worth thinking about, but some things, while great in theory, just don’t work so well in practice. And I don’t think there are any tried-and-tested tail-risk hedging strategies.

COMMENT

Wearing a bullet proof vest everyday is a sure way to reduce the risk of a mortal bullet wound to the chest, however, staying inside all day would even be better.

Of course this analogy does not profit you much…the better strategy is learning how to “dodge” bullets. My 8 year old understands moving averages (not to start a discussion on MAs) and this could have curtailed a lot of loss if one simply “dodged” the bullet.

These discussions can be of great help to new investors, but some times its best to keep it simple.

Posted by Nicoli1020 | Report as abusive

Are kids getting less creative?

Felix Salmon
Jul 13, 2010 14:05 UTC

Po Bronson and Ashley Merryman take to Newsweek to break the shocking news that creativity is on the decline:

With intelligence, there is a phenomenon called the Flynn effect—each generation, scores go up about 10 points. Enriched environments are making kids smarter. With creativity, a reverse trend has just been identified and is being reported for the first time here: American creativity scores are falling.

Kyung Hee Kim at the College of William & Mary discovered this in May, after analyzing almost 300,000 Torrance scores of children and adults. Kim found creativity scores had been steadily rising, just like IQ scores, until 1990. Since then, creativity scores have consistently inched downward. “It’s very clear, and the decrease is very significant,” Kim says. It is the scores of younger children in America—from kindergarten through sixth grade—for whom the decline is “most serious.”…

It’s too early to determine conclusively why U.S. creativity scores are declining. One likely culprit is the number of hours kids now spend in front of the TV and playing videogames rather than engaging in creative activities. Another is the lack of creativity development in our schools. In effect, it’s left to the luck of the draw who becomes creative: there’s no concerted effort to nurture the creativity of all children.

There’s no link to Kim’s paper, which I suspect has not (yet) been peer-reviewed. But I’m inclined to take this finding with a very large pinch of salt.

For one thing, as Kim himself has demonstrated at some length, it’s hard to make apples-to-apples comparisons of Torrance scores as they change from decade to decade. Which makes sense, since conceptions of things like originality and elaboration are culturally determined and evolve over time; indeed, every so often the tests are “renormed” making long-time-series comparisons even harder.

The nature of creativity might be changing: children who grow up with videogames might be creative in different ways to children who spend more time with more traditional toys. And that change in creativity might well show up as a decline in a creativity test invented in 1966, renormings notwithstanding. I’d certainly be interested in what Steven Johnson thinks of Kim’s paper, if and when it’s released.

I’d also love to see statistical evidence that the decline in Torrance scores is significantly correlated with a decline in (rather than simple lack of) creativity development in schools. Bronson and Merryman spend a lot of time talking about how schools can and should teach creativity, but they never quite come out and say that schools were better at such things in the past than they are today.

I have no problem with creativity-based education being baked in to school curricula, and there’s a case to be made that such a change is desirable whether or not Torrance scores are declining. That said, the evidence in favor of innovative kinds of teaching is often based on looking at a handful of schools which have adopted such ideas enthusiastically, and those kind of findings tend not to scale when you try to adopt them across an entire school system. And if big changes to a national curriculum are being proposed as a solution to a given problem, the first thing to do is surely to check and double-check that the problem actually exists. So let’s hold off a minute, here, and look for reactions to Kim’s finding within pedagogical circles. A single paper from a single researcher shouldn’t be enough to spark widespread worries about our children’s creativity.

COMMENT

you’re all in denial

Posted by rjs0 | Report as abusive

Paying executives in debt

Felix Salmon
Jul 13, 2010 13:17 UTC

Alex Edmans makes a very good point today: it makes a great deal of sense, especially in leveraged companies, to pay CEOs in debt rather than equity. What’s more, such compensation is already quite widespread: if a company has promised an executive a defined-benefit pension upon retirement, that’s essentially unsecured debt of the company, and can be substantial.

Edmans is right that there’s the germ of something possibly quite powerful here. If companies started institutionalizing payment-with-debt, rather than having it simply be a necessary byproduct of making promises to pay out money in the future, that could go a good way towards reducing incentives for executives to take on excessive amounts of risk:

The risky project can sometimes create value (e.g. investing in R&D) but sometimes destroy value (e.g. subprime lending). A CEO who holds exclusively equity will take the risky project even when it destroys value (a behaviour known as “risk shifting” or “asset substitution”) because, if he gets lucky and it pays off, his equity will shoot up in value, but if the project is unsuccessful, it is bondholders who suffer the bulk of the losses – as has been clear in the recent global crisis. Equity holders’ losses are capped by limited liability – thus, if the firm is already close to bankruptcy and equity is close to zero, things can’t get any worse and so the manager may “gamble for resurrection,” taking riskier and riskier projects to try to salvage the firm.

The problem, of course, is getting companies to sign up to such a scheme. Compensation committees are created by the board of directors, which is elected by shareholders, not bondholders. So it’s only natural that those compensation committees will structure things in the benefit of shareholders, with bondholders bearing the brunt.

But in extraordinary circumstances, it can be done. AIG executives’ compensation is in 80% debt and 20% equity, for two unusual reasons. Firstly, the equity is worthless, and the executives know that the equity is worthless. And secondly, the debt is paying an attractive coupon.

Expanding this model from AIG to other leveraged companies will be hard. But increasingly institutional investors place their money across the whole capital structure of a company, rather than just in equity or in debt. If a firm’s big shareholders are also big bondholders, they might be able to persuade the board to do the right thing.

COMMENT

Felix, think this guy is a little bit confused. He is confusing people who bought ABSes and the bondholders in the firms. Bond holders most certainly did NOT get screwed in the current environment – with the politically sensitive exceptions of the automakers where the current regime decided to screw bondholders to payoff the people who had caused the automakers to crash in the first place, organised labour.

With the notable exceptions of WaMu and LEH most holders in debt of financial orgs were made whole and it was equity holders who got shafted. Look at Fannie, Freddie, AIG, BSC, C etc. This bondholders got bailed out because they were politically sensitive, such as the chinese and Russians who stood to get killed if the GSEs defaulted or pension funds who invested in “safe debt”.

Also debt is usually considered LESS risky than equity. You are senior in the capital structure and like equity the most you can lose is your principal and you have a contractual arrangement to receive coupon payments unless you are a zero. The only thing that he says that sort of makes sense is that in a near insolvent company a bondholder has more incentive to force a bankruptcy than shareholders because of this seniority

Needless to say if your assumptions are wrong that casts doubt on your conclusions.

Posted by Danny_Black | Report as abusive

Counterparties

Felix Salmon
Jul 13, 2010 05:37 UTC

Merkel’s Rules for Bankruptcy: Berlin Club as ‘International Guarantor’ — Spiegel

Adventures in bank PR doublespeak, BofA edition — ProPublica

Wherein the Daily Telegraph calculates that £20 placed on a 3,000-to-1 bet will pay out at £6,000 — Telegraph

Box-office futures, RIP: Cantor fires most of its HSX staff — The Wrap

Consumer Reports Says It Doesn’t Recommend Apple’s iPhone 4 — Bloomberg

William Poundstone’s new book sounds like a great addition for your behavioral-economy shelf — Aleph Blog

COMMENT

it’s the extra 000′s and that British lb. sign…add in it’s a story problem and it’s 4th grade, right? :)

although I wonder if the odds makers blew it, too…I thought the odds were 2^7, which is 256, not 300, and not 3000. SO they not only failed basic math, but probability!

Posted by REDruin | Report as abusive

Short-seller demonization watch, ProPublica edition

Felix Salmon
Jul 12, 2010 20:08 UTC

Remember when left-wing inside-the-Beltway pressure-group person Tom Matzzie started demonizing Steve Eisman for being a short seller, without actually engaging with any of his arguments about how for-profit colleges are causing a huge amount of damage and very little benefit? Well, it wasn’t long before another inside-the-Beltway pressure group joined in: this time it was Melanie Sloan, of something called Citizens for Responsibility and Ethics in Washington.

Sloan’s letter to Tom Harkin, of the Senate Committee on Health, Labor, Education, and Pensions, received a great reply, pointing out that Sloan had no problem with people invested in the for-profit college’s success testifying in front of Harkin’s committee:

Mr. Eisman is not the only person to testify before a Senate Committee this year who has a stake in federal policy. Indeed, the same panel had another witness with a financial stake in the regulatory treatment of for-profit colleges: Ms. Sharon Thomas Parrott of DeVry University. In the case of both Mr. Eisman and Ms. Parrott, their financial interests did not preclude them from having valuable information that benefited our discussion of the for-profit educational industry…

We welcome your observations and invite you to further explore the actual matter of our hearing. I have attached a report released at the hearing that outlines in greater detail how the for-profit colleges receive $23 billion in taxpayer dollars, but offer little transparency regarding the outcomes of that investment. Your assistance in seeking greater transparency in the for-profit higher education industry, for example, on behalf of its students, as well as taxpayers, would be a great service.

Good for Senator Harkin. But of course there’s clearly a fishy organized campaign going on here: why exactly are people like Matzzie and Sloan suddenly getting terribly exercised about Evil Hedge Fund Short Sellers in general, and Steve Eisman in particular? Eisman’s testimony is very compelling, and so the only possible grounds to attack him are ad hominem ones, essentially saying that he can’t be allowed to testify just because of who he is and how he makes his money.

Now Matzzie and Sloan have a most unlikely new bedfellow in their campaign against the short sellers: Sharona Coutts of ProPublica. Last year, ProPublica launched what it calls an “ongoing investigation” into for-profit schools, especially their graduation and loan-default rates. She’s naturally on the side of the angels here, which is to say, the short-sellers. But nothing was published in 2010, until now, when Coutts filed a story headlined “Investment Funds Stir Controversy Over Recruiting by For-Profit Colleges.”

You might remember Coutts from a dreadful story she filed in 2008, attacking Goldman Sachs for putting out credit research. This story isn’t half as bad as that one, but at heart it’s similar, assuming that anything done by anybody on Wall Street must be suspect:

Some short sellers appear to be moving beyond assessing particular companies and taking a financial position accordingly. Now, says the Career College Association, some are trying to stage-manage the reporting of negative stories to fuel the impression of a groundswell of anger against the schools.

“Certainly there are legitimate critics. I may not agree with them, but they’re not in it to fatten their wallets,” said Harris Miller, president of the CCA, which represents for-profit schools. “But I think that a lot of the activity going on, and with other media reports, is being driven by the short sellers, who are hiring people who are semi-disguising who they are and not being candid with people about their role in trying to drive down the stock price of certain companies.”

The only remotely scandalous thing in Coutts’s story is the tale of a single researcher, Johnette McConnell Early, who helped to organize a letter signed by the representatives of 19 different homeless shelters, complaining about how “for-profit trade schools and career colleges are systematically preying upon our clients.” Early’s mistake was that she didn’t tell the signatories that she was employed by an investment firm. She could and should have done so, because now some of the signatories feel that they were duped:

“Had I known, I probably wouldn’t have signed on,” Panico said. “I probably would have contacted one of the other people and said, ‘Hey, now that we have all this information, let’s do this ourselves.’ I think it’s sleazy to basically use me and use other executive directors that have a real issue to make a profit for some companies.”

The irony here, of course, is that the letter would have had even more force if Panico and the other signatories had simply taken the information from Early and put together the letter themselves: that way no one could discount the real moral force behind the letter on the grounds that there was any kind of hidden agenda.

But instead, Coutts is now writing a silly exposé of a non-issue, quoting the paid representative of the for-profit schools uncritically, and training her sights instead on exactly the people who are willing to invest a lot of time, effort, and money into uncovering the gruesome truth.

Coutts doesn’t know who paid Early: it may or may not have been Eisman. I hope it wasn’t: it would be an ethical blunder on Eisman’s part to be anything but fully transparent about his efforts to get the government to crack down on this sordid industry. On the other hand, she’s not being entirely transparent herself about where she got the information that Early was working for a hedge fund; in fact, she never says in the article who fed her that particular nugget. If I had to guess, I’d say that it was Harris Miller, and I’d also be very interested in finding out what his connections might be with Matzzie and Sloan.

As for the headline on Coutts’s piece, it’s clearly Coutts herself, rather than “investment funds,” who’s stirring controversy here. (Incidentally, it’s pretty hard to justify the plural in the headline: even if Coutts Early was hired by an investment fund, it’s pretty safe to assume that there was only one fund involved.) Unless and until Coutts started phoning up the signatories to the letter and asking them how they felt about being duped by Evil Hedge Fund Short Sellers, there was no controversy here at all: in fact, it looks to me that the entire controversy, insofar as it exists, has been manufactured by Coutts and the anti-Eisman brigade. Certainly there’s no indication, anywhere in Coutts’s story, that the likes of Miller and Sloan look pretty desperate if the biggest gun they have to train on Eisman’s arguments is that a single researcher, who might not have anything to do with Eisman at all, made a stupid mistake regarding her personal disclosure. Especially since full disclosure would have made no real difference to anything.

The lesson here, I think, is that short sellers have to be very, very careful to be whiter than white in anything they do or say: the companies they’re campaigning against will happily just start shouting “short sellers!” in an attempt to drown out rational argument — and those shouts, sadly, can be very effective. Happily, Tom Harkin, at least, seems to be quite good at ignoring them.

Update: ProPublica’s Dick Tofel leaves a comment, saying that “ProPublica found out who wrote the letter by asking some of the people who signed it”. Which makes the whole thing seem even less scandalous.

COMMENT

Kid, I need no luck. My ethics remain intact and although you feel a need to reproduce the same argument over and over, I am not moved by your ‘facts.’ I was only interested in the fox being asked to guard the henhouse and ethics being thrown out the window.

I understood your (supposed)position and where it came from, from the beginning, but see it more as a defense of Eisman, given your admiration of his ilk and a demonization of the authors rather then some (supposed)interest in the students or the reason for the inquiry.

I think you are both full of it in that regard, so PLEASE do not bother to explain your (supposed) logic.

Posted by hsvkitty | Report as abusive

The economics of a college degree

Felix Salmon
Jul 12, 2010 17:04 UTC

BusinessWeek has a big feature on the value of a college degree, and naturally has presented it in the format of a ranking. College rankings are profoundly silly things, and this one is no exception; it purports to calculate the extra amount of money that graduates of certain universities earn, compared to the amount that they would earn if they hadn’t gone to college, thereby coming up with some kind of dollar figure for value-for-money. It then ranks “30-year net return on investment”, which ranges from $1.69 million at MIT to just $998 at Black Hills State University in Spearfish, South Dakota.

There’s a lot to dislike here, and the BW story twists itself into knots listing one disclaimer after another. For one thing, the survey doesn’t look at how much people actually spend on college tuition: it just looks at the headline rack rates, failing to take into account any kind of grants or student aid. It also uses a 30-year-long dataset, which includes a lot of years when women were chronically underpaid. That penalizes women’s colleges.

What’s more, the survey does a very bad job of quantifying the benefits of a liberal-arts degree. Let’s say you go to college and then earn $45,000 a year working in the theater, or you end up with a steady job in public administration or social services. You’re clearly better off in many different ways than a high-school graduate earning the same amount — you’re probably happier in your job, you’re doing what you want, and you have more job security. But the BW methodology would give you a negative return on your university tuition, on the grounds that you missed out on earning money while you were at college.

There are other problems with the survey, too, which aren’t even hinted at in the BW story. Pay for college graduates has been rising over the past 30 years, while pay for individuals with no more than a high-school education has been falling sharply. But the survey pays no attention to those trends, and assumes that the income prospects for someone with no college education are the same now as they have been, on average, over the past 30 years. Needless to say, that’s ridiculous.

The survey also assumes that students who drop out of any given university will make no more money than if they hadn’t enrolled at all. That’s trivially false in the case of top-ranked universities like MIT and Stanford, where you could probably make the case that dropouts end up making more money than graduates.

And the survey also concentrates solely on income, rather than wealth. Getting large paychecks is one — but only one — way to get wealthy. And I’m pretty sure that college graduates in general are wealthier than non-graduates earning the same amount of money. If nothing else, they have a tendency to marry each other, so even if they don’t end up earning a lot of money themselves, they can still benefit from their spouse’s higher income.

Even with all those caveats, one thing jumps out from the survey, which again BW doesn’t mention: even the very worst-performing colleges — the ones coming 851st and 852nd out of 852, for instance, where fewer than one in three students even graduate — have significantly positive “annualized net ROI”s. John Carney looks at these numbers and concludes that “the ROI on going to college is worse than the S&P” — not when the ROI on the S&P is negative, it isn’t. Clearly anybody who’s got a good chance of graduating from university would be much better going to university than investing their tuition money in an S&P 500 index fund.

The one thing which most annoys me about the survey, however, has nothing to do with the methodology, and rather the way that the results are presented: you have to do a lot of clicking and scrolling to try to read them, and they’re not searchable. So while the results carefully make the distinction between public and private colleges, they don’t make the distinction between for-profit and non-profit private colleges. Are there any for-profit colleges in the list? How do they stack up? That’s one datapoint I’d be fascinated to see, but I can’t find it anywhere.

COMMENT

When I was 20, I was a college drop out. In my 20s I worked very hard to become an expert software engineer – mainly self-taught. By 31, I was VP of software engineering and had “made it.” Only after I had a child did I feel the need to formalize my education so that she could aspire to similar success. By 40 I had my master’s and now I teach part-time at a university. Not having a degree hung over me for a long while and now I finally truly feel as if I’ve “Made it.”

Posted by MinFL | Report as abusive

Moving out of equities

Felix Salmon
Jul 12, 2010 15:29 UTC

The WSJ’s Jim Browning has a big story today saying that small investors are “fleeing stocks” and “running for cover”. And interestingly, this is not a particularly new phenomenon, and it predates the big crash of 2008:

flows.gifAfter getting hurt in the 2000 tech-stock crunch, individuals came back to U.S.-stock funds in 2003, as stocks were entering a new bull market, ICI data show. But the buying proved tepid and turned to net selling in the latter part of 2006, even before the bull market ended in 2007. Despite occasional periods of inflows to U.S.-stock funds, the selling trend has continued since then.

It’s only natural for buy-side types to look at this data and conclude that this is a great buying opportunity — but I’m not so sure. Browning concentrates on investors who are rotating out of equities by choice, but I suspect that a lot of what’s going on here is a matter of necessity: people are selling their stocks because they have to, not because they want to. After all, they no longer have the ability to take out home equity lines of credit whenever they run into a liquidity crunch.

There’s also a certain amount of delevering going on, which is encouraging: Browning talks of one investor who sold a third of his stocks and used the proceeds to pay down the mortgage on his second home. Sensible.

And while Browning talks of the new conservatism as emblematic of the way in which the stock market is being left to large institutional investors, the fact is that underneath their monolithic exteriors, those big investors are mostly just aggregations of little investments at heart. It’s entirely possible that retail investors are ahead of the curve, here, and that institutions will end up following suit: what are the chances that they will continue to see inflows rather than outflows, over the long run?

What’s undeniable is that it makes a lot of sense for the “comfortably retired” Karen and Roger Potyk to sell their stocks. If you have enough money to live on, why take the risks associated with equities? Especially when doing so makes you feel bad about yourself morally?

“In the military, you learn that you want people you can respect, trust—who have integrity,” Mr. Potyk says. “Over the last five years or so, I find that our financial institutions have no shred of the character I describe.”

The last straw was the May market volatility, accompanied by widespread fears about European government debt. On May 20, the Potyks asked their financial adviser to sell the last of their stock mutual funds.

Now that their portfolio consists entirely of fixed-income investments, “I won’t make 8% on my money. I will make 4% or 5%, but the money will be there,” says Mr. Potyk.

It’s worth noting here that Mr Potyk still thinks of stocks as something which can and should return 8% a year, despite the fact that they’ve done nothing of the sort for the past decade. In that sense, we haven’t had a real capitulation yet. It’s rational to exit the stock market even if you think it’s going to go up, so long as you also think there’s a serious risk it’ll go down, and you can’t afford to lose that hard-earned money. But for the time being, in the public mind, stocks are still things which go up over time. Which says to me that there’s still at least as much downside as there is upside.

COMMENT

ckbryant, a high comfort level with your approach is perhaps the most important piece of any investment plan. The people who REALLY do poorly are those who are constantly panicking when the market cycle turns against them, chasing yesterday’s returns and finding that they consistently catch tomorrow’s losses.

If you stick to index investing, your current approach is sound. However, I would encourage you to at least consider the possibility of picking your own domestic stock portfolio. Because the S&P500 is dominated by the mega-caps anyways, you can restrict your attention to the big names without significantly altering your investment universe.

The reason for investing in index funds is the (essentially accurate) premise that no strategy will consistently beat the market by a significant margin. However the flip side of that is equally accurate — no sensible strategy will consistently UNDERPERFORM the market by a significant margin (assuming low transaction fees and no tax implications).

Thus my strategy is focused on quality companies, sound management and accounting practices, easily understood businesses, and modest, predictable growth. I won’t beat the market with this strategy — but I’ll capture a majority of the positive returns with roughly half the downside in any crash scenario. My portfolio with 80% stocks is actually less volatile than an index-based portfolio with 60% stocks (and I’m betting will have superior returns in the long run).

Those who view the stock market as a (toppling) monolith are tarring with a broad brush… If you explicitly set out to reduce risk, you can construct a balanced portfolio that successfully reduces risk without sacrificing much of the upside. I will absolutely lag the market if it goes on a 20-year bull run, but if THAT happens I’ll never live long enough to spend my savings anyways. I’m more concerned with getting a reasonable ROI in scenarios involving economic stagnation and/or turmoil.

Posted by TFF | Report as abusive

The minimum wage and productivity

Felix Salmon
Jul 12, 2010 14:45 UTC

Cardiff Garcia pushes back a little at my contention that raising the minimum wage might help the problems of unemployment, underemployment, and bad employment:

How do we know that with a higher minimum wage, employers will “compete on who has the best employees” and “invest significantly in those employees”?

It seems just as possible that employers would react by doing one of the following, or some combination thereof:

  • Hiring fewer workers and asking existing workers to do more (a tactic employers are more likely to get away with in an environment of sustained unemployment)
  • Investing more in capital (whose price relative to labor obviously declines as the minimum wage increases) to help the company do the same work with fewer people
  • Simply continuing to compete on price, even if the prices will be higher across the board as the increased minimum wage affects all employers in the same industry…

I’ve never seen the argument that employers react to higher minimum wages by increasing their investment in human capital.

To Cardiff’s last point first: pretty much by definition, an increase in the minimum wage forces an increase in employers’ investment in human capital. And my point is, at heart, the idea that the more employers spend on human capital, the more they think about it as an investment, as opposed to merely an expense.

To Cardiff’s other points, yes, it’s entirely possible that employers will hire fewer workers to do the same job, if those workers become more expensive. That’s called improving labor productivity, and it’s a good thing, especially when labor is rewarded for its improved productivity in the form of higher wages. Going back to Rich Florida’s original point, America doesn’t just need more jobs, it needs better jobs — especially in the service sector. And in the long term, more productive companies are more successful, and grow more, and end up hiring more people. Higher-productivity jobs are precisely the ones we most want to create.

Finally, Cardiff seems to worry that an increase in the minimum wage would cause price inflation. We should be so lucky. Right now, a bit of wage-driven inflation is exactly what the doctor is ordering. I just don’t see it happening, unfortunately.

COMMENT

1.Imho you totally miss some basic economic fact/laws.
Higher wage will simply (at least at first) mean lower demand for labor.
2. In the Henry Ford days because of a mostly closed economic enviroment (US as a seperayed market) it also meant higher demand for products etc. in THE US.
3. The problem is the situation has largely changed. It might short term at least mean higher demand but this could be (or is even likely) demand for Chinese goods.
In the present situation it would work as well on a per country basis (as you are suggesting) as it would by only implementing it in say Ohio and not in neighbouring states.
In a worldmarket you have to look at things on a worldscale.
4. At the end of the day the wealth of the US as well that of other countries is too a large extent based upon what you can sell abroad so you get money that can be used to buy the things you want or need from abroad. Increasing minimum wage doesnot make the US export more it simply only makes it more expensive. Leading to lower exports and for ther country as a whole less wealth. Only because the division of income has changed low incomes could overall be better of but the rest an dthe country as a whole will be worst of.
5. Employers will only invest in human capital if they cannot get the same kind of thing for free (or at least cheaper). Making the lowest category as expensive as the next one (with a lot of unemployment) will simply lead to replacing them by better educated ones.
6. PER EMPLOYEE employers might invest more however that doesnot mean that OVERALL they will invest more.
7. You use basically the same argumentation as a lot of (semi-) socialist European governments have used by increasing the number of civil servants (they consume and you train them as well) Now we see where that has brought them.
8. Imho rising minimum wage will be an economic disaster
(like you can see in many countries in Europe) high minimum wages simply mean more unemployment in that sector.
9. Escape from there is imho only possible by especially better education other measure are simply ignoring economic facts and a total waist of time and energy. Could do more harm than good.
10. If you like to do the increase for other than economic reasons, social or political please say so, but don’t try to use economic arguments that make no sense from an economic point of view, for that.

Posted by Rikh | Report as abusive

Why Bernanke won’t ease further

Felix Salmon
Jul 12, 2010 14:20 UTC

Paul Krugman’s column today is devoted to telling off the Fed for not being aggressive enough about deflation:

Conventional monetary policy, in which the Fed drives down short-term interest rates by buying short-term U.S. government debt, has reached its limit: those short-term rates are already near zero, and can’t go significantly lower. (Investors won’t buy bonds that yield negative interest, since they can always hoard cash instead.) But the message of Mr. Bernanke’s 2002 speech was that there are other things the Fed can do. It can buy longer-term government debt. It can buy private-sector debt. It can try to move expectations by announcing that it will keep short-term rates low for a long time. It can raise its long-run inflation target, to help convince the private sector that borrowing is a good idea and hoarding cash a mistake.

Nobody knows how well any one of these actions would work. The point, however, is that there are things the Fed could and should be doing, but isn’t.

In a blog entry, Krugman explains why he’s so convinced that deflation is a real and immediate problem: monthly price inflation has been falling steadily since January 2008, and has now reached the point at which it’s sometimes negative.

Krugman’s argument is certainly defensible. But I do wonder whether he isn’t essentially asking Ben Bernanke to step up and provide the stimulus that Summers and Geithner have rejected:

Washington seems to feel absolutely no sense of urgency. Are hopes being destroyed, small businesses being driven into bankruptcy, lives being blighted? Never mind, let’s talk about the evils of budget deficits.

Still, one might have hoped that the Fed would be different. For one thing, the Fed, unlike the Obama administration, retains considerable freedom of action. It doesn’t need 60 votes in the Senate; the outer limits of its policies aren’t determined by the views of senators from Nebraska and Maine.

This is the point at which I remind myself that Bernanke is a Republican. He’s not a party-political hack, but he never evinced any substantive disagreement with Alan Greenspan when the two of them were on the FOMC together, and his extraordinary interventions into the realm of unprecedented monetary policy nearly all happened while he was working hand-in-glove with a Republican administration. Now, Krugman is asking him not only to break significantly away from Republican party consensus but to go much further than even Democrats seem willing to go.

Bernanke is a consensus builder, as Krugman knows, having been part of the Princeton economics department during Bernanke’s tenure as its head. And it may or may not make sense for the Fed to ease much more aggressively. But so long as that remains outside the general consensus, Bernanke’s not going to do it.

COMMENT

Ok, now time for a total reversal. The scales have fallen off my eyes.

With the US dollar as our reserve currency, we suffer a massive problem of Dutch disease.
“Dutch Disease and the U.S. Dollar”
http://seekingalpha.com/article/212811-d utch-disease-and-the-u-s-dollar

Here is some good reading to understand Dutch disease and its cures.
“The Dutch Disease and Its Neutralization: A Ricardian
Approach”
http://www.networkideas.org/featart/jan2 010/Dutch_Disease.pdf

The point is that having the dollar as the reserve currency is not helping us; it is hurting us. ‘Irresponsible’ Q.E. would go far to cure American Dutch disease by scaring away the flood of capital. This is very serious because our economy is being gutted.

Posted by DanHess | Report as abusive
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