The tax cut compromise as a sign of broken politics

So in order to avert a middle class tax hike, Obama agreed to revert tax cuts for everyone and a cut to the payroll tax. In order to give Obama and his party what they wanted, Republicans agreed to extend unemployment benefits.  Everyone wins, just as long as the government can spend money that it doesn't have.

When people worry about inflation or deflation, they are wrong as long as politics are functional. However, events like the recent compromise demonstrate that politics are not really functional.  If more compromises of this nature are expected, then that means that it might take a crisis to fix the deficit.  If the crisis is about dollar confidence, then the crisis will be inflationary. If the government is able to react with austerity to head off the crisis then the crisis will be deflationary.

It is hard to know which way the economy will break, but with each compromise of this nature the probability of a long term goldilocks goes down.

Shorting the VIX

Eric Falkenstein has a post up highlighting another area where there seems to be money on the sidewalk: Shorting the Vix.  He notes that the VXX has underperformed a hypothetical outright short VIX position by a large margin due to the contango in the curve.   

It seems like the people selling lottery tickets are making money, but it is unfortunate that his sample analysis period doesn't go back to the crisis of late 2008.  Any trading strategy that was short volatility over a 10 year period and didn't blow up completely in that time period would probably have made a lot of money overall, but the "not blowing up completely" part is not trivial without utilizing future information.

He links a post from VIX and More where the author of that blog highlights new VIX Exchange Traded Notes (ETNs) and reveals that they are short VXX, one of the front month VIX ETNs.  

One conclusion that can be drawn from this is that if someone wanted to go long volatility to protect their portfolio, front month VIX at this level of contango is one of the most expensive and therefore worst ways to do so.  Now, there are probably good traders who are long the VIX at the short end, but these would be people who are either trading at small enough holding periods that the annual drift doesn't impact them or traders who have found something even better to be short and need to be long the VIX to protect their portfolio.

QE, the deficit and the TSA: Links

1. Scott Sumner Has an open letter to conservatives about monetary policy.  A lot of it is pretty reasonable, but he makes the mistake of thinking that conservatives care about nominal GDP when in reality they care more about real GDP.

2. My solution to the deficit, according to choices offered by the NYT.  It's nice how they let you cap spending on medicare at GDP rates without explaining how this is going to happen.  But it does show how the budget deficit can be balanced without tax increases. I chose to remove the employer tax break on healthcare (which for some reason the NYT doesn't treat as a tax increase), since the connection between employment and healthcare has been one of the reasons the healthcare system costs have gotten out of control.

3. The quantitative easing debate, in video format. Against QEII. For QEII.

4. Orlando is trying to opt out of the TSA, but the TSA points out that their regulation for private screeners requires them to be just as invasive. Ron Paul proposed a law that would remove the immunity of TSA screeners.  Hopefully this issue will get fixed soon, but preventing is people who think the only thing worse than everyone getting seen naked or groped is a little bit of racial profiling.

Mark Cuban against start ups

Mark Cuban has a blog post up where he shows that he thinks the government should encourage people to work at steady 250k a year jobs rather than getting a job in a potentially successful start up where they are often paid via high capital gains.  He tries to justify this by calling it "earned money" vs. "found money" but his definition of "found money" sounds awfully similar to something that would impact early employees in a successful start up.

The disparity in wealth in this country does not come on the backs of people making 250k, or even 500k or 1mm per year FROM THEIR JOBS. The ever increasing delta between the rich and everyone else does not come from EARNED INCOME at all. It comes from found money.

Found money is when an internet bubble hits and the options you got for 1 dollar are sold for 250. It comes from buying a stock for $1 and seeing it turn into a “10 bagger”. It comes from hitting the lottery. It doesn’t matter whether you were smart or lucky, it is money you FOUND based on good fortune.

He seems to assume that everyone making enough income from multi-hundred percent capital gains for it to be called "found money" is in league with him or Steve Jobs. 
When I sold broadcast.com does anyone seriously think I would have cared if the tax on my FOUND money was 10pct or 20pct more ? Hell no. Would I have made any decisions differently, HELL NO.
But he sets the bar to impact people much lower than that level.

For long term capital gains, it would be more difficult, but I would tax it at a gain greater than $1mm or a basis equal to the compounded CPI for every year held, against a 300pct increase and reduce the GOT LUCKY percentage to 20pct..

He'd have to raise the bar much higher if he wants good people to continue focus on building companies. I know a lot of people who have had to choose between the start up world and the corporate consulting/finance world. Passing a law like this would make it much easier for them to decide to avoid start ups.  

But even with a higher bar, that would only incentivize founders of moderately successful companies to focus on generating cash flow for income and dividend payments sooner than they would otherwise chose to because they would be hit hard by high "Found money" gains if they let their capital appreciate by too much. If raising taxes is the goal, raising it from some of the most productive people by calling it "found money" or a "lucky tax" might sound good but it probably won't work out in practice when the second order effects beyond its impact on Steve Jobs and Mark Cuban are considered.

Do people realize that in the next economic downturn the dollar will most likely strengthen?

People talk about a weak economy and weak currency almost like they are the same thing.  Certain commentators like Peter Schiff encourage this view. However, the correlation in the US has actually been the reverse.

When there is growth, a lot of things are pushing down the dollar at the same time the market goes up.

1. Increased demand for commodities weakens the US's terms of trade.

2. Re-leveraging allows people to increase their bets against the dollar.

3. Many other countries (excluding Japan) have interest rates that react more strongly to global growth, so an economic recovery means that the interest rate differential will become less favorable for the US.

4. When the Federal Reserve promises weaker monetary policy than expected the market reacts positively.

Of the variables listed here, numbers one through three will most likely reverse in a downturn not centered around a dollar crisis. People in macro often focus on reason number 2, calling any dollar strengthening during a downturn a "Dollar carry unwind" in reference to the people who have been short the dollar and long a higher yielding currency that have to close out their positions during volatile markets.  This explanation is probably underweighted by people following the markets from day to day, but correlation it describes is still accurate even if the causal reasons behind it are not.

Political Time Preference: A Case Study

Jerry Brown was governor of California in the late 70's and early 80's.  During that time he had an opportunity to try and push government towards defined contribution plans rather then defined benefit plans, but the topic never came up because he was a big supporter of unions*. Defined contribution plans contain the potential for economic volatility, something unions try to avoid at all costs.  

When Jerry Brown was mayor of Oakland some unions received generous pension increases, presumably in lieu of large pay increases. Defined benefit pension promises are currently a major cause behind California's budget problems, some have estimate that California has about $500 billion in unfunded pension liabilities. So 25 years after his governorship when the pension problem is coming home to roost the people of California decide to elect... Jerry Brown**.

And if we wonder why politicians seem to think too short term, it is because voters don't have very good memories. This short sighted point of view is also why the economic environment of election year is much more influential than other years.

*Maybe it is unfair to blame him for not fixing a problem that no one else in the public sector fixed, but 401(k)'s were written into the law around 1980. His first governorship's term coincided with a large shift among private companies towards defined contribution and away from defined benefit plans. 

**The budget was balanced when he was governor, and the stupider pension mistakes have occurred in the last few decades such as SB400 passed in 1999.  If not for Brown's support of union pensions from his position in Oakland and his support of unions more generally things might be looking up.

Reason's Ford Blind spot

In the course of promoting free markets, Reason points out that Ford is a free market success story while the recipients of government bailout money are still struggling to become profitable. The headline of the story is Unsubsidized Ford Profitable for Six Straight Quarters.

Ford was the only domestic auto manufacturer to avoid bankruptcy or take a bailout from the federal government. 

This simple analysis misses the a lot, because the government's programs did a lot to help Ford.  There was a cash for clunkers program and various government stimuli that helped keep the consumer in a better position to spend money, but the largest subsidy was the bail out of Ford's suppliers. Without the GM and Chrysler bailout Ford's supply chain would have been in dire straights, and the final impact on Ford would have been anywhere from bad to catastrophic. 

This blind spot appearing in the blog of a libertarian oriented magazine bothers me.  Libertarians often become libertarians because they habitually look at second order effects of government action. If an unpopular company whose suppliers were subsidized by the government was distorting the market by out competing a company with unsubsidized borrowers I'm sure Reason would be quick to point this out.  Just because Ford did a lot of things right and is popular doesn't mean that it is an example of a free market success.

Taking Buffett's idea about the EMH being good for him one step farther

I was listening to a relatively old book about Warren Buffett in my car.  In the book, the author mentions that Buffett likes to talk about how MBAs who are taught to believe in the efficient markets hypothesis are making his job much easier because he has competitors who aren't thinking clearly about investment opportunities.  I find it funny that the same thing can be said about Buffett's ideas on the impossibility of forecasting.  

The MBAs who believe in the EMH and the followers of Buffett* both believe that forecasting the future macro environment is too hard.  A more subtle version is that even if someone is right slightly more often than not the transaction costs make trading off of the forecasts useless. 

The net effect of this is the same as the impact of the efficient market hypothesis being popular - the more people who believe that forecasting is irrelevant then the less accurate the current market forecasts are, which means there is more reward for those right forecast.  We saw this during the housing bubble, with many investors making a lot of money off of a forecast that was pretty accurate in hindsight. 

In the immediate aftermath of a bubble which shook many businesses to their core there will be more focus on forecasts in the short term, but identifying under appreciated or unsustainable trends is usually an undervalued approach.

*Buffett does forecast in that he has a slight bias towards inflation

BLS Benchmark Revision

Last Friday the BLS released their benchmark revision with this month's nonfarm payroll number. This number is an under appreciated statistic, as the information it provides about the jobs picture is much larger than the monthly change*. The benchmark revision was -366,000, while the monthly job change in September was -95,000. This means that their 2010 estimates of the amount of people working need to be adjusted down by 0.3%.

Industry: Benchmark revision (Percent revision)

Total nonfarm: -366,000 (-0.3)

Total private: -371,000 (-.4)

Mining and logging: -20,000 (-3.0)

Construction: -62,000 (-1.2)

Manufacturing: -114,000 (-1.0)

Trade, transportation, and utilities: -144,000 (-.6)

Information: -11,000 (-.4)

Financial activities: 42,000 (.6)

Professional and business services: 14,000 (.1)

Education and health services: 6,000 (*)

Leisure and hospitality: -91,000 (-.7)

Other services: 9,000 (.2)

Government: 5,000 (*)

(*) Less than 0.05 percent.

The industry breakdown shows that there has been a lot more adjustment in the manufacturing and trade, transportation and utilities, and the leisure and hospitality industries than have previously been accounted for. The carnage in the finance industry was overestimated, and there were more jobs there than previously thought.

The BLS suggests that there revision in the benchmark survey comes primarily from nonsampling error.
Sources of nonsampling error include coverage, response, and processing errors in both data series. Additionally, the survey is potentially subject to sample design and estimator biases.
Calculated Risk collected the data of BLS benchmark revisions over time and a quick glance at the data shows that negative revisions are common during or directly after recessions.  The benchmark revision wasn't as important as last year, when it was revealed that BLS data was too optimistic by almost one million jobs, but it is still an indicator that the economic picture is not quite as rosy as many people would like it to be.

*Some people might argue that the monthly BLS numbers are more important because the direction of where the economy is going is much more important than its level.

China impressions

There have been no posts because I just finished up a Korea/China trip.  My experience in Korea consisted of more of an introduction to the life of western expats teaching English (they drink a lot) than it was an education in the life and economic system of Koreans, so I'm going to focus on China.

Since this was my first time in China, it doesn't really help me understand China very much outside of giving me a rough understanding of what their GDP per capita, adjusted for purchasing power parity, looks like in real life*. Still, there were some interesting things that I learned on this trip.

1. Traffic - it looks almost like a first world country, but then there are some notable differences.  People on bikes seem to feel like they have a right to go wherever they want to without regards to any kind of traffic laws - kind of like the critical mass people in the US but as individuals.  They are often going the wrong way in a two way street, so looking both ways is always important. There aren't very many pedestrian walkways without bikes, and sometimes cars, honking at people to get out of the way. Taxi's are also ruder than in the US - I've seen numerous taxis with their available lights on reject passengers for apparently no reason.  People don't look at their blind spots when the merge, but thankfully they also avoid driving in the blind spot of other cars. There seem to be way more cars than parking spots.

2. Paying for things. First, there are no tips - this makes it hard to get better service unless the person is intrinsically motivated to provide it, while at the same time when this is combined with no sales tax it makes paying relatively easy when the final cost is the listed price. The exception was when I had to haggle.  Sticking close to someone who looks Chinese and can speak the language definitely helped, since it implies that there is someone who knows the scene who is looking out for their friend. One of the shop keepers even mentioned that they find it hard to get good prices when there is an Asian person helping a white person shop.  Otherwise, everything made in China was really cheap, which made certain imported goods like wine seem ridiculously expensive.  I would be surprised if China ever develops a market for rented videos while people can still buy any DVDs they want to see on the sidewalk for the equivalent of 50 cents.

3. Food and drink: McDonald's delivers 24/7. It seems like no one drinks anything like tap water**, nor do they like to drink anything cold. Only places expecting foreigners will have cold drinks. A restaurant with a poor beer selection in the US would have an amazing selection if it were compared to the restaurants in Korea and China.  Perhaps because of the lack of cold beverages, there is a much larger selection of cold dishes than I've seen in the states.  Chinese restaurants will have one menu per table, and often they will have items on the menu that are expensive and that they don't stock because they don't expect anyone to order.  These expensive items are also there because there is huge income inequality in China and these restaurants want to capture as much of the market as they can.

4. Brands*** seem to have a lot more value in China.  It seems to be one of the main ways they can differentiate quality. The premium brands are really expensive, which is part of the point. They see sales as a betrayal - they buy the brands precisely because the brands are expensive and therefore exclusive. This extends beyond products into the job market.  Most people would prefer to work at a company that their parents have heard of, regardless of whether or not it is a better opportunity than a small growing company.  

5. Real estate. Rents are ridiculously low relative to the prices, as many people have pointed out.  I was more intrigued by the policy that makes it illegal for people in certain areas to sell or rent out their homes. They are living in poverty when the real estate they own but can't sell is worth millions of dollars.  In the middle of Beijing it didn't seem like vacancy rates were absurdly high, but this is the type of thing where an anecdotal visit does not give very much useful information.

In China, there were a lot of ridiculously poor people working at very low productivity jobs such as taking the subway into the city each day to set up little shops on the sidewalk.  There is definitely room for them to move up the value chain, the question is whether or not their human capital and overall economic system will be flexible enough to allow these people to move to higher productivity jobs.

*The main surprise in Korea was getting a glimpse of what poverty can look like in a homogeneous population. Also, as I walked down the main market area into the poorer sections the things for sale got progressively weirder.
**Not drinking the water is important for foreigners, so it might also be a good idea to be careful when ordering hotpot.
***There are counterfeits, but they are obviously much lower quality.