Why does tapering freak out the bond markets?

Since Ben Bernanke announced on May 22nd that the Fed was contemplating tapering the rate of its asset purchases in the near future, market watchers have been obsessing over how near that future is exactly. With a positive payroll report for June, the new consensus seems to be the September meeting for the start of tapering. The mere possibility of reducing the rate of asset purchases from the current $85 billion per month has sparked a paroxysm of selling in the bond markets. The yield on 10-year Treasury soared to 2.73% last week; that’s up from a low of 1.66% at the beginning of May. It seems that interest rates are much more dependent on the flow of assets into the Fed’s balance sheet, rather than its stock. But long-term interest rates are just the sum of short-term interest rates, of which the Fed has considerable control. So why do markets suddenly think ZIRP will end soon than previously thought? In other words, why does the mention of tapering send interest rates skyward?

The answer to this question has two, interrelated parts. First, and most important, is the method by which the Fed conducts monetary policy. It is a sclerotic institution that moves slowly and deliberately, regardless of whether it is tightening or loosing policy. A committee is an inherently difficult conduit for decisive action. Ben Bernanke understands this and therefore chooses to build consensus before changing policy, lest his gains backslide at the next meeting. So, for lack of a better term, the Fed makes sequential decisions. That means you should think of quantitative easing as a firewall between the Fed and ZIRP.

In the course of a single meeting the Fed will not stop asset purchases and increase its target for the federal funds rate. It will first reduce purchases to zero and then at a subsequent meeting increase the target rate 25 basis points. This is why the flow of purchases is so much more important than the stock of purchases. QE serves as way to allow the Fed to credibly commit to ZIRP for an extended period of time. When viewed this way, it doesn’t even matter if asset purchases have direct effects. Their main purpose is to put space between the Fed and pushing off the zero lower bound.

For evidence of this sequential decision making, consider the history of changes in the federal funds rate target. The modal change, when there is one, is 25 basis points. When the Fed feels it needs to send a strong message to the markets, it changes its instrument of choice 50 or 75 bps. That’s it. Since 1990, the year for which this Federal Reserve website begins reporting federal funds rate targets, there has never been a change greater than or equal to 1 pp in a single meeting (at the December meeting in 2008, when the economy was teetering on the edge of the abyss, the FOMC lowered the target by slightly more than 75 bps to reach the ZLB).

Furthermore, consider how the Federal Reserve has approached quantitative easing. There have been three “rounds” of quantitative easing, not including Operation Twist. In the first few rounds the Fed just announced the quantity of assets it was going to buy and went out and bought them. Then it tried open ended policy consistent with an Evans rule. Note that this is a sequential series of moves that all attempt to solve the same problem: lower long-term interest rates. The Fed didn’t just jump into an Evans rule. It took years to get there. It needed to make small changes at each meeting, moving inexorably toward “QE infinity.”

Though Obama is likely to appoint someone with inclinations toward dovish monetary policy, the exact identity of this person is unknown and financial markets loathe uncertainty. Neil Irwin summed up the state of play thusly: “The people who know aren’t talking, and the people who are talking don’t know.” Smart money seems to be on Janet Yellen, the current Fed vice chairman, succeeding her boss. But this is far from a certain outcome. Obama reportedly had serious discussions with Larry Summers about the position back in 2009 before he reappointed Ben Bernanke. The president is also very fond of his former Treasury secretary, but Geithner seems content making money speechifying in the presence of bankers. There are also dark horses like Stanley Fischer, the former head of the Bank of Israel, and Don Kohn, Yellen’s predecessor as vice chairman, who can never be ruled out completely.

This all adds up to a murky world for post-Bernanke policy. The heuristic the market seems to be relying on is how many barriers lie between the FOMC and interest rate increases. And with every dollar reduction in the rate of quantitative easing, there is one less barrier in place. Bernanke says that asset purchases won’t end completely till the middle of next year, if the recovery continues at its current pace. But there is one problem with that prediction – it won’t be his decision to make. With that in mind, we can’t blame bond traders for fearing that sooner tapering means sooner rate hikes. That’s how the Fed likes to operate.

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Thomas Babington Macaulay’s Speech to the House of Commons on Jewish Emancipation, April 17th, 1833

Ed. Note: Below the fold is a speech given by Lord Macaulay to the House of Commons in 1833 in which he argued for the rights of Jews in England. I’m reposting this here because there does not seem to be a quality version available online yet. 

On the seventeenth of April, 1833, the House of Commons resolved itself into a Committee to consider of the civil disabilities of the Jews. Mr Warburton took the chair. Mr Robert Grant moved the following resolution:—

“That it is the opinion of this Committee that it is expedient to remove all civil disabilities at present existing with respect to His Majesty’s subjects professing the Jewish religion, with the like exceptions as are provided with respect to His Majesty’s subjects professing the Roman Catholic religion.”

The resolution passed without a division, after a warm debate, in the course of which the following Speech was made.

Continue reading

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Should Bill Gates buy health insurance?

Since Covered California, the ACA health care exchange in California, released the premium rates submitted by participating insurance companies, the debate over the future of the ACA has been heating up, a la summer 2009. The focus of that debate is the existence or non-existence of “rate shock” experienced by individuals who will get their health insurance through the exchanges. From my view, the debate seems to boil down to whether young, healthy males will have to pay so much more for the “catastrophic plan” in the exchange as compared to their catastrophic plan in pre-ACA world, that they will opt to pay the individual mandate penalty/fee/tax instead. If too many young, healthy males choose to opt out, the exchanges will collapse due to adverse selection (insurers must cover people with preexisting conditions).

I won’t dive into the minutia of that debate, especially since the inevitable conclusion seems to be “we’ll have to wait and see.” Instead, since I have catastrophe insurance on the mind, I want to consider a related question: is it smart for Bill Gates to buy health insurance? I think this thought experiment might offer some insights about the state of the health insurance market in the US today.

So, put yourself in Bill Gates’s shoes. You have approximately $67 billion in net worth and no preexisting conditions (we assume) to exclude you from the health insurance market. Forget Cadillac plans; you can afford the Bugatti plan if you want it. But is purchasing health insurance a sound financial decision? First, consider the net present value of any insurance plan. If the actuaries at your insurance company have done their work, and they are paid handsomely to do so, then the expected net present value of all the health care you will consume in your life will be less than the expected net present value of all the payments you will make to said insurance company. This must be true in the long run or the insurance company would go out of business! But if the net present value of insurance is negative, why does anyone, let alone Bill Gates, buy insurance?

The answer to this question has at least two parts (please let me know in the comments if you think of any others). First, the expected utility of insurance is different from the net present value of all future health care consumption. For the non-überrich, health insurance serves to eliminate the possibility of health-care-catastrophe-induced-bankruptcy, which would ruin a family’s finances and possibly lead to the death of a family member from lack of treatment. For most people, it makes sense to hedge against this risk by purchasing health insurance.

Second, as we learned from Steven Brill’s magisterial piece in Time magazine on the high cost of medical bills in the US, the driving force behind what prices people end up paying for hospital services is how much bargaining power they have. In rank order, from lowest to highest prices paid, it’s Medicare/Medicaid, large insurance companies, small insurance companies, and, placing last by a long shot, uninsured individuals. The reasoning behind this is simple: the more people a group has, the more leverage it has to bargain for lower prices.

This has a very important consequence for the answer to our thought experiment. The expected net present value of insurance is negative, excluding non-pecuniary considerations, but the next best alternative is even worse. If you ever end up in the hospital for anything remotely serious, you can expect to pay through the nose if you are uninsured. So the small loss from buying insurance is easily dwarfed by the cost of paying for health care out-of-pocket without a megainsurance company or the federal government bargaining prices down for you.

Along with the minor benefit of hedging idiosyncratic risk, this consideration – insurance companies pay prices you can’t get as an individual – seems to seal the deal for Bill Gates’s decision. He should buy health insurance because the expected loss of paying for insurance is less than the expected costs of paying for health care out-of-pocket. But this whole exercise just goes to show how messed up the health insurance system is in the US! The point being, Bill Gates shouldn’t want to buy health insurance. He doesn’t need the benefits of catastrophe protection and therefore should be able to save money by cutting out the middleman, i.e. the insurance company.

But the current system has so distorted incentives, inefficient health care decisions like these are commonplace. As Evan Soltas has argued in Bloomberg View, a simple start to reforming health care would be to mandate price transparency, especially at hospitals, which are the greatest abusers of price discrimination. As Lara Hoffmans so elegantly put it in a recent Forbes piece, “Is there a single thing you buy, other than health care, that you and the service provider both don’t know how much said service costs at point of delivery?”

Price transparency, however great an idea it is, would just be a start to making the health care system more efficient in the US. Other common ideas for reform include ending the tax exclusion for employer-sponsored health insurance, which causes workers to overconsume health care because it is purchased with pretax dollars, and allowing competition between health insurers across state lines. The goal of these reforms wouldn’t be to save Bill Gates a few bucks by making it easier for him to avoid paying for insurance; it would be to create a system where dumb outcomes in general don’t happen anymore.

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No, Robert Shiller, We Shouldn’t Index Social Security Benefits to Economic Growth

Over the weekend, Robert Shiller wrote a piece in the New York Times arguing that the two political parties should reconsider how they want to approach reforming Social Security. Recently, Republicans and Democrats have started to converge on a compromise to keep the trust fund solvent past 2033, the current projected year in which reserves run dry, by cutting benefits without explicitly saying they’ll be cutting benefits (which is a huge part of the appeal). Without getting too far into the weeds, it suffices to say that the current price index used to make cost of living adjustments for Social Security has been overestimating the rate of inflation for goods and services typically purchased by seniors and we can save money by indexing benefits to a stingier, but more accurate, measure of inflation. Because this new price index is more accurate, politicians can dodge claims that they cut benefits (even though in reality this would mean someone retiring today would receive about 5% less over the next 20 years).

Shiller takes issue with this compromise, not out of liberal anger that it will cut benefits too much or out of conservative conviction that it doesn’t cut enough, but because he sees the purpose of Social Security as a way for younger generations to take care of older generations, with the level of care depending on the state of economic growth. In his mind – and this is key – he thinks benefits should increase more during fat years and less during lean years, which would send a “we’re all in this together” signal to the country.

While this novel view of Social Security has some intuitive appeal, Shiller’s plan is another instance of economists trying to turn economics into a morality play. Just because some people in society are hurting, that doesn’t mean others – and especially not those who are most vulnerable – should suffer unnecessarily.

What’s more, this solidarity of suffering would most likely worsen and prolong the economic downturn, further increasing the pain of all people. This is likely because one of the hidden virtues of Social Security is that it is moderately countercyclical. Social Security transfers are a form of exogenous spending, which means they don’t decrease as incomes decrease. In fact, as a share of GDP, Social Security spending actually increases during recessions.

In a way, Social Security checks, along with food stamps and Unemployment Insurance benefits, put a floor on aggregate demand. Best of all, the countercyclical effects of Social Security occur without Congress having to pass new legislation or the Fed having to guess that we are in fact in a recession and cut interest rates accordingly. The transfers increase as a share of GDP automatically as we enter a recession. This makes sense, as more people opt to take Social Security early at 62 rather than fight younger workers for fewer jobs as the labor market deteriorates.

Social Security spending as a share of GDP

Looking back on the policy response to the Great Recession, many economists and bloggers have argued that more automaticity in fiscal and monetary policy would have blunted the severity of the downturn and helped speed along the recovery, which we are still muddling through. For fiscal policy, Clive Crook has suggested we institute a national sales tax (consumption is more pro-cyclical than income), eliminate the tax preferences for debt, and increase the funding and expand the scope of the Trade Adjustment Assistance program. On the monetary policy front, we should change to a rule-based policy, like NGDP-level targeting, which would remove some of the discretion, and therefore some of the delay, in combatting recessions. In contrast to these policy changes, indexing Social Security to GDP growth would turn the program into an automatic destabilizer, immiserating seniors along with the rest of the public. Solidarity of this kind is overrated.

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“The charitable deduction doesn’t benefit the individual.” Right.

Picture: T. Boone Pickens *not* benefiting from his $165 million dollar donation to OSU. That’s the head coach of the football team, Mike Gundy, he is casually chatting up.

The prospects for a grand bargain that includes tax and entitlement reform dim by the day as we get closer to the fiscal cliff, a set of spending cuts and tax increases automatically scheduled to take place on January 1st absent new legislation. Lawmakers on both sides of the aisle are scrambling to reach a deal that would prevent the Bush tax cuts for the middle class from expiring, though the Republicans aren’t giving up the tax cuts for the rich without a fight. This tight deadline means significant action on the long-term debt problem will most likely have to wait till next year. In the meantime, before the debate over which tax deductions are worthwhile resumes again, I want to make a small point on the semantics of charitable giving.

First, some background: In a tax reformer’s fantasy, all deductions would be eliminated (also known as base broadening) and tax rates would be lowered. This change could be revenue-neutral or it could aim to increase revenues to pay down the federal debt. Tax reformers hate deductions because they distort incentives and cause people to consume too much of certain goods, like health care and housing. The main impediment to this fantasy becoming a reality is the fact that many of the current tax deductions are very popular. People like being able to deduct their mortgage interest, charitable contributions, and state and local taxes from their federal tax bill.

The charitable tax deduction in particular has been hotly debated as a source of potential revenue. Charities have argued that we cannot get rid of the charitable tax deduction because giving will go down without the tax break. Proponents of the deduction say we cannot cap total deductions either, at say $50,000, because that would eliminate the incentive for giving when a person reaches that threshold. Instead, they argue, we should put a floor on the deduction, possibly around 2% of income. A floor would preserve incentives to give while raising significant amounts of revenue. Conservatives in particular like the charitable tax deduction because they view it as a free market poverty program. Instead of financing big government programs to ameliorate poverty, like Medicaid and Social Security, conservatives believe taxpayers should use their money to support charities of their own choosing.

All of this makes logical sense to me and I hope policymakers listen to the tax wonks when the make their reforms. The problem I have is one of semantics. Diana Aviv, the head of a trade group for nonprofits, crystallizes the conventional wisdom with this line, courtesy of a wonderful piece by Mina Kimes on the charitable deduction:

“‘The charitable deduction is not the same as other deductions,’ she says. ‘It doesn’t benefit the individual.'”

No. No. A thousand times, no. Charitable giving, and therefore the deduction, most certainly benefits the individual. Let’s consider two cases of charitable giving: large and small. Large charitable contributions provide the most manifest example of how charitable giving benefits individuals. Billionaires who have the means to write checks with eight digits or more are often invited to sit on the boards of the organizations they give to. That means they just bought power and influence in a respectable organization. Additionally, large enough donations are bound to attract media attention. See John Paulson’s $100 million gift to Central Park or T. Boone Pickens $165 million donation to Oklahoma State athletics (yep, donations to college football teams are still tax deductible). So, Paulson endeared himself to millions of New Yorkers and Oklahoma State renamed their football stadium after their most generous benefactor. No personal benefit I can see there.

The second case, small charitable giving has a subtler benefit to the giver: good feelings. Charitable giving, even on the small scale, has all the characteristics of a textbook economic exchange. You give the charity money and in return you get to feel like a good person for awhile. A boost to your moral fiber may not be as tangible as a new car or new clothes, but the utility it gives you is just as real.

Heads of charity trade groups, like Diana Aviv, don’t like to point this stuff out, or put it so bluntly, but this is the actual context in which charitable giving takes place. Let me be clear, by no means am I opposed to having special tax breaks for charitable giving. I, like the conservatives, believe it is a more efficient way to help the poor and indigent than another government program would be. However, just because the charitable deduction is desirable, that does not mean we should propagate falsehoods like, “The charitable deduction… does not benefit the individual.” It clearly does. The mortgage interest deduction does, too. There is also a case to be made that homeownership has positive externalities, which means society benefits from having a tax code that incentivizes homeownership. So, instead of having a simplistic discussion where the charitable deduction is a sacred cow protected by selfless saints, let’s have a real debate about how we can create a tax code that is best for society.

 

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Predicting the Future: Baumol Cost Disease Edition

In one of my first posts on this blog, I discussed a possible method for curing Baumol’s cost disease: turn services into goods. For those of you who didn’t read that post, Baumol’s cost disease describes the situation where wages rise in industries that do not experience productivity growth to remain competitive for labor with industries that do experience productivity growth. Most commonly, the industries that are affected by Baumol’s cost disease are service-based and rely heavily on non-routine labor.

Baumol’s cost disease has yet to vanish from the economy since I detailed the cure, so I think we can safely assume it will be with us for the foreseeable future. As labor costs rise in sectors of the economy that do not increase worker productivity, we should expect to see less production from those sectors (companies cannot raise prices indefinitely to account for increasing labor costs). A simple example that we have already seen is the decline of live theater performances. Outside of New York City, plays and musicals are rarely produced as profit-seeking ventures. Based on the implications of Baumol’s cost disease, I want to make a few predictions of my own about the economy:

1. All men’s haircuts will be buzz cuts. Barbers do quintessentially non-routine work when they cut people’s hair. Every head of hair is unique in some way and people have distinctly heterogeneous preferences about what hairstyles look good. In the future, however, they won’t be able to afford such stylish hairdos. As barbers’ wages increase to keep up with the wage increases in, say, the automobile assembly industry, a barber’s time will become more expensive to rent out. At some point, most budget-conscious men will opt for the buzz cut to avoid paying a hundred bucks for the Bieber.

2. Your waiter will be an iPad. Among the most innovative companies in the restaurant industry over the past few years are Chipotle and Chop’t. What’s their secret? They deliver sit-down quality food at near-fast food prices. They are only able to do this by maximizing efficiency and cutting out the waitstaff. They still have cashiers though, and the next logical innovation step will be replacing them with iPads. Look for this change to happen at restaurants all across the cost spectrum, not just at the assembly line fast food joints. Now that socially acceptable tipping has creeped int the fifteen to twenty percent range, isn’t it time we brought in the computers? They don’t forgot drink orders and they definitely won’t spit in your food.

3. You won’t have a mailbox. Alright, this one is a little easy to predict, considering the United States Postal Service is losing $25 million dollars a day and is currently the largest employer in the U.S. At a certain point those labor costs were bound to sink the post office. Coupled with the rise of email, texting, and Facebook, the decline in mail volume should spark a major restructuring of the USPS. Among likely changes, guaranteed mail delivery to rural areas, which are more expensive to service on a per capita basis than urban ones, will come to an end. As some people begin to lose mail service entirely, network effects will start operating in reverse. As fewer people have mailboxes, it becomes less necessary to have a mailbox yourself.

4. Your banker will be your smartphone. I already wrote a full-length post about the coming revolution in the banking industry, but here’s the gist: it no longer makes sense for banks to provide services through full-service branches. Smartphone apps, point-of-sale machines, and third-party outlets can delivery the vast majority of banking services without incurring the costs of building, staffing, and maintaining brick-and-mortar bank branches. Tellers haven’t become drastically better at counting money over the past few decades (low productivity increase), but their wages have had to rise as the wages in other industries have gone up. In the near future, banks will replace their employees with the smartphone in your pocket.

There are many more predictions that could be made based on extrapolations of Baumol’s cost disease, but I’ll leave it at four. If you have any predictions of your own, please share them in the comments below.

 

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The Risk-Free Rate, Reconsidered

The risk-free rate of return, which is the return on investment that is required as compensation for not having access to the capital for a period of time, is a fascinating theoretical notion from the finance world. In essence, the risk-free rate is trying to untie the time value of money from the risk premium, i.e. the rate of return required in excess of the risk-free rate to account for default risk. Together, these two factors determine the interest rates for all debt obligations. I say that the risk-free rate is a theoretical notion because there is no such thing as a truly risk-free investment. Even 3-month U.S. Treasury bills, the most commonly used proxy for the risk-free rate, still have some remote risk of default (in the event of a nuclear war, the Treasury might miss a payment or two). For context, the graph below shows some historical data on the 3-month U.S. Treasury bill:

The purpose of this post is to question whether it makes sense for finance professionals to use the 3-month U.S. Treasury bill as a proxy for the risk-free rate of return. First, I want to change the time period of the sovereign bonds I will consider from three months to ten years. I am doing this because it is much easier to do a cross-country analysis of 10-year bonds, which almost every debt-issuing country has, than of 3-month bonds. I don’t think this will detract from the validity of my analysis significantly because though there is a higher risk premium associated with a longer time period, it makes sense that the “risk-free” country over the next three months is also the least likely to default over the next ten years.

Now let’s look at some data for 10-year government bonds from various countries:

Screen Shot 2012-12-24 at 1.25.21 AM

The data above are provided by The Financial Times and you can see updated figures by clicking on the table. The main takeaway from this is that the United States does not have the lowest yield on its 10-year bonds. In fact, as of this writing, there are eight countries who have a lower cost of funds than we do. That means global investors believe the risk associated with those government bonds is lower than the risk associated with U.S. government bonds. They believe those countries are more likely to make all their payments on time than the richest country on earth is. Why is that?

For starters, we have a seriously dysfunctional political system in which artificial crises are manufactured by the two-parties (think debt ceilings and fiscal cliffs) in order to score political points. Many people claim these crises are the only way policymakers in Washington can get anything done anymore. But instead of getting things done, they just end up kicking the can down the road to another unnecessary flashpoint. One of these days, we could end up with a staring contest in which neither party blinks and the Treasury Department is forced to default on some of our debt.

Secondly, the U.S. debt-to-GDP ratio, which represents our ability to pay back our debt, has been rising at an alarming pace over the last decade (we haven’t had a budget surplus since the Clinton Administration). As of yet, there has been no run on the U.S. Treasury (as reflected in our historically low interest rates), and it does not appear as though an attack from the bond vigilantes is imminent. Nevertheless, it can’t help our Treasury yields that our debt-to-GDP ratio is approaching an all time high:

Critics of my argument might point out that Switzerland recently pegged its currency to the euro prevent it from appreciating further and that Japan has a gargantuan debt, coupled with low growth prospects. These reasons might explain why Switzerland and Japan have lower yields on their 10-year bonds, without having to claim they are more “risk-free” than U.S. debt. But what about the other six countries ahead of us on the list? Many of them have strong fundamentals (e.g. low debt, strong growth, current account surplus) and unlike the United States, they are unlikely to default via a gridlocked political system.

So, does it make sense to continue to use the U.S. 3-month Treasury bill yield as a substitute for the theoretical risk-free rate? There are eight countries who have lower yields on their 10-year bonds and many of them appear more stable than the United States. I think it’s about time we reconsidered which country is the least likely to default on a 3-month debt obligation and therefore is the closest to the theoretical risk-free rate of return. Right now, I wouldn’t bet on that being us.

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