Follow the Money

That suggestion is often applied to crime investigations, fictional or real. I suggest it should also apply to understanding the basis of someone’s argument. To judge whether someone’s advice is unbiased and independent it is important to recognize how that person receives compensation.

Here’s an example in which I had personal involvement. In the late 1980s I switched consulting firms from one that took no commissions to one that accepted commissions as payment for some services—mostly involving health care, disability and life insurance. For some clients our total compensation consisted of the commissions paid by the insurance company for placing the business. For others, we offset our normal fees by the commissions we received. Either way, at least annually we disclosed to each client the commissions we received based on their policies.

Except, it turns out, we didn’t. Some insurance carriers paid our company “bonuses” once we reached certain volume targets. That meant that if the premiums by all of our clients paid to XYZ insurance company for a year exceeded (say) a million dollars, the insurance company would pay us a small percentage of the overage. These override commissions were never disclosed to affected clients. Once I became aware of this issue I got our reporting changed so an allocable portion of these override commissions also showed on client statements.

That, however, didn’t end the internal discussion. Remember, I had come from an environment where clients paid for our advice based on time spent plus expenses, not commissions. Consultants who took no commissions claimed that they were totally independent and served only in their client’s best interests. I fully subscribed to that thinking. Now I was working for a company who might be paid more or less for the same work depending on which insurance carrier we recommended because commission rates differed between insurance companies and because of the possibility of additional override payments.

Oh, no, my new colleagues said, we’re totally independent too. Our clients choose whether to pay us in commissions or fees. I might have bought the argument until I discovered that my predecessor maintained monthly totals of business sold by each insurance carrier and at the top of each carrier’s column was the override level trigger for the year. That chart was distributed to the consultants, “for their information.” Oh, and consultants get personal bonuses based on how profitable their clients are. No conflict there.

In fact, many clients (human resources or finance, depending on the company) liked the commission basis of payment because it didn’t come out of “their” budget. Since commissions were included as part of the benefit cost, it was included in that budget line. Consultant fees were in a separate budget line. In fact, all things equal, some clients liked very high commissions because we offset those commissions against our total fees. The higher the commission, the lower the net fee paid for consultants.

But wait—it turns out that if some of my buddies in the fee-only consulting business met “personal targets” set by the various insurance companies, those companies rewarded the consultants with trips to resort locations for beach, golf, tennis and schmoozing with the insurance company’s bigwigs. You betcha—no conflict there!

Throughout my career, wherever I worked, however we were compensated was the right way to provide the best service to clients. It’s not just my field of human resources consulting. Look at how a hospital is compensated, and you need not wonder why they encourage as much testing as possible. The same thing happens when doctors own the testing facilities—the utilization of those tests goes up.

Lawyers prefer to litigate rather than negotiate because litigation pays better.

Investment consultants, who used to be more honestly called brokers, working for Merrill Lynch and their ilk, are only paid commission when you buy or sell a stock or bond. Is it surprising that they recommend frequent changes to your portfolio? Or since they get extra bucks for selling their employer’s mutual funds, who is being best served when they recommend their high expense fund over a competitor’s lower-cost alternative.

Despite politicians’ denial, I am convinced that who contributes to their campaign makes a difference in their votes. If your family makes its living from mining, then I’ll bet you diminish the costs of ecological damage from mining relative to the benefits of “good” jobs. If you are an environmentalist living downstream from an oil shale field involved in fracking, then water pollution is a vital concern, the heck with the gas and oil produced.

None of us likes to live in cognitive dissonance. As a result we tend to see what we believe. It’s human nature. Therefore, to protect ourselves when we are getting advice or weighing arguments, it is important for us to distance ourselves from our own beliefs.

Even if we accomplish that no small task of independent evaluation, we must recognize that no one gives completely unbiased advice, and we must be wary of any claims made by those who have a stake in the proposition.

~ Jim

Why Gerrymandering is Bad for Democracy

I was in Iowa for the weekend attending Jan’s xxth high school reunion. (I don’t have permission to fill in the xx!) It got me thinking about the redistricting process most states are undergoing.

The US constitution calls for a census every ten years and, based on its results, the maps for US congressional districts are redrawn. The stated object is to balance districts so that each of us has an approximately equal vote for our representatives. Enter the politicians.

In most states the state politicians get involved and those elected representatives get to redraw federal and state election districts for future elections. Not surprisingly, the currently elected want to keep their jobs and so draw district lines to include people who think like them and keep out people who do not. Since it is difficult for each legislator to accomplish this task, it is done along party lines.

There is nothing new about this. The word gerrymander came into existence almost 200 years ago in Massachusetts when then Democratic-Republican governor Elbridge Gerry signed a bill that produced a district that looked to one political cartoonist of the day as a dragon. Another saw a salamander. Gerry + salamander + political cartoonist = gerrymander, or so said the Federalists at that time.

So, if it has been going on for 200 years, what’s the problem? Technology has materially changed politicians’ ability to mold election districts to favor one party or the other, leaving fewer and fewer districts that are up for grabs in normal (not landslide) elections. When this happens, the real election occurs during the primary, not the general election.

To see how this plays out, let’s postulate two districts: one 80% Republican and 20% Democratic; the other the reverse with 20% Republican and 80% Democrats. District 1 will reliably vote Republican. District 2 reliably votes Democratic. In District 1, unless the Republican is caught fellating an elephant, the Democrats have no chance, and in District 2 the Democrat needs to be caught screwing with a donkey to lose an election. Simple theft, getting caught with hookers and the like are often insufficient to lose an election (although these days the caught politician might be forced to resign).

Since Republicans are more conservative than Democrats, in District 1 the candidates for the Republican primary tend to move away from the national political center and toward the right. In District 2 the primary candidates tend to move away from the national political center and toward the left. If Independents can vote in any primary election they choose, the candidates need to pay some attention to their rhetoric in order to avoid triggering the independents to vote en masse for their opponent. But in most states you must declare your party affiliation before you can vote in a primary, and in these states the push to the extremes (right and left) is stronger, especially when combined with the belief that conservative/liberal voters are more likely to vote than moderates in primaries.

You can see where this is heading. If you do not need to worry about attracting Independents or voters from the other party and the most extreme voters of your party are the ones most likely to vote in a primary, to get elected you need to move toward your party’s extreme in the primary.

The greatest extent of this polarization will be in house seats (state or federal). State senate seats will be less affected because they per force cover a larger geography. Federal senate seats are the least affected since the entire state must be reliably Republican or Democratic. The ameliorating factor is the extent to which a general election counts in who is ultimately elected. Presidential candidates have a meaningful general election and they must attract votes from the center (regardless of party affiliation or independence) in order to win. As a result, presidents often reflect the sensibilities of the national center more than they do the center of their own party.

Two examples of the ameliorating effect of meaningful general elections are the recent senate races won by Joseph Lieberman and Lisa Murkowski. In 2006 Sen. Lieberman from Connecticut, a former Democratic vice-presidential candidate, lost the Democratic primary to a more liberal candidate and had to gain reelection as an Independent. In the 2010 Alaska Senatorial contest Sen. Lisa Murkowski similarly overcame the right wing of the Republican Party and won re-election as a write-in candidate. In both cases the incumbent won because politicians can’t redistrict a state’s boundaries and the victors could draw votes from across their state, persuading enough Independents, Democrats and Republicans that the incumbent would serve them better than either the Democratic or Republican nominees.

Unlike these state-wide races, in many gerrymandered Congressional Representative districts there are insufficient independent and other party voters to counteract the conservative/liberal primary voters leaving the extremes in each party mostly unchecked. Thus party faithful elect most Congressional Representatives and these politicians need make no accommodation for voters from the other party. In fact, to avoid a challenge from the more conservative (liberal) wing of their party they must NOT move toward the center. While currently we see this most clearly with so-called Tea Party Republicans, this is not a Republican-only phenomenon as evidenced by the 2006 challenge to Sen. Lieberman.

Therein lies the challenge to democracy. Without compromise, it becomes majority rules, minority be damned. That eventually leads to a tyranny of the majority.

Iowa has a better way

Iowa law forbids gerrymandering. No kidding. Iowa Code Section 42.4 lists eight criteria for redistricting. Number five reads:
A district shall not be drawn for the purpose of favoring a political party, incumbent legislator or member of Congress, or other person or group, or for the purpose of augmenting or diluting the voting strength of a language or racial minority group. In establishing districts, no use shall be made of any of the following data:
   a. Addresses of incumbent legislators or members of Congress.
   b. Political affiliations of registered voters.
   c. Previous election results.
   d. Demographic information, other than population head counts, except as required by the Constitution and the laws of the United States

I can’t say I’m too fond of Iowa’s presidential caucus process, but when it comes to redistricting, they get my vote hands down.

If we voters want to take back our stolen voices from the politicians of both parties who want to strip away our real election power to vote them out of office, we need to insist that every other state adopt a process to redraw election districts that is at least as effective as Iowa’s.

Now that I’m back home, I plan to write my state representatives and ask why Michigan doesn’t do as well for its voters as Iowa does. I hope that, regardless of your political beliefs or what state you live in, you will join me in this effort to take back the value of our voting rights.

~ Jim

Solving The US Income Imbalance

In this post I am going to simplify the US economy and ignore both imports and exports. I know that’s a gross simplification, but with that assumption it is much easier to illustrate my central point. Once we’re through with the analysis you can decide whether including exports and imports (and the fact that we are importing more than exporting) materially changes my basic proposition.

Let’s further simplify and start with an economy of 100 people, no inflation or deflation, no imports or exports. At the beginning of our analysis the economy is “balanced.” It produces exactly 100 units of output. Each person is paid 1 unit of output, is allowed 1% of the produce and owns 1% of the production facilities. We’re starting with a utopian commune.

But we live in a capitalist society and after a short time (say 1 year) the economy has changed. Efficiencies have been discovered and the same 100 people can produce 105 units of output. However, not all people in the economy participated in creating the extra five units. The laborers retain their one unit of purchasing power; the 5% of management employees retain the extra five units. The math is simple: 95 of us are paid (and spend) 1 unit each. The five folks in management receive (and spend) two units each—one unit they spend on “necessities” and one on “luxuries.”

The economy hums along. Growth continues so in year two the economy can produce 111 units of output. The 95% aren’t quite as willing to see all of the productivity accrue to the managers and insist on a raise. Management counters with a dividend of .01 units per share. The masses now receive 1.01 units of output. The top 5% get 2.01 units and pay themselves each a 1 unit bonus for a total of 3.01 units. [Math check: (95 x 1.01 = 95.95) and (5 x 3.01 = 15.05) total 111 – yep good to go.]

The masses spend their 95.95 units (95 on necessities and .95 on luxuries). Management spends say 2.5 each (1 on necessities and 1.5 on luxuries) for a total of 12.5 units for the five of them. They still have a total of 2.55 units left over but have nothing else they really want to buy, so they look for a place to store their accumulated wealth. Let’s say the five get together and decide to buy up some farmland (they aren’t making more, you know). They convince a few of the masses to sell their portion of the country’s farmland and because of the effect of supply and demand, the value of all farmland increases.

Everyone in the economy feels better about that and those of the masses who sold their share of the nation’s farmland take the 2.55 units they received and acquire additional luxuries. The economy is balanced: somebody buys everything that the economy produces. Everyone feels better because they were able to increase their purchasing power and (for those who still retained their portion of the farmland) their net worth increased because of the increase in farmland prices.

This process continues: the economy becomes more productive. Most of the productivity is returned to management in the form of bonuses. They use a portion of those bonuses to acquire assets (farmland and factories). The masses continue to receive their wages and sell off assets to afford some of the luxuries the rich can afford. Some even go into debt to get some luxuries now rather than deferring consumption.

By 2007 in the US the share of income going to the top 1% was about 23%, approximately the same peak level attained in 1928, the year before the Great Depression started. As a comparison, from the start of World War II through the mid-1990s the share of income going to the top 1% varied from around 9% to 15%. (Source: Piketty & Saez: “The Evolution of Top Incomes: A Historical and International Perspective)

As reported by the Wall Street Journal, (4/30/2010), a study by New York University economist Edward Wolff estimated the top 1% of wealth holders in the US owned about 35% of all national wealth. Since there is a mismatch between what the top 1% of wealth holders own and what the top 1% of income receivers get, it means wealth is not getting its “fair share” of the income pie. Management (who supposedly work for the owners) have skewed the game to capture an outsized percentage of corporate profits. As one example of this phenomenon, in 2007 the CEO of Bank of America, Kenneth Lewis, took home about $100 million in total compensation (including the value of stock options).

Consider for a moment how you could possibly spend $100 million in a year. Every day you must spend over $270,000—and you can’t skip any holidays or take a vacation from your shopping. Because of the inability for the superrich to spend all their income, there will be a mismatch between what the economy produces and what the people can purchase unless the excess the rich don’t spend on goods and services is taxed away and given to the less well off. This is a far cry from the utopian beginning where production and spending corresponded.

Republicans maintain that if we drop the marginal tax rate on the well-off (they never call them rich) this will magically cause employers to create more jobs and thereby stimulate the economy. Here are some inconvenient facts: The top marginal Federal income tax rate in 1950s was 91-92%. In 1964 it declined to 77% (70% in 1965). In 1982 it dropped again to 50%. In 1987 it decreased to 38.7%. I suspect we would all trade the 1950s economic growth, when Federal tax rates were indeed a confiscatory 91-92%, for that we have experienced in the first decade of the 21st century, when the highest Federal income tax rate was a comparatively modest 39.1%.

Because of advances in technology the US economy produces more goods and services than we can buy, leading to excess capacity. If income were more evenly distributed, consumption would increase. Kenneth Lewis and his ilk have (cue the violins) tremendous difficulty spending all their income; but if we took his $100 million in 2007 and spread it around to 300 million Americans we each wouldn’t have much problem spending an extra thirty-three cents, would we?

We could, of course, attack our US deficit by increasing tax rates and thereby allocate income to more “productive” purposes than bidding up asset prices (farmland, housing prices, gold, etc, etc.). Far better is to allocate a larger percentage of the accumulated productivity gains of the last twenty or thirty years to the middle class—the people who actually created the gains (as opposed to those who managed the creation) through the form of increased wages. Such a redistribution would immediately stimulate the economy. Even if the masses did the “right” thing and saved a significant percentage of their wage increases to prepare for retirement, in the aggregate they would save less than the rich, who cannot spend their money fast enough. The increased consumption would stimulate the economy, provide additional jobs (further stimulating the economy) and, even at current income tax rates, the extra taxes the Federal and state governments collect would go a long way to balancing the various budgets.

To close, I don’t mean to imply that nationally we should be consuming more meals out or plastic dojobbies that will break after a year. In fact, we should be investing in our education, our crumbling infrastructure, our basic research to fuel future productivity gains. Consuming those goods and services will continue to fuel the productivity gains we need to develop a better tomorrow—but that’s a blog for another day.

In the short-term, government spending can (and did the last two years) ameliorate the negative impacts of the recession portion of business cycles. Such spending cannot correct structural imbalances within the economy. To regain a humming economy and full employment we must address the current gross income inequality in the US.

~ Jim

Anchoring, the Current Housing Crisis and Why US Economic Growth will be Anemic

In the previous post I discussed anchoring and how it affects our personal finance decisions. In this post I’ll look at how anchoring’s is exacerbating the current housing crisis.

Most commentators agree the housing bubble was caused by a combination of factors including speculative fever (prices will only go up), overleveraging (requiring 0% down and no asset verification in the worst cases) and fraud (both by mortgagees who lied about their income and assets and lenders who fraudulently enticed owners to take our first, second and third mortgages with misrepresented terms). Add to the mix that many homeowners drew down their equity in attempting to maintain a standard of living that their incomes could no longer support.

When supply (builders were creating new homes at accelerating rates) finally surpassed demand, housing prices stopped rising and started to decline. Like a tiny pinprick in a fully-inflated balloon, it doesn’t take much to let all the air out of an asset bubble. Once prices stabilized (or declined), banks realized the gig was up and tried desperately to strengthen their balance sheets. A financial game of musical chairs ensued and as always seems to be the case, the taxpayers were the ones without a seat and ponied up billions to save the investment banks, AIG, and eventually GM and Chrysler. [To be more accurate, future taxpayers were the victims as there was no increase in taxes to pay for the bailouts.]

That was then; this is now: Homeowners and banks are both falling victim to anchoring errors. Until these are corrected, the economy will have a difficult time making much forward progress. Homeowners with positive equity (market value less mortgage is positive) are still anchoring on what they paid for their home. When evaluating a job offer in a different area, they decide they cannot afford to sell because they have lost money on their house. They fail to recognize that the money has already been lost whether or not they sell. This makes it harder for geographical imbalances in the labor market to correct.

Similarly, banks holding underwater mortgages (the market value of the house is less than the remaining mortgage) are often unwilling to take a loss on their mortgage if the owner finds a buyer willing to buy their house for fair market value (called in today’s parlance a “short sale”]. They too have already lost on their investment, but prefer to defer full recognition of their loss. One reason is anchoring—in this case they have not fully written off the lost value of the mortgage they hold.

In every market downturn, anchoring on historic housing prices lengthens the duration of the imbalance between asking prices and selling prices. Sooner or later, the strength of market forces brings the prices together and market stability returns.

The strength and length of the housing bubble means that the adjustment process will be longer than usual. The number of foreclosures that have and will occur has generated another perverse reason for lengthening the turmoil: the company that services the mortgage only earns money while the mortgage exists AND they earn even more money when it goes through foreclosure proceedings. The mortgage itself may have several owners as part of the Collateralized Mortgage Obligation market. The mortgage servicing agents have little incentive to reflect the economic interests of the homeowner or mortgage owner over their own.

A short sale in which the mortgage owner writes down the value of the mortgage to the net sales price might be the best thing for both homeowner and mortgage holder, but it stops the cash flow for the mortgage servicer and is therefore rejected. Even when the mortgage servicing agent and owner are the same financial institution, the employees are from separate departments and their compensation structures are not aligned to overall corporate goals, but to departmental goals.

In the meantime these two anchoring forces have bumped heads and eventually underwater homeowners realize they have already lost all of their equity. They reset their anchor and understand anything they pay to the bank is throwing good money after bad. They stop paying on their mortgage, ultimately being evicted from their house through foreclosure. They also stop paying real estate taxes, and maybe insurance too; both costs provide no benefits to them. The mortgage servicer ends up with increased fees and the mortgage owner doesn’t get his money until the house is eventually sold, usually at a much lower price than market value. By the time a house is foreclosed, the owner is usually over a year in arrears.

I’m a big fan of the blog Calculated Risk. It has frequent posts on the housing market and my extrapolation of their charts and graphs implies that we are still at least three years out from foreclosures returning to “normal” levels. The results of these overhangs are that housing prices continue to slip, and because of the excess inventory (supply greater than demand) new construction is at record lows as a percentage of housing stock.

The good news is that current construction is near all-time lows for housing stock. Continued population growth (and eventual household formation) means that demand will grow to meet supply and the dearth of new construction will hasten that day.
However, construction is usually a key driver of new jobs in economic recoveries. Job growth has been anemic is this recovery, largely (but not entirely) because of the paucity of new construction. New construction employs not only builders, but those who supply building products, appliances, etc. The leveraging of one new job within our economy has the effect of creating four or five total jobs.

Economists may determine economic cycles based on increases and decreases in macroeconomic statistics such as GDP (gross domestic product) or perhaps the more indicative GDI (gross domestic income). Nominal GDP is higher now than it has ever been. Even real GDP (nominal GDP adjusted for inflation) is near or at an all-time high. So what’s the problem?

People (voters) based their understanding on microeconomic values. Can they buy as much as they used to? NO. Are they being paid higher wages for the same amount of work? NO. The population continues to grow and per capita GDP is still below all-time record levels. And remember, we humans anchor at the best of times…

But wait a minute: if that’s all true, why is it that I noted in my last post that at the end of April 2011 my net worth had almost returned to its all-time high? (Note: May and the first few days of June have not been as kind and perhaps April will turn into a new temporary anchor for me!)

Loosely speaking, stock markets have done well because corporate profits have soared. Bond markets have done well because the Fed has kept interest rates very, very low. These corporate profits have not been uniformly distributed across the economy—only those with substantial assets have benefited. Real wages continue to decline for most working Americans; corporate executives, for whom real wages are once again increasing, are the exception.

In the next post, I’ll talk about why this imbalance, unless corrected, will put a hobble on the economy.

~ Jim