Thursday, April 27, 2017

Fiduciary Rule And Alternatives

I'm from the government and I'm here to help you.
Pardon me but this isn't my first rodeo.
Who's Making the Money?
Where's Bogle when we need him?
A different conflict of interest.

The Department of Labor’s fiduciary rule demands that advisors who work with retirement accounts act in the best interests of their clients, and put their clients' interests above their own.  Working with a fiduciary makes sense for many retirement planning activities. However, fiduciary is a higher level of accountability than “suitability,” the standard required of financial salespersons, such as brokers, planners and insurance agents. For most activities related to ongoing management of a retirement account a salesperson is totally appropriate, and in the case of the no-load mutual fund, even a salesman is unnecessary.

Every investor has a right to an opinion about the fiduciary rule, and most investors probably have an opinion. No doubt, that opinion is influenced by the degree to which one wants to take responsibility for making one’s own investment decisions and doing one’s own research. However, some people do not realize that taking responsibility for making one's own decisions and doing one's own research are probably the most important fiduciary rules.

A disclosure is in order. My initial reaction to the fiduciary rule was to wonder whether it was a hoax or a joke. The idea that the government could pass a law that would force others to understand my best interest seemed ludicrous. It also seems apparent that paying someone else to try to understand something that is self-evident to me, my self-interest, was going to get expensive. As Bogle has pointed out on numerous occasions, investment costs are the enemy of successful investing. So, I was skeptical from the start.

On 4/19/2017, the WALL STREET JOURNAL had an article entitled “Wall Street’s Fee Bonanza.” It pointed out that even though the fiduciary rule may not be implemented; firms were already shifting to a fee-based service. The explanation is simple: the firms have found that fees for advice and services could be more lucrative over the longer term compared with commissions.Researcher Morningstar Inc. says fee-based accounts can yield as much as 50% more revenue than commission accounts.”

The fiduciary rule would affect about $3 trillion that brokerage firms oversee in tax-advantaged retirement accounts. Generally, the fee under a fee-based management system is 1% or more. So, the rule would introduce $30 billion of costs into the system. That $30 billion is not all new costs since brokers were previously earning commissions that may be reduced as a result of the fiduciary rule. However, commissions at brokerage firms have been falling without the fiduciary rule, and mutual fund management fees have been shrinking. Introducing this new fee is counter to the trend in the industry.

Theoretically, the fiduciary rule would force the brokers who oversee those accounts to act in the best interest of the clients. Advocates of the fiduciary rule argue that it would address a cost of $17 billion a year in extra expenses that result from conflict of interest. They base that estimate upon the existence of a lower cost “equivalent” investment product. Critics of the rule dispute that estimate, but even if the estimate is right, $17 billion is only about .6% of the $3 trillion in brokers’ tax-advantaged retirement accounts.

It's also worth noting that the $17 billion estimate is not based on the $3 trillion in brokerage accounts. It's based on $6.8 trillion in defined contributions market. Using the $6.8 trillion figure and a 1% wrap fee, the cost could be $68 billion. Finally, even if the $17 billion estimate is correct, there's reason for skepticism about how much of that conflict of interest cost could be eliminated by the fiduciary rule.

As is pointed out in an April 8, 2017 article by Jason Zweig in The Intelligent Investor section of the WALL STREET JOURNAL, conflicts of interest is not so easy to identify, and they are much harder to eliminate than simply passing a rule. The article was entitled “Conflicted And Not So Free Of Friction” and concluded with the statement “the label ‘conflict free’ can lull investors into dangerous complacency.”

He points out that anyone who provides a service including financial advisors has a conflict of interest. “And you should be wary of financial advisers who aggressively market themselves with the label ‘conflict free.’ No matter how sincerely they may believe it, that description is impossible.”

He then goes on to point out some of the “conflict free” claims made by some firms. He gives an example where the claim is made based upon not having proprietary products: “Because the firm has no proprietary products to sell, … advisers can provide truly objective, conflict-free advice and investment recommendations.” However, that language refers to the relationship between the adviser and the company. Yet, people who work for the company may receive special payments for bringing clients with them from their former firms and may earn more when clients invest in one product or service than in another.

The article quotes Brian Hamburger, president of MarketCounsel, a firm that helps advisers comply with investment regulations. He comments: “Conflict free is good marketing. But it is a bad description of financial advice, because it can lull investors into dangerous complacency.” He then gives some examples:

“Some financial advisers charge higher fees to manage stock than bond portfolios: That’s a conflict. Advisers can earn more if you take a rollover from a 401(k) retirement account than if you leave the money where it is: That’s a conflict.”

“Many advisers charge fees on money-market mutual funds but not on a certificate of deposit you hold at a bank. Not surprisingly, they often favor money funds over CDs even though CDs can offer higher yields, and that’s a conflict.”
A conflict of interest can arise from something as simple as which product requires the least paperwork. In the case of the heavily regulated industry like investment advisories, it can arise from the amount of paperwork required to comply with regulations. With the fiduciary rule, the risk of lawsuit undoubtedly would create conflicts of interest between what best serves the client and what minimizes the risk of lawsuit.
The fiduciary rule is not going to relieve investors of the necessity of doing their own due diligence. The investor still needs to know exactly how the adviser is compensated if conflict of interest is a major concern. However, conflict of interest should not be a major concern. The major concern is whether the investment is consistent with the investor’s objectives and competitively priced. An adviser may be selling a product that satisfies the investor's objectives even though the adviser is consciously pursuing his own self-interest.
It just seems inappropriate to potentially introduce $30 billion or maybe $67 billion in cost in order to eliminate what might be as little as a few billion in conflict of interest costs that can be eliminated. So, there has to be some other justification for introducing that cost.
Higher fees may well be justified if they are associated with the higher-level service. Under this fiduciary rule, people managing retirement accounts will have to spend more time trying to understand the client’s full financial situation. It would be unfair to fee-based advisers not to acknowledge that they put considerable effort into understanding the investor’s risk tolerance and personal circumstances. Some advisers are probably very good at it, but others will undoubtedly just be filling out forms in order to check the boxes they need to check in order to protect themselves under the fiduciary rules. However, not all investors need expanded services. So, why make every investor pay for them?
Further, my reaction is colored by the fact that I seriously considered and looked into what is required to get the designation Certified Financial Planner, and I also studied the requirements for a Series 65 license. My conclusion from those experiences was that, rather than improve one's ability to give good financial advice, the regulations introduced a different conflict of interest. That different conflict of interest doesn't preclude giving good financial advice, but it is a conflict of interest between giving advice consistent with regulations versus giving the best advice possible.
Lest all those with a CFP or Series 65 license grabbed their pitchforks and ready the tar and feathers, I want to make it clear that I believe that a fee-based advisory service for financial planning makes sense. So much so, that I invested the time and effort to study the CFP and Series 65 requirements in order to learn more about how to do it. However, using a fee-based advisory service to set up a financial plan is different from ongoing investment advisory services. Many fee-based advisers with the CFP or one of the other designations won't even recommend specific financial products; rather, they'll identify what's needed in generic terms. It's then up to the individual to decide whether those products are appropriate and which products to purchase.
Financial planners provide a tremendous service by showing their customers/clients how to go about setting up a financial plan and helping their clients do it. However, that's quite different from the fiduciary rule that's currently being considered. The fiduciary rule creates the mistaken impression that the financial adviser, because he or she is a fiduciary, can develop as well as implement a financial plan for you. Further, it ignores the issue of whether complying with the fiduciary rule increases the cost of investment management to the point where the fiduciary rule itself conflicts with acting in the best interest of the client by increasing the cost.
Many advisers with the CFP or similar designation pursued the designation out of a desire to provide conflict-free financial advice. That, however, is quite different from a large corporation switching all of its brokers from a commission-based compensation scheme to fiduciaries so that they can have access to large amounts of money for the company to manage. In essence, the fiduciary rule may have shifted the fiduciary designation from a benefit of working with a fiduciary to a marketing program for large brokers.
Some investors undoubtedly need to be protected from their own financial advisor. Others find it far less expensive to just dispense with the financial adviser totally. It would seem to make sense to let the investor select the type of financial adviser that best suits him or her. However, there is the potential for the fiduciary rule to be justified because of an adverse selection process. Those who need the protection of the fiduciary as a financial adviser may also be those who have to have it forced down her throat.
For example, common sense would dictate that one would save and invest for retirement. Yet, one of the greatest benefits of pensions is that they force savings and investment upon individuals who otherwise might not save and invest. Similarly, default 401(k) enrollment and even mandatory 401(k) offerings by employers have many advocates among those who have looked at the issue. So, absent the fiduciary rule, the negative impact might be concentrated among the least financially savvy participants in retirement programs and those least able to avoid the appeal of the sales pitch. However, it would have no impact on those who are so financially unsophisticated that they don't even participate in retirement programs.
However, that raises yet another question and potential objection to the fiduciary rule. If the fiduciary rule benefits primarily the less financially sophisticated, there is an increased potential that acting in the client's best interest would involve forcing them to purchase a product they don't understand. That raises the question whether a fiduciary should sell someone a product that they know the purchaser doesn't understand.
Again, pensions provide an example. Many pension participants understand only that the pension involves a promise to pay. They have no concept of the importance of the ability to pay or the role of the pension fund, and often they haven't the foggiest idea where the pension is investing.
It would seem that the fiduciary rule has the potential to harm a significant number of investors by increasing the cost of investing in a retirement account. Those most likely to be negatively impacted may be sufficiently financially sophisticated to figure out a way to avoid the costs. However, it would seem more reasonable to use the fiduciary rule as a default status while allowing an option to opt out.
Despite the inappropriateness of the fiduciary rule as currently being considered, there is ample room for improving how retirement accounts are run. It is a common complaint that fees associated with 401(k) and other defined-contribution accounts are too high and opaque. However, the high cost and opaqueness are as much a product of the structure of the programs as a conflict of interest. Further, what is true of 401(k) programs isn't true of all retirement accounts.  There's no evidence that self-directed IRAs require a fiduciary broker. A fiduciary is appropriate for some investors and not for others.

Placing the emphasis on providing participants with accurate information on 401(k) programs, especially all costs, may be far more productive than the fiduciary rule. 

Saturday, April 22, 2017

The Ying and Yang Regarding Part of Dodd-Frank


In the Wall Street Journal on April 22, 2017 the “Heard on the Street” section had an article entitled “Too Many Questions For Revamp.” In the course of discussing the Treasury’s review of the Orderly Resolution Authority (a provision of the Dodd-Frank law giving government the authority to take over and wind down a failing financial firm) the author, Aaron Back, reports on one view of the pros and cons associated with the decision:

“The debate over this part of Dodd-Frank is one of those strange Washington conversations in which the two sides talk past each other. Conservative Republicans in Congress abhor it, saying it enshrines the concept of “too big to fail” in law by giving the government authority to lend to a failing firm while it is being wound down.”

“But the law’s architects cast it as the solution to “too big to fail.” A government liquidity backstop is provided to a company while it is wound down to make sure its collapse won’t destabilize the financial system.”

It would qualify as honest reporting except that the author is in such a hurry to get to his personal opinion about the issue that he completely overlooks the real substantive source of the disagreement. The author concludes with the statement “Keeping the authority in place makes it riskier to invest in individual financial companies, because the government retains the power to wind them down when it deems it necessary. But it makes the system as a whole safer.” In so doing, the author shifts from reporting to editorializing and ends up not doing either very well. In bankruptcy investors are as much at risk as in an orderly wind down. The power to wind down institutions only creates additional risk for the investor if the government would be inclined to wind down institutions that would otherwise not fail. That would not make the whole system safer.

That brings up one of the real issues behind the difference in policy inclinations. There are legitimate grounds for a difference of opinion about whether the markets or the bureaucrats would be better at identifying failing institutions. Markets will not be made less risky and systemic risk will not be reduced if regulators have a bias toward taking control of institutions they think are at risk. I have a lot of respect for the people I dealt with at the regulatory agencies, but they are definitely excessively risk adverse. They’re paid to be risk adverse. I bet they'd be the first to admit that they are risk adverse.

One of the complaints of the populists of both left and right is that the government was “bailing out” a lot of the big banks. Many of those banks were not at risk of failing, but risk-adverse bureaucrats intervened with liquidity anyway in the name of maintaining orderly markets.

Providing liquidity to maintain an orderly market is quite different from taking over an institution that is failing. It's a different risk, but it is not clear that when regulators intervened they were clear about whether they were making an institution viable or making a market more orderly. But regardless of which risk they were responding to, they were displaying heightened sense of risk aversion. When one goes beyond the risk-adverse bias of the bureaucracy and look at politicians, the situation is even scarier. One of the concerns is that power-hungry politicians like Bernie Sanders and Elizabeth Warren would use Dodd Frank authority to take over banks. It's an issue the author completely ignores, and it's definitely a serious issue.

A second real issue is a substantive difference of opinion about what should be done with banks that are at risk of failing. On the right, the opinion is they should be forced out of business. On the left, the opinion is that management of them should be taken over by government. Which of those options would make the system safer is not a foregone conclusion. One can reasonably argue that the failure of Lehman was disruptive, not because it was a bankruptcy, but because it created a liquidity crisis. Once the liquidity crisis was addressed, the bankruptcy proceedings related to Lehman ceased to be disruptive.

A disclosure is in order. Nothing said above should be interpreted as a criticism of the policies that regulators took during the financial crisis. They made profitable investments that provided liquidity and a guarantee of liquidity exactly as they should.

“Too-big-to-fail” is a legitimate issue worth considering. However, as is explained in some detail in an October 17, 2015 posting entitled “Getting History Right,” the financial crisis hardly justifies the view that regulators lack adequate authority. A simpler approach would be to acknowledge that regulators handled the financial crisis appropriately, and then to clarify any areas where they felt they were going beyond their mandate. But alas, that requires giving up the “bailout” mischaracterization that both the left and the right are so fond of.



Tuesday, April 18, 2017

Today Is Tax Day

In thinking about taxes we often focus on the wrong issue.

Levels aren't the be-all and end-all.

There are a few glaring structural deficiencies in our tax code

Some should be recognizable by any objective observer.

This posting introduces two examples of structural deficiencies in US tax code. They are only examples. There are many other structural deficiencies and each of the topics discussed below introduces a raft of subsidiarity issues. However, the broad issues these two topics raise are badly in need of focused attention and rational political discourse.

1. Tax Reform Is Bigger Than a Bread Basket: Personal Income Taxes.

It's an incredible mess because it's treated as if it were a bread basket.

It is unfortunate that a substantial portion of the voting population approaches tax reform and taxes in general from a totally selfish “what's in it for me” perspective. They pursue that selfish objective from the narrow perspective of how much they are going to have to pay in taxes if nothing else changes. By so doing, they often defeat their true self-interest. Taxes have broad economic and social implications that are often far more important to an individual's future than the narrow issue of what their tax bill will be next year if nothing else changes. One of the most perverse of those broad economic and social implications results from the inefficiency of the tax system in the US.

Keep them in the dark

No one can ensure that taxpayers understand the difference between their marginal tax rate and their average tax rate, and even if they do, it's easy enough for politicians to make statements about tax rates without saying which they're talking about. Add deductions to the mix and changes in income levels at which different marginal rates apply; then the calculations are more complicated. Just to round things out, add in different tax rates for capital gains, dividends, wages, and transfer payments received from the government.

If that isn't burdensome enough for taxpayers, create a totally separate tax system called the Alternative Minimum Tax. To really make it opaque, hide some taxes some by calling them contributions, and then tax income used to pay the contributions. Add some negative taxes and tax credits so that taxes can be something you pay or something the government pays you. For good measure, have some taxes that are paid by entities other than the individual but are passed on to the individual. Just in case someone does figure it out, wait till the end of the year, or better yet, the beginning of the next year, and change everything retroactively.

Provide lots of opportunities for theater

The personal tax system doesn't look like a system designed to efficiently raise revenue for the government. The only things it does efficiently are to allow lots of opportunities for political theater, grandstanding and raising revenue from lobbyists. By making personal income taxes so confusing, politicians can focus on minor changes that appeal to a particular group they are addressing. In addition, the system is so complicated that any changes can be presented in a way that appeals to any particular group. Tax changes can be presented in terms of dollar impact, the impact on the percent of all taxes paid, the impact on the portion of income paid in taxes, the impact on marginal rates, the impact on average rates, the total impact on revenue, or the impact on individuals with a particular interest.

If you can’t provide benefits, fan envy

Paying taxes is not a benefit of government. It's a necessity in order to have the benefits of government. So, changing the personal tax system doesn't provide benefit to anybody unless it leads to a more efficient system for raising the revenue the government needs. However, honest politicians won't get reelected if they put their faith in the public's willingness to accept efficiency as an objective. Few politicians are willing to point out that it's always in the government's interest to raise more revenue; after all, it gives them more power and money. But, they can derive benefit from changing the tax system by claiming that they are protecting a particular group from, depending upon your attitude, the burden or responsibility of paying taxes. It's a perfect issue to use to fan a class warfare mentality and cultivate destructive envy.

Implications for serious tax reform advocates

It's unfortunate that personal income taxes are such a convenient way to cultivate class warfare and envy. But, given that that is the case, it's an issue that is best skipped if one wants to accomplish serious tax reform. So, for this tax day don’t focus on whether personal income taxes are too high or too low, too regressive for to progressive, or administered fairly or not. Instead, think about the drag on the economy the results from the system that's taken on a life of its own and develop the ability to defend its own inefficiency. That's the tax code of the US.

2. Tax Reform: Corporations Are Not All Businesses

Price the value of incorporation whether for business or pleasure.

There are advantages to incorporating regardless of the purpose of the corporation. Principal among those benefits is limited liability. That limited liability applies to an investment in the business or a donation toward a nonprofit corporation.

Price the benefit

The law treats corporations as having certain rights as individuals. All individuals should pay taxes. The object of the tax code should include pricing the benefits of incorporation. It should not be dependent upon a judgment about the objective of the corporate individuals.
However, we place a much higher cost to incorporating based upon totally irrelevant criteria. We don't tax the benefit of incorporation directly. Rather, we tax it indirectly by taxing the income of a small subset of all corporations. It would be more appropriate to tax the benefit of limited liability than to discriminate under the law based upon the objective and financial performance of the corporation.

Corporate individuals receive benefit from offering limited liability to those who participate in the corporation. The benefit to the corporation can be either priced directly by charging the corporation or indirectly by charging the participant. In the interest of simplicity, it may be much easier to price that benefit by charging the participant. That charge to the participant could take a multitude of forms, but a simple option for consideration would be to levy a fee on the participant at the time they participate. So, for example, there could be a charge of 1/10 of a cent per dollar of participation. In this example, a $20 donation to a nonprofit corporation would require payment of two cents. Similarly, a $20 investment in a bond or equity of a for-profit corporation would also involve a fee of two cents. Revenue raised by the levy could either be treated as a cost of the corporation or as an expense of the individual.

Keep it simple and efficient

The levy could be made very efficient by having it collected and paid by the nonprofit in the case of nonprofits, and collected and paid by brokers in the case of for-profit corporations. For nonprofits, consideration would have to be based either on the input of the participant or the expenditures of the Corporation. In most cases, a levy on the participant input would be appropriate. The only exception would be instances where the activity of the corporation is intentionally biased away from the input of the money and toward the expenditure. An example would be an individual who funnels all expenditures through a corporate entity without acknowledging that the use of the income automatically implies the participant’s income is being treated as income for the corporation in the first place. Funds received from an endowment would be treated the same as any other participation. The intent of pricing the benefits of incorporation suggests that the levy should be uniform and universal. It would apply to any and all incorporated activities.

There is considerable evidence that many nonprofits, especially charitable foundations, act as fronts for personal aggrandizement for their founders. The IRS also expends a fair amount of effort (i.e., taxpayer money) to ensure that nonprofits are only nonprofit for that portion of their activity that “qualifies” for nonprofit status. Neither problem would be eliminated by the presence of the levy. However, the incentive to abuse the tax codes related to nonprofits would be reduced to the extent the levy is substituted for current taxes on profits. It would also reduce the need for the government to essentially regulate the activity of the nonprofits through IRS examination and rulings.

Acknowledge the alternative

Nonprofit corporations know they benefit from limited liability. If they are unwilling to pay for it, an alternative is unlimited liability applied both to the nonprofit corporation and to those who contribute to it. The alternative of unlimited liability is analogous to businesses that are not incorporated. It's a perfectly legitimate way to operate.

Stop adding a subsidy to the existing benefit of incorporation

Participants in a corporation received the benefit of limited liability regardless of whether they participate by contributing or by taking partial ownership. Equal treatment under the law suggests that providing tax deductions for participation in the limited liability corporation should either be tax-deductible or not tax deductible. If participation in a corporation through a charitable donation is tax-deductible on personal income taxes, the same should apply to participation by stock or bond ownership. However, making neither tax-deductible is appropriate. Both the donor and the investor are receiving the benefit of limited liability. Congress should eliminate the charitable deduction on personal income taxes.

Scoring consistence

Eliminating the charitable deduction and charging a fee for the privilege of enjoying limited liability status would raise revenue. The revenue could be used to offset reductions in reliance on taxes on profits of profitable for-profit corporations. Profitable for-profit corporations are, after all, a very small portion of the total number of corporate individuals. All corporations benefit from the limited liability of corporate status.

The fee for the privilege of enjoying limited liability would obviously be set based on negotiations within Congress. It could be 1/10 of the penny per dollar as in the example above or at 100th of a penny or any other level. But, the level selected should, to the extent possible,   reflect the benefit of limited liability. The total amount of the fee should be larger or smaller based upon the size of the organization as reflected by the revenue being raised. 

Scoring, that is estimating the revenue implications of these measures, can be done in two ways. Static scoring assumes nothing changes other than the tax. Dynamic scoring estimates both the change in the taxes and the change in behavior the results from the taxes. Whichever technique is used for one tax measure should be used for all other components of these tax changes.

The issue of scoring could lead to a comedy of hypocrisy. Since the elimination of the charitable deduction and the levy on the privilege of operating through a limited liability corporation will affect many organizations that currently have advocacy operations. Watching them change their position regarding which is the most realistic approach will be interesting. Some of those organizations have argued for static scoring on tax cuts such as the reduction in the corporate profits tax. Yet, they will be quick to argue that eliminating the deduction and adding the levy has dynamic consequences that will have detrimental impacts on them because it will reduce the amount of revenue they raise. A little self-interest sometimes reveals truths that were previously hidden by ideological blinders.


Saturday, April 15, 2017

CBO on government debt and its budget impact


Overview

CBO reported that the federal budget deficit rose $63 billion in the first half of fiscal 2017 (OctoberMarch) to $522 billion from a year earlier. Those aren’t estimates; they are actual numbers. But, they were used to introduce CBO estimates of deficits over the next 10 years. Since the forecast has implications, it's worth looking at how much value to place on CBO estimates. Only then does it make sense to look at the substance of their forecasts.

You gotta love the CBO.

While Obama was doubling the national debt over eight years, the CBO wasn't just low-profile on the issue; in many cases, they actually obfuscated it. For example, they grossly underestimated the deficit impact of the stimulus plan. If you think it was a partisan ploy, you might note that this was done by overestimating its stimulative impact. As I argued in a bunch of postings in September 2010, every neo-Keynesian was overestimating the stimulative impact because of flaws in their models. CBO was just particularly bad.

If you need another example of CBO's wacko analysis, the Affordable Care Act (ACA) was estimated to reduce federal deficits by $124 billion by 2019 (March 2010 estimate by the CBO before the law was enacted). They not only got the magnitude wrong; they may have gotten the direction of the impact wrong. Their estimates were so indefensible that CBO has stopped estimating the effect on the deficit from the ACA.

It isn't just economic impacts CBO screws up. In February 2013, CBO predicted that ACA enrollment in the individual market would be 13 million in 2015, 24 million in 2016 and 26 million in 2017. The actual enrollments were 11 million, 12 million and about 10 million. As recently as March 2016, CBO was projecting an enrollment of 15 million for this year. They were equally flaky on their forecasts for Medicaid.

Similarly, CBO was also badly wrong about the 2003 Medicare prescription drug benefit. The drug benefit cost about 40% less over its first decade than CBO projected. You may recall that this was the unfunded entitlement that was going to destroy the world.

The less you think it is a partisan issue, Ryan Lizza in “The Mandate Memo: How Obama Changed His Mind,” (NewYorker.com, March 26, 2012) reports that Obama became so frustrated with the CBO that at one point during the healthcare debate he banned aides from using the term “CBO” in his presence. Instead, he called the CBO “banana.”

Don't misunderstand my comment about nonpartisan. I'm not naïve enough to believe that public employees don't respond to the conflict of interest of being a public employee when evaluating the impact of public sector activities. I'm just pointing out that CBO isn't a serious analytical organization. One doesn't need partisan politics to be incompetent. CBO could be incompetent and partisan, not just incompetent, but that's a different issue.

The debt is real and the problem is real

There is one aspect of CBO’s analysis of the deficit outlook that is free of the conflict of interest noted above. To some extent, their projection of the deficit is based upon their assessment of another government organization’s impact, rather than the impact on the public sector of the private sector. Part of their projection for growth in the deficit is an assessment of how much the Federal Reserve (FRB) is going to contribute to the deficit.

The CBO deficit forecasts are predicated on their own economic growth forecasts as well as stability in policies. Policies will change, and the CBO is no better at economic forecasting than anyone else. So, the forecasts themselves are of less value than their analysis of what's driving the debt and deficit. In some instances, the impact of CBO forecasts and assumptions are easily isolated. The impact of the debt on future deficits is one such variable. The impact of the debt is a product of the size of the debt and the interest-rate the government pays.

A logical question is how sensitive are the forecasts to the CBO's assumptions regarding interest rates. CBO estimates that if interest rates are one percentage point higher than in its current projections, the result will be $160 billion additional spending in each year over the next decade. Given that level of sensitivity and the uncertainties associated with any interest-rate forecast, current data on the debt and deficit are important to understanding the forecasts.

The Federal Government’s net interest payments increased $7 billion in March from a year earlier. To put that in perspective, the president’s 2018 preliminary budget proposes cuts of $2.7 billion in discretionary spending. So, the interest costs increase in one month was almost 3 times what the president was able to propose cutting in his first year of operations. Further, it's worth noting that the increase is about 30% for the month. Payments increased by $28 billion for the six months of fiscal 2017 to $152 billion. That is about a 22% increase and it is among the biggest single spending items in the CBO estimates.

The increases reflect the larger debt.  As mentioned, the debt has doubled over the last eight years, but the more ominous fact is that the growth in the debt accelerated in the last year: Federal spending exceeded revenue by $176.2 billion last month. The budget gap was about $68.2 billion higher than a year ago. For the first six months of the fiscal year the deficit was about 15% higher than the same period a year earlier. Over the past 12 months, the deficit stood at $651.5 billion, compared to $460.6 billion a year ago. Those are Treasury Department figures not CBO estimates.

The size and accelerating growth of the debt obviously has implications, but those implications depend upon one's forecast of interest rates that will be applied to that debt.  For the last eight years the FRB’s near-zero policy kept Federal government interest rates at historic lows. That reduced net interest payments even as the overall debt increased. However, at the same time, the federal fiscal outlook deteriorated due to ever-higher future interest obligations. In the CBO forecast the Federal Reserve’s decision to raise interest rates after years of near-zero rates compounds the impact of the debt.

Raising interest rates is not the only way the FRB is influencing the deficit forecast. The FRB’s bond-buying programs earned money that the FRB turned over to Treasury each year, reducing the size of the federal budget deficit by tens of billions of dollars. FRB officials are indicating that this year they may stop buying new bonds as those on its balance sheet come due. That will reduce the number of bonds they have earning interest, and, as a consequence, there will be smaller FRB contributions to the federal budget. Also, as interest rates rise, the FRB will have to pay more on bank reserves deposited at the Central Bank. The FRB pays banks 1% on reserve balances. As the amount the FRB has to pay banks increases, it will reduce the amount they can turn over to the government. The amounts aren’t negligible; they pay about $20 billion a year on reserves.

Thus, in addition to the higher interest rates that the federal government will have to pay, there will be a reduction in the more than $90 billion the FRB has turned over to Treasury in recent years. According to CBO, all of this is set to explode on President Trump’s watch. One might ask why CBO ignored this time bomb for so long.  After all this is not the first time they've done 10 year forecasts, and even they aren’t naïve enough to have assumed that interest rates would never rise. But the more important point is that the chickens have come home to roost, here-and-now, according to CBO.

The FRB is not the only instance where the government pays interest which is then recovers. According to the Flow of Funds data from the Federal Reserve, about 28% of the federal debt is held on other federal accounts. That includes about 16% of the total federal debt held by the Social Security Trust Fund.

Consequently, between the FRB which holds 13 to 14% of the debt and the other agencies that hold about 28%, a significant portion of the federal debt, about 42%, is held in accounts were some or all of the interest is recovered by the government.  Even that 42% estimate understates the total public-sector ownership of federal government debt. Another 3 – 4% is held by state and local governments and about 1% is held by the pensions of state and local governments.

The fact that close to half the federal government debt is held by the public sector determines the implication of the rise in the deficit and debt. Basically, the higher interest payments remove control of how taxes are spent from the current elected federal officials. Some of it is shifted to the state and local governments that hold the debt. But, the main effect is that it shifts those revenues to mandated expenditures resulting from the actions of previous elected officials.

The interest on debt run up by previous administrations and previous commitments to programs that where expenditures are determined by a formula, independent of revenue, consume a larger portion of tax revenue. Social Security and Medicare are the largest such programs, but now they must compete with Affordable Care Act mandated expenditures. The fact that the interest cost of the debt rose by three times as much in one month as the administration was able to cut in its plan for a year of operations illustrates the loss of control implied. Basically, elections become irrelevant as current elected officials have less and less control over government priorities. Increasingly, the only option open to an elected official who wants to control government priorities is to ignore the deficit, run up the debt, and let the next administration worry about it. That is a terrible set of incentives.



Sunday, April 9, 2017

The Curious Case of Friday's Employment Report

Labor markets are still tight
The labor market may be indicating an inflection point
The timing of the inflection point would be unusual
The implications would be far-reaching

Every once in a while employment reports get interesting. Most of the time, the various reports on employment are straightforward.   When different reports on employment are consistent, they are easy to interpret. But that's not always the case. The report 4/7/2017 for the month of March was one of those reports that requires more than a superficial review.

The WALL STREET JOURNAL on 4/8/2017 in the “Heard on the Street” section included an article entitled “Data Obscure Tight Jobs Market.” The theme of the article is that Friday's report can be subject to two different interpretations depending upon which source of data is considered more important.

It states “The best way to understand Friday’s employment report is to ignore the jobs number, which was lousy, and the unemployment rate, which looked good.” For those who missed the report it showed the economy added just 98,000 jobs last month, below expectations and well-off of the previous months’ gains. The contradiction is that the report also showed that the unemployment rate fell to 4.5% from 4.7%.

The article starts by pointing out that the best way to understand Friday's employment report is by ignoring some of the actual data items. Instead of trying to focus on either number, the article suggests focusing on differences in the implications of data from different sources. Unfortunately, the article limits its focus to just the Friday report.

The jobs number comes from a survey of businesses (with various adjustments made by the Department of Labor), while the unemployment rate is calculated from a survey of households which also contains a measure of employment gains. So the two numbers actually come from different reports. The approach of comparing different sources is definitely on target, but there's no reason to restrict attention to just the Friday report. On Wednesday there was unemployment report on private sector employment as estimated by Moody's Analytics using ADP data. On Thursday there was a report on new claims for unemployment insurance.

Labor markets are still tight

From the Friday report:

(1) The drop in the jobless rate occurred even as more people entered the labor force. In other words, the labor market is tight enough to be drawing people into employment who previously were not seeking work.

(2) An alternative measure of unemployment as well as underemployment, which includes those who have stopped looking and those in part-time jobs who want full-time positions, dropped to 8.9% in March, down from 9.2% the prior month and the lowest since December 2007.

(3) Similarly, there was a continued decline in the incidence of long-term unemployment.

(4) In another sign of labor-market tightness, average hourly earnings rose 2.7% from a year earlier. This indicates that the people who are finding employment either by entering the labor market or upgrading from part-time employment are not being forced into desperation jobs. They are probably abandoning desperation jobs for jobs that are more appealing.

(5) The survey of households, upon which the jobless rate is calculated, showed a large gain in employment— 472,000 for the month. There are reasons to believe the household survey is a more accurate measure this month. The difference in magnitude may be due to differences in definitions, but the relative size and direction of change is probably more accurately reflected in the household survey (as discussed below).

(6) The weak job growth number comes from the employer survey. A winter storm struck during the Department of Labor's survey week. People who missed a paycheck that week more often than not would not be counted in the business survey. However, in the household survey people who miss work because of the weather still get counted as employed.

From other employment-related reports:

(1) Unemployment insurance filings reported on Thursday show that the number of people applying for new unemployment benefits fell in the week ended April 1. Initial jobless claims decreased by 25,000 on a seasonally-adjusted basis. As the WALL STREET JOURNAL pointed out on 4/7/2017 in its “U.S. WATCH” section, last week’s report points to consistent job creation and certainly precludes the possibility of major layoffs on a large scale.

(2) On 4/6/2017 the WALL STREET JOURNAL reported on the employment report generated by Moody's Analytics and ADP. As pointed out in the article entitled “Hiring Robust in Private Sector,” private payrolls across the nation rose by 263,000 last month. Using payroll records and an alternative definition from the BLS survey avoids the weather impact that showed up in the Department of Labor's Friday's employment report. Thus, the ADP number is a better reflection of the underlying state of the labor market.

The labor market may be indicating an inflection point

A divergence between the jobs report from the employer survey and the employment component of the household survey can be a random fluctuation attributable to differences in samples and methodologies. However, occasionally it is a very telling sign of the change in the underlying dynamics of the economy. Consequently, “maybe" is the appropriate way to interpret this section. This can only be a “maybe,” but it's worth considering because it would have major implications because of the timing.

As has been pointed out a number of times in this blog, the household survey captures people who become self-employed, start businesses, or are hired by small companies. They generally aren’t counted or are undercounted by the employer survey. In fact, trying to get adjustments to the survey to reflect the undercount in business startups and small companies has been an ongoing problem for the Department of Labor.

Self-employment, business startups, and small business hiring have all been weak spots in this recovery. If those three sources of employment growth have finally kicked in, the economy has undergone a fundamental shift in the sources of growth. While still tentative, there is evidence that such a shift is occurring.

First, from the ADP report quoting directly from the WALL STREET JOURNAL article: “Most of the job gains came from small businesses, defined by ADP as companies with 49 or fewer employees. These firms added 118,000 jobs. Midsize firms with 50 to 499 employees added 100,000 workers, while large businesses added 45,000.”

It's no secret that small businesses are a major source of employment growth. However, the ADP report shows that they are now starting to respond in their traditional role as job creators rather than as the punching bags they seem to have been during most of this recovery.

Second, it's also no secret that the drop in the number of startups during this recovery has been frightening. It's been characterized as a “collapse” in startups. It has surfaced in numerous data sources including IPOs, new business registrations, and tax filings. Unfortunately, the most reliable data on business formations (tax filings) is only available with a lag.

Contrary to the Wall Street focus, new business formations usually originate below the financial radar. Individuals go out and start a business. Only later is a clear that they did more than just become self-employed. So, the fact that employment rose while the unemployment rate fell is significant. That phenomenon, in combination with low growth in the jobs number, is often associated with an increase in self-employment.

The timing of the inflection point would be unusual

A posting on August 4, 2010 entitled “An Article about a Fiction and theEmployment Report” noted that: when the business cycle is just turning up, a divergence between the jobs number from the employer survey and the employment figure from the household survey would indicate a normal recovery. The reason is simple: as confidence increases, and John Maynard Keynes’ animal spirits surface, people are more willing to start a business or try self-employment. Further, as that posting noted: “Recoveries don’t come from having the same set of employers hire back people. Recoveries have always come mainly from new or different companies hiring. Interestingly, it tends to be smaller companies and often startups from the current or the last cycle.”

However, as noted above, new business startups have collapsed during this recovery. The divergence never showed up. So, if next month's employment report confirms the divergence that appears to have occurred in Friday's data, the timing would be quite unusual. It's usually a phenomena observed at turning points when the cycle turns positive.

There are reasons to believe that phenomenon is real. Business confidence surveys ranging from surveys of small businesses to announced hiring plans of the large businesses would be consistent. They all show an increase in optimism. Even more telling for the particular data we’re discussing is the increase in consumer confidence. Self-employment is very much a function of consumer confidence.

The implications would be far-reaching

The divergence might not persist. The normal interpretation of such a divergence could be wrong given that it's occurring at an abnormal point in the business cycle. However, if it is real and the normal interpretation is appropriate, it has major implications across a variety of areas.

Economic Implications

(1) It has cyclical implications. Resurgence in small business, startups, and self-employment this late in a recovery would, at a minimum, indicate a need to rethink where the economy is in its recovery. Perhaps this cycle lasts longer than is typical or maybe it will just require a different kind of shock in order to produce a downturn. Or, perhaps the recovery is just now gaining its footing.

(2) It has structural implications. As noted in the WALL STREET JOURNAL on 4/7/2017 in a special "In Depth" section under the title “Why You Work for a Giant Company,” the US economy has undergone a transition from being largely composed of small businesses to one dominated by large businesses. A revival of small business at this point could reverse the trend and restore the structure that was characteristic of the US economy historically.

(3) It has growth implications. The lack of productivity gains during this recovery is a major concern. Without productivity increases it is very difficult to get wage and income increases. Not to demean the research done by large companies, but traditionally startups and new businesses have been responsible for much of the growth in productivity. Federal Reserve Board in one paper estimated that changes in the number of startups create a persistent increase in GDP through productivity growth. Specifically, they found that a one-standard deviation shock to the number of startups led to an increase of real GDP culminating to 1-1.5% and lasting 10 years or longer.

(4) It has policy implications. The divergence between the household survey and the employer survey would indicate that the labor pool is deeper than superficial employment measures indicate. Thus, inflation is less of a risk than superficial employment measures imply. In essence, if this age of the business cycle is “younger” than its chronological age, then perhaps fiscal stimulus is appropriate.

Investment Implications

(1) As financial markets seem to have surmised, the headline number (98,000 new jobs) is meaningless. It's one of those flukes that show up in any series. It is worth noting that previous postings have argued that trying to invest based upon monthly employment numbers is a fool’s errand. Even if it was a valid measure of employment, a couple more months’ of data would be required before one could surmise that it's a trend. Then one would have to conclude that the employment trend has implications for future profitability. That would be a reversal of the way the economy actually works. Employment is a lagging indicator.

(2) Since the headline number is meaningless, any investment implications arise from the discrepancies between the different reports. Since interpreting those discrepancies involves a lot of “maybes,” there is considerable investment risk associated with making any asset allocation decisions based upon currently available employment data. Now, that's not unusual given that employment levels are a lagging indicator.

However, employment levels aren't the same as structural changes in the economy that are reflected in employment data. Employment data may be the first indicator of structural changes. Most leading indicators provide little or no information about structural changes. The best leading indicator on structural changes is new business formations by industry and size. It is only available with a considerable lag. Thus, even if the phenomenon (new business formations) leads, the data lags.

(3) The issue is investment implications, not speculative implications. Consequently, structural changes are extremely important since they tend the last over a reasonable investment horizon. They are persistent; there's no harm in waiting for confirmation of the implications of the current employment data. The advantage of identifying the structural implications of the current employment data is that it points to a potential trend. Trends are a much better basis for investing then cycles.

(4) Trends are such a firm foundation for investment decisions that most commentators are willing to jump the gun and call any two points a trend. There is a risk of making the same mistake with regard to the structural change being discussed here. There are, however, two differences.
Structural changes are very different from changes in direction in a cycle. Structural changes only appear dramatic after-the-fact; they are subtle while they are occurring. Thus, changes in the direction of the headline number seldom provide any information about structural change. The composition of economic activity revealed by the detailed data is where structural change can be identified. 

(5) Acting on the investment implications of this potential structural change does not have major negative implications if the structural change never appears. To illustrate, a posting on February 11, 2014 introduced “The Three FundPortfolios.” Subsequent postings on the topic provided the rationale and examples of individual funds that can be used to construct a portfolio. One objective of the three fund portfolio is to get exposure to small and medium-size companies without having to select a portfolio of individual companies.

A simple strategy to capitalize on any structural shift toward small and medium-size companies would be to increase the assets allocated to mutual funds targeting that asset class. A posting on February 4, 2016 entitled “The ThreeFund Portfolio in 2016” discussed the ongoing management of the portfolio. It recommended dollar cost averaging into the portfolio. One could capitalize on any structural shift toward small and medium-size companies by targeting the new investment into the mutual fund containing small and medium-size companies.

Dollar cost averaging is a good example of an approach that reduces the risk associated with investing based upon any thesis (i.e., forecast). If the forecast doesn't materialize, as actually was the case with respect to developments in 2016, dollar cost averaging allows one to respond. With respect to the structural change being discussed in this posting, after a few months' of allocating new investments to the fund targeting small and medium-size companies it should be apparent whether the structural change is actually occurring. If it is, one has the option either to continue investing in that mutual fund on a monthly basis or accelerate the rebalancing toward that mutual fund. Given the “maybes” associated with structural changes, dollar cost averaging is a low risk approach to a potentially important investment opportunity.

Friday's job report at first seemed to muddy the water regarding the trend in employment, but on close examination, the issue raised is more subtle. The headline number in the employment report is seldom justification for changing one's financial plan. But, the report does provide information about the performance of the economy. Often that information is just a lagging indicator, but sometimes it reveals underlying trends that has not shown up in other data. When that is the case, it does create opportunities for investors.