Friday, December 31, 2010

Investing PART 7: “To every thing there is a season.”

Some know it as the words to “Turn! Turn! Turn!”; others as Ecclesiastes 3:1-8.

For those who feel the Byrds ruined a good folk song: “The first one now will later be last” according the Bob Dylan, and for those who prefer classical music, remember Vivaldi wrote of “Four Seasons.” Doesn’t matter how you come to the realization, but change is inevitable.

Rebalancing is one response, but it too has its season. An autopilot annual cycle does fit with Turn! Turn! Turn! One reason autopilot rebalancing doesn’t work is that you can’t REbalance into an asset class that didn’t exist or wasn’t accessible to you before. Things change including investment options. Also, even within classes that have existed for decades, remember that looking backward has its limitations. Fitting the history in order to show optimum returns is an abuse of looking backward. Better to look at conditions today.

You can look at market conditions. Here are a couple of discussions I ran across lately. The first leans toward looking at conditions today, but uses history to interpret them. From a website entitled “Early Retirement Planning Insights” an article entitled “Shun Rebalancing” says: “The argument in favor of rebalancing rests on a series of flawed assumptions. The most important is that there is no meaningful way to measure valuations. Our research has shown otherwise. Professor Shiller’s P/E10, the dividend yield equivalent of P/E10 and Professor Tobin’s q all work well.”

The second reference takes a different approach that advocates nothing but looking at recent history. From the WALL STREEET JOURNAL, December 11, 2010 Personal Finance section an article by James Stewart entitled “As the Nasdaq Rises, Consider Trimming Some Holdings” proposes what the author describes as a common sense system for buy and sell decisions.

What’s curious about this is that these type of articles are still being written. Going back to Graham’s THE INTELLIGENT INVESTOR there are piles of books and articles on the topic. However, the intelligent reader might come away concluding the essence of Graham’s book is do a lot of analysis, then guess. More recently, ACTIVE VALUE INVESTING by Vitality N. Katsenelson takes up the intelligent investor mantel and tries to present some more mechanical rules. (As an aside, those two books and WHAT WORKS ON WALL STREET by James P. O’Shaughnessy offer far more useful insight than most of what’s written. That isn’t intended to disparage the articles cited above. They are much briefer and quite useful).

The deadly flaw in EVERY discussion of rebalancing and market timing that I’ve seen hinges on the interpretation of the statement that rebalancing should reflect current conditions. They all focus on the wrong current conditions, namely market conditions. What is far more important is your condition.

So, to change music genre “I just stopped in to see what condition my condition was in.” To illustrate with an extreme, if you don’t have a cash cushion, you should only be rebalancing within cash equivalents. Does that even count as rebalancing?

Similarly, to use an example the financial industry beats to death, the assets appropriate to young investors and older investors are different. However, look at the spreadsheets in PART 5 and PART 6 of this series on investing. If you can / will take advantage of the opportunities available to you, age is only a minor factor. By the time you’re approaching retirement you should be managing a portfolio of over a million dollars. So, even if Rod Stewart was singing about you in “Forever Young,” new options should become relevant with time. However, it relates to your portfolio not just or even mainly the market. Further, as discussed in PART 2, the annual changing of the calendar has nothing to do with when and what to rebalance.

Now let’s introduce some more looking backward. However, this time let’s discuss history from the perspective of personal circumstances. Table 1 shows data the media and some in the financial service industry like to misinterpret. It shows annual changes in the S & P 500.

Come the end of 2010 you can grab an update from any of many websites. With or without 2010, it is data worth having around. I only went back to 1975 because that covers the same period as the discussion of IRAs. It’s useful to keep data like this in mind when viewing the long-run IRA returns.

The 9.71% average is a number you might hear people throw around. Since a 50% decline requires a 100% gain to get even, don’t pay too much attention to it when planning for anything important. Personally, the 8 down years out of 35 seems more interesting. The more important issue is the compound annual rate of growth (CARG). However, before proceeding to CARG, a few observations about this table are warranted.

First, the data in this table ignore dividends. Hopefully you just shouted, “WHAT?” Many people, who have an axe to grind, leave out the dividends and talk as if they were saying something. They’re not. As a result, I’ve been in some amazing conversations. People will insist that if dividends are reinvested, that constitutes putting new money into stocks. I’m pretty indifferent to the exact form I get the return on my capital. Dividend or cap gain, doesn’t matter to me. Either way it’s the compounded growth that matters.

In fact, I confess, I’m partial to dividends for a number of reasons not the least is what they say about the management’s philosophy, and usually, the financial health of the company. I’m also sufficiently familiar with accounting to know cash flow beats increased book value. That’s true in your own account and a company’s books.

Second, the data show volatility in a way never conveyed by a few statistics. I’m continually amazed by the fact that volatility surprises people. I think it was J. P. Morgan who when asked what the market would do answered “fluctuate.” He probably wasn’t the first. Yet, people plan as if JP didn’t know what he was talking about.

I know a number of successful investors who time the market quite well. When I express my preference for buy-and-hold investments, they counter by pointing out the “don’t lose the capital” rule. They are fond of showing how much better the return would be by avoiding down markets. The attached spreadsheet Table 1 will let you do the exercise using annual data. Pick any criteria you want. For example, without the 8 down years the simple average return is 13% verses the 9.7% actual. That’s significant any way you look at it. If monthly or peek to troth data are used, the difference is even bigger.

However, I point out the Vinik problem. Jeff Vinik managed the Fidelity Magellan Fund from 1992 to 1996, where he averaged 17% annual returns. But, he was severely criticized for missing some up years. Some would argue that missing up years cost him his job at Fidelity. (After leaving Fidelity, he started a hedge fund called Vinik Asset Management. He made investors about 50% a year for about four years. Before closing down the fund to manage his own funds.)

To see the importance of not missing up years, take out the 8 best years on Table 1. The the average return drops to 3.15%, mirror image of the change resulting from taking out the 8 down years.

So, the issue of rebalancing out of assets that are falling in price is important, but it’s equally important not to make the opposite error, being out of rising markets. If you’re interested in what happen if you’re out of down markets and miss the 8 best years, the result is a 6.4% average. However, remember the more years you’re out of the market the more years in which you have to replace the dividend flow.

Well, all that’s fun with numbers, but “So what?” you ask. Well, Vinik’s experience at Fidelity and his decision to retire his fund illustrate the real problem. Worrying about timing the market can be hard work. It’s pretty clear that in most years you’ll make money being in the market. Maybe you can’t guess how much or when the down years will be. That’s no reason to give up. You’ll make money in most years. So, stocks should be a major part of your portfolio.

It would be nice if your fund manager could avoid down cycles, but it seems that ever since Vinik’s experience at Fidelity, mutual fund managers have considered it a sin to venture far from fully invested, a fixed ratio by asset type, or some other benchmark. So, don’t look to your mutual funds for help. No, the money you pay them won’t get you any benefit of insight about overall market direction.

Keep in mind that annual and especially calendar years are really irrelevant. Looking at annual results is just a way to compare two arbitrary points in time. It isn’t a good way to look at results over time. Looking at reesults over time immediately shifts attention away from changes in levels at different times. So, let’s look at returns over time. Dividends are earned over time. So, let’s include them and just let them compound. Now we’re talking about CARG.

CARG varies by what time frame is covered because dividend payouts change and stock prices change. Table 2 shows the CARG for periods running from every year since 1975. They all end with 2009. It covered the same period as the IRA spreadsheet and Table 1. In many respects it is the stock market data relevant to retirement planning.

Over this 35 year period there were 5 years where if you invested in the stocks of the S & P 500 at the beginning of the year, you’d have less money as of the end of 2009. The other 30 investments would have grown at compound annual rates ranging up to 12%, (ignoring 2009 a one year period). It’s also no accident that the longer the holding period, the more likely there is a gain and the larger the gain. As much as some people would like to ignore and deny it, over time economies grow, societies progress, and the market goes up.

Many people have jumped to the wrong conclusion based on the facts Table 2 demonstrates. More on that after the market closes on 2009.

Wednesday, December 29, 2010

Investing PART 6: Perhaps some seasonal music

Don’t say “bah humbug” unless you’re so rich you don’t need the money being offered.

Don’t expect “A Partridge in a Pear Tree,” but the tax code does provide it’s version of “Two Turtle Doves.” If you dig into the tax code, you might even find “Three French Hens” and more.

Following up on the use of IRAs to illustrate the importance of starting your investments, this posting’s theme is simply “don’t look a gift horse in the mouth.” IRAs and 401(k)s (or their equivalents -- 403(b)s, etc.) are widely available. They weren’t created for the rich. They were set up to benefit “the working man.” In fact, there are numerous obstacles and limitations on high income earners’ ability to benefit from them. So, when people say they don’t / can't contribute to their 401(k) or IRA, if you want to start a raucous, ask if it’s because they’re too rich. But, don’t be surprised if “the working man” insists on staying “the working man.”

It’s a lot more difficult to construct a spreadsheet like the IRA toy for a 401(k). It isn’t as useful either. With 401(k)s, our wizards in Washington have played around with limits: thus, there is no hard and fast maximum to put in as a placeholder. First, the max was a max on total employee and employer contributions, and then in 1987 they put a max on employee contributions.

Through the history of the 401(k) the government has encouraged, regulated, and generally messed around with the portion of wages that could be contributed pretax. There is also the issue of whether a specific plan allows nondeductible contributions. Many plans used the pretax limits to set the max, thus reducing the max to a percent of wages rather than a dollar amount.

Most crucial of all, each employer can select the structure of their plan. Contribution limits can also be affected by who else contributes. So, there isn’t a typical contribution limit. But, the issue is too important to an investor to ignore.

A 401(k) is one of very few instances of a guaranteed return, and not a small one. To start with, there is the potential of tax deductibility. Depending on your marginal tax bracket, that can be a 10-36% contribution to your income right out of the gate. Earnings on the investment receive the same immediate kick regardless of whether the 401(k) contribution was deductible or not: that’s guaranteed and that’s a pretty nice subsidy to your investment returns. (The same benefits accrue to IRAs). Add to that similar tax treatment in many states and the subsidy is hard to pass up. That alone is justification for maxing out a 401(k).

But, like the late night direct sales commercials shout: “Wait, wait there’s more.” No, it’s not free shipping. It’s the potential of an employer contribution. The employer contribution is optional and varies with your employer’s fortunes, but who else is giving you money just to do what you should be doing anyway?

Now, I’m not a fan of many 401(k) offerings. Some are good, and they certainly have gotten better over time. For example, my first 401(k) offered one fund in each of about five categories and none where low cost or could be expected to deliver market-beating returns; vanilla at best. But, a tax subsidy and employer match made them a dynamite opportunity. The same fund family administered a 401(k) at a more recent employer. It had more funds than anyone could possibly take the time to explore while also holding a full time job. They included both managed and index funds of every conceivable stripe. Many were offered under a variety of load or management fee options.

The point being if mutual funds are your preferred investment vehicle, 401(k)s generally won’t come up short nowadays. (Granted some employers pick bad plan administrators, but competition is forcing most employers and fund managers to offer a viable range of options). However, as discussed in “Wall Street Doesn’t Run the World,” money managers have limits when it comes to meeting your financial objectives. Consequently, I recommend rolling 401(k)s into IRAs as soon as you leave an employer. Then, as will be discussed in subsequent postings, restrict the use of mutual funds to the areas where they have a big advantage. I’m just not a big fan of mutual funds and that especially includes most ETFs.

Again, “Wait, wait, that’s not all.” There is a point that’s even more important than whether your plan is the be-all-and-end-all of investment offerings. The simple fact is that 401(k)s have so much going for them in terms of tax treatment, employer matches, and the automatic deduction of contributions that you’d be a fool to hold out for some hypothetical better alternative. You don’t need your 401(k) to be knocking the socks off of the averages in order to accumulate a nice chunk of change. Besides, as is apparent from the discussion of cash (PART 3), a 401(k) shouldn’t contain your only assets. Knock the socks off the market in your IRA, or better yet, have a taxable account where the range of investment options is only limited by your skill and knowledge.

Don’t think you can live with less than stellar results? Well, it may be a rough estimate, but the table below illustrates what can be achieved. It’s constructed just like the spreadsheet presented in PART 5 except that in this case it’s just a table not a live spreadsheet. If you want to do the same games with your 401(k) as with the IRA, just use the spreadsheet. However, getting all the contributions histories makes it a chore. Realistically, continuous access to a 401(k) much less 29 years of uninterrupted employment and a continuous option to make the maximum contribution are not what most people can realistically expect. Nevertheless, the table illustrates the role your 401(k) can play. Note I’ve added 12% to the range of annual average returns. With tax free compounding and decent occasional employer matches, it’s realistic.

These comments should provide a hint at how I suggest you incorporate your 401(k) into your portfolio, but that’s a topic by itself. Briefly, they’re a good way to accumulate assets to roll into your IRA. You'll need the 401(k): a contributory IRA isn’t going to much more than cover your medical expenses in retirement especially given the cuts in Medicare the administration just enacted. However, it seems logical to leave some assets in your 401(k) as a form of diversification across legal ownership structures, again, especially given the current administrations tendency to play it loose with legal property rights. Even when the administration changes, it can be useful to have some funds in mutual funds in a 401(k) as something to benchmark your investment decisions against. So, have fun.

Saturday, December 25, 2010

Investing PART 5: Oldies: When looking back is most valuable.

To paraphrase a Greek philosopher: “Investor, know thyself”

Sticking with the Rolling Stones, the song “Start Me Up” begins with the lines “If you start me up. If you start me up, I'll never stop.” So, with investing the first question is: when to start? One thing is sure: once you start you’ll probably never stop.

Here looking backward can help. There is a technique called back-casting that statistical modelers use. I want to introduce an analogous tool. Back-casting, as one might suspect, is forecasting backward. One might ask: “Why would anyone do that?” For some purposes it is useful because it abstracts from what really happened.

For example, back-casting is one technique used regularly to validate models. Some portion of the historical set is withheld from the model. The model is then run and the withheld portion of what actually happened is estimated or “forecast” using the model. The “forecast” of history is then compared to actual history. If the “forecast” of history is markedly different from actual events, the model is usually discarded. There are all sorts of variations, but that’s the essence of at least one use of back-casting.

Another use of back-casting is to estimate history for period where no history exists. For example, the broader measure of unemployment, U6, doesn’t have a long history. So, to compare this “total” measure of unemployment and underemployment to a like measure for other cycles, people back-cast U6. Both uses have their limitations, but are useful once the limitations are understood.

This posting discusses an approach that is analogous. In this case the purpose is to take current period data and imply something about history. It is analogous to the second use described above except in this case, the implications are about a variable not in the model, specifically ones’ personal behavior. It’s a way to check ones’ self-perception.

If you think such self-analysis is irrelevant, good luck; you can skip this posting. But, before you dismiss self-analysis consider whether the volatility in asset prices over the last few years caused you to reconsider your asset allocation. If that doesn’t convince you, consider which is more important to retirement planning: when you start or your rate of return? If you’re short of your retirement goals, is it just a bad patch for your investments or is it the amount you’re saving?

Since this posting deals with self-analysis, each reader is uniquely qualified to judge whether what is implied is valid and useful. It’s totally self-analytical. Even if a reader thinks he or she knows himself or herself, the exercise is a way to validate that assumption. Besides, it yields some data an investor should know.

Let’s start with what’s known. Most people know, or can calculate, how much money they contributed to their IRA each year. (If not the attached spreadsheet may make it easier). If they’ve mixed rollover and contributory IRAs, the analysis gets a little harder, but the approach still works. (And, the spreadsheet is still useful). Further, they know what their IRA is worth. Many know what their return has been recently. But fewer know what their compound average rate of return has been over the life of their IRA. It is this last issue that is the focus of the attached spreadsheet.

There are numerous ways to calculate an average annual compound rate of return. Many are more sophisticated (i.e., more accurate at the decimals of a percent) and many would require more data (e.g., exactly when contributions were made). But, remember the purpose of this exercise is self-analysis. A blunt instrument is all that required.

So, let’s look at the spreadsheet. It is fairly self-explanatory. The columns are the year, contributions (basic and, for older readers, catch-up), and various rates of return. Down the rates of return columns the balance at each compounded rate is calculated. I used 4, 6, 8, & 10% returns. Back when I put this together, I figured at one end, a person could average 4% in a bank. Nowadays the Fed has made sure you have to look elsewhere for an assured 4%. At the other end, if you did better than 10% over a long time (e.g., 15-20 years) you’d be sufficiently confident and competent not to need the analysis. It wouldn’t be easy since initially the investment options in IRAs were very limited (e.g., in the initial years only bank deposits were relevant to most investors).

For each year there is a cell for your contribution. The maximum allowed is shown. There were quite a few years where some people with pensions, 401(k)s, or high incomes couldn’t make the maximum contribution. Depending on your age, 1975 may be interesting history, but irrelevant. Similarly, catch-up contributions may be irrelevant. So, the actual entries and calculated balances are of passing interest; the spreadsheet is a tool (or toy) not an answer. For convenience, a spousal spreadsheet is also shown. So, working spouse or not, a tool is available.

How it works is fairly simple. You enter your contributions in place of the contribution data shown. The spreadsheet then calculates a balance as of 2009. If you’d like, add a year 2010 by copying the last row for an additional year. Either way, the result then can be compared to your balance to see which average annual rate of return fits. You now have your average annual rate of return. You also have alternative rates of return to use if you’re figuring you might try some new investment approach being promoted by some tout. It is an interesting little toy. (See, I’m easily amused). Over simplification? Yes. Yet, if you play with it for a while, you’ll see ways to illustrate some facts about investing. It’s easy to project YOUR results forward, backward, or for different levels of contributions.

Showing the full history facilitates the “what if” scenarios that allow you the flexibility to see the importance of when you start. You can calculate a dollar value associated with changes in the start date. For example, take out the first five or ten years and compare the result to the differences in results associated with different rates of return. (For example, taking out the $7,500 allowed during the first five years when contribution limits were lowest has an impact roughly comparable to a couple percentage points in average return, just slightly less). It’s very naive to assume you can overcome a late start with investment genius. Better to accept reality and figure you’ll need to pump up the savings rate.

Put differently, it sure looks better to just dive in, start investing even if it means accepting a slightly lower return: it’s better than to wait until you feel sure you can beat the averages. As the commercial says in a different context: “Just do it!” The initial $7,500, less than 9.5% of all contributions, at the sample rates accounts for from almost a fifth to almost half the balance in 2009. Such is the impact of compounding.

Alternatively, take the current contribution limits and paste them into the earlier years. You can compare your portfolio to a hypothetical portfolio earning the same return, but started at a different date. Years ago, I also used this as a forecast tool when planning -- kind of silly today given that now many web sites offer sophisticated Monte Carlo simulators.

Why did I stop at 2009? I wanted a way to show how a one year drop in value changed the lifetime average rate of return – at most a couple of percent depending on when it happens. Remember, at the end of 2008 the market had dropped almost 40%. I listened to more than one person try to argue that 2008 wiped out years of investment gains. You’d have to really fiddle the numbers to get that result.

Don’t get me wrong. A couple percentage points of return is important when compounded. For example, the discussion of cash holdings identified approaches which might increase returns by a percent or two. What would be the impact over a lifetime? Since we are talking up to a year or two’s cash needs held over most of a lifetime (exceptions being when you chose to tap the funds), it’s substantial. While designed with other purposes in mind, the spreadsheet shown below can be used to calculate a dollar value. However, that shouldn’t be necessary. It’s obvious: a few percent is important.

Similarly, avoiding declines in the value of assets can add substantially to returns. The first, second, and third rules of investing are: first, don’t lose the capital, second, don’t forget rule one, and third, never forget rules one and two. Also, rebalancing to avoid asset price declines is, after all, the reason we turned the music on in the first place. However, rules one, two, and three don’t matter if you don’t start. So, “Start me up.”

An interesting toy for the holiday. Please download it rather than using it where it is.

Thursday, December 23, 2010

Investing PART 4: Same genre, different tune

Beetles and Kingsmen aren’t your style? How about the Rolling Stones’ “Give Me Shelter?”

“Gimme, gimme shelter or I’m gonna fade away,” so say the Stones. Well, shelter is what cash is. By now you may have figured out that I don’t hide from risk. It really isn’t that hard to manage. Cash is a shelter that I seek to minimize. Cash isn’t the only shelter, but it does seem to be the one with the least potential.

Some investors try to “move to cash” as a market-timing effort. Others realize building up cash only makes sense if you can’t identify any better alternative. Cash is almost never the best shelter for any reasonable period of time, but not being the best is better than being the worst.

Even when cash does seem competitive, a portfolio will generate cash as assets reach sell points, come due or are called, or generate interest and dividends. In that sense, just not reinvesting the cash a portfolio will generate is fading away. Other than not investing until or unless you see an opportunity, building up cash beyond the level described in PART 3 doesn’t make sense. Keep in mind PART 3 can imply a cash position as large as a few years’ living expenses if you’re living off your investments.

Ultimately, what cash does is hedge the risk that other assets will become illiquid. For that purpose, it can’t be replaced. However, there are close substitutes. Since we could be talking about a few years’ cash needs, how it is held isn’t trivial for most people.

One close substitute to consider is a bond or bond-like instrument that you can call. Sound strange? They are offered from time to time. For example, no penalty CDs (i.e., CDs with no interest penalty if cashed in before maturity) were attractive at one point. FDIC insured no penalty CDs certainly meet the need for access to cash.

A ladder of appropriate maturity FDIC insured CDs or Treasury notes can meet the need. Remember we might be talking about covering a few years’ of cash needs. If you’re covering a few years, not all the cash needs to be available from day one. Keep in mind the yield curve generally is upward sloping so a two year note pays more interest than a 30 day note. Once constructed, that means you’re holding a ladder of maturity dates, but all CDs or notes have two year maturity. It’s the maturity dates, not the lengths of the bonds, that form the ladder.

Another option worth watching is Savings Bonds (I Bonds indexed for inflation or EE Bonds with a variable rate pegged to a percent of the 5 year Treasury). The Government periodically changes the terms of I Bonds and EE Bonds. Right now the Government seems to be bent upon making Savings Bonds unattractive, but there still are advantages. They can meet immediate cash needs until after they have been held for a year (with an interest penalty) and after 5 years the interest penalty is dropped. So, after 5 years they are totally liquid. (Interest is federal tax deferred and state and local tax free).

It is possible to reduce the pain associated with the lack of return on cash, but it is important to remember that the purpose is to have cash available when needed. Any instrument has counterparty risk. The options discussed above place that risk with the government. Governments issue cash; so, the counterparty risk doesn’t really change.

Similarly, once FDIC insurance was extended to money markets, counterparty risk was shifted to the government for money market funds too. However, money markets funds hold short-term assets. They don’t take advantage of the common theme of the alternatives discussed. Assets with maturities further into the future generally pay higher interest. No penalty CDs, ladders, and Savings Bonds take advantage of the higher yield characteristic of longer maturity assets without sacrificing liquidity.

Recent events like the freezing of the auction rate market for munis and the impact of the liquidity squeeze on the ability of some money market funds to redeem at a dollar per share illustrate another potential risk. Any cash instrument that provides liquidity based on the ability to sell the underlying asset introduces market risk. Thus, other near cash instruments will be discussed along with other investments in subsequent postings.

Sunday, December 19, 2010

Investing Part 3: Setting the volume

Lyrics to the song “Money” by the Kingsmen, the Beetles, and others

“Money, that’s what I want. That’s what I want,” but for heaven sakes let’s hope it isn’t all you want. That’s true of life, and it is equally true of investing. So, how much is enough? How much money to hold is quite different from how large a portfolio? We’re talking about liquidity. Cash is the usual portfolio term.

It’s that time of year again, so here’s a reference to that seasonal movie classic “It’s a Wonderful Life.” There’s a scene where shortly after getting married, George Bailey has to try to save the Bailey Building and Loan. The run is on. The first depositor wants to withdraw his entire balance. (We’ve seen that recently.) Then, however, things settle down. At this juncture, a subtle point surfaces. Subsequent depositors start making smaller withdraws. The amounts are quaint. But, the point that is easy to miss is that they, the classic “man on the street,” know how much money they need to live. You should too.

Further, you should keep in mind that money represented total cash flow requirements at the time the movie was made. In today’s terms, it represented total ATM withdrawals, automatic payments, checks written, cash, and debit or credit card purchases. In short, it was everything they would spend between banking cycles, probably paydays for most of them.

To hearken back to previous discussions, especially “Wall Street Doesn’t Run the World,” you have a big advantage if you know how much money you need. To illustrate, poor George Bailey doesn’t know how much money he’ll need to make it through that day. By contrast, his customers, who aren’t bankers, can put a dollar figure on what they need.

Indirectly, George avoids the clutches of the evil banker, Mr. Potter, due to the astute financial management of Miss Davis who only withdraws $17.50 rather than the $20 withdrawals of the customers before her. That she knew she could get by for $2.50 less than the previous customers. That she leaves that $2.50 in the Bailey Building and Loan is crucial. George squeaks by with $2 left at the end of the day.

Now $2.50 then isn’t $2.50 today, but could you make an estimate of your needs to within the current dollar equivalent of $2.50. If you can get close, you have a handle on your liquidity needs. If you can’t get close, work on it. It’s essential. If you can’t do better, take your after tax income from your w-2 last year and divide it by 12. Use that as monthly cash needs. Once you get a figure, all that remains to do is decide how long you would want to be able to leave everything else untouched.

You’re probably thinking: “That’s no help. I don’t know how long that should be. Are we talking until next payday?” Well, at this point things get personal. Personally, living payday to payday never appealed to me. Plus, I realize that next payday is only as reliable as my employer and my continued employment. I’ve experienced time when I skipped a payday and meeting payroll meant payroll for everyone except owners. (That, by the way, isn’t unusual. In small businesses it is usually the owner’s choice. In large businesses, dividends usually disappear before a payroll can’t be met).

The issue becomes: how long are you willing to go without a payday? For most people it means: how long will you allow yourself for a job search if you get canned, laid off, downsized, right-sized, etc.. I once heard a “rule” that went “Have one month of rainy day funds (i.e., cash) for each year you’ve worked. The logic is the longer you’ve worked the more specialized your skills and the higher the pay; thus the longer it will take to get a comparable job.

If you follow the practices in these and subsequent posting on investing, and follow a few simple rules like not borrowing to consume, you’ll find that employment becomes far less financially important than what you do with your investments. Then the “money” issue becomes a little more complicated. Yet, one principal remains the same. You still have to address the question: “How much money will you need to hold in order not to be forced to make decisions you wouldn’t make otherwise?” From this perspective the question becomes: “How long can you live comfortably without touching your portfolio?”

For investors, that means you need to know where a few years of cash flow will come from. If you doubt it, just talk to anyone forced to liquidate much of their portfolio during the recent crisis or the internet bubble’s aftermath. The complicating factor is cash flow generated by the portfolio. That can’t be taken at historical rates since the very nature of the risk you’re addressing will have an impact on the cash flow (dividends get cut, bonds default, etc.). Add to that the fact that earnings even continued employment can be called into question and you see what I mean by “complicating factor.”

Note that the basic logic of this approach puts rebalancing in overdrive. Instead of reducing cash to keep the portfolio balance, it forces actively reducing cash to pay living expenses or to avoid other portfolio adjustments. That tilts the portfolio toward the depressed, non-cash assets at the very time they are under stress. It also treats cash as what it is, a sterile non-productive asset.

The overdrive can be enhanced by monitoring cash flow from the portfolio. As mentioned, during periods of depressed asset prices, cash flow from a portfolio usually declines. Use cash to restore the cash flow from investments also encourages asset purchase when prices are down. But, that assumes not all the cash will be needed to get through the hard times. The final consideration is particularly relevant if employment related earning are depressed.

But, money isn’t wealth and generally doesn’t contribute much to efforts to generate wealth. It’s a sterile asset. When you hold cash equivalents, you're usually paying someone else to take your money and generate wealth with it.

Friday, December 17, 2010

The tax cut compromise and the news as entertainment

Often tongue in cheek is the only way to smile.

Now it’s a fact. It gave rise to a discussion last week:

The Hedged Economist wrote:

Well, unless they reinstitute 99 weeks, people will exhaust their claim sooner. Life is getting interesting. Are people allowed to complain if UI is interrupted for a week or two? I can't imagine our government making people responsible for two entire weeks of unemployment. Isn't that unconstitutional? Oh well.

I get new windows tomorrow and Thursday, so I made the energy tax credit cut off. The work that will be done next year is a different story. People who chase the subsidies have to be wondering: “What comes next?” For me, it’s an asset allocation issue.

[A friend in NJ] had some new rant about Governor Christy. He blames Christy the way [friend who is a Democrat] blames Bush. I blame everyone, the short and the tall, the large and the small, you name it. I'm an equal opportunity blamer. ME? !!! You've got to be kidding.

By the way, did you check on an energy credit on the work on the second home? I don't know if HVAC and windows / insulating are separate credits or what happens with second homes? I think HVAC and insulation may be separate credits. You may have a twofer. You're probably a step ahead of me on that one.

I'm still waiting for tax rate resolution to pass. Time is getting short. I have to pay estimated taxes by the 15th. I'll bet they won't cut me slack for their inability to tell me whether I owe AMT. Have we ever gotten things messed up!! A person can't pay their taxes even if they want to.

The retired Treasurer wrote:

I think current recipients get an extension, but the 99 cap remains for those who already exhausted their benefit. This was what the Internet was saying last night. Also it seems that the AMT will be fixed. I have maxed out the credits with windows here, but the State will give some money towards the new furnace.

It is a wonderful blood bath right now has the dems are really pissed at Obama. He has lost a lot of face.

The blame game is a waste of time, unless you know how to change things.

I think we are on a very bad course of action, doing things like the 2% cut in Soc. Security contributions. The road to hell seems to be paved with trying to screw your friends and blame your neighbors.

The Hedged Economist wrote:

Now we see whether it gets passed. 99 weeks is an awful long time. You'd think it would occur to someone that maybe, just maybe, they should stop messing with people and let the economy grow. Guess there's no political gain in that. The AMT fix will be welcome. Once passed, I can pay my taxes.

The infighting in both parties is entertaining. I think just about everyone (dems, reps, independents, non-pols, and pols alike) has concluded that Obama's an empty suit.

Please, please don't take my blame game away. It's too much fun and entertainment. Besides what would the media do; start reporting facts?

You kept thinking there would be a double dip. Well, there was no double dip; GDP will soon be back to where it was before the recession started. However, the risk of a new Obama instigated recession is very real. Dems and media will want to call it a double dip because that can be used to shift blame, but we're creating a new risk. Interestingly, none of the measurers they put in place over the last two years is at all relevant to the mess they, we, are creating.

Speaking of screwing your friends and blaming your neighbor, I'm getting a kick out of the Dems’ frustration that they can't screw the "rich." Seems that they'll take 250k or 1M as a definition of rich, just as long as they get to screw someone. Never seems to occur to them that "you can't make it better for yourself by making it worse for someone else." Despite their supposed sense of community, they just can't accept that we all sink or swim together.

The 2% cut in the SS tax is an interesting illustration of just how misguided the pol class is. They cut the individual's payment, not the employer's. The logic being that individuals will use it to consume more (create demand). Like we didn't try that for 20-40 years. Americans don't have a problem figuring out stuff to buy. For goodness sake, they do it even if they don't have the money. That's how we got into this fix. The problem is that many of them don't have jobs. Seems to me cutting the employer's tax would be more direct. I know from personal experience, when meeting a payroll, taxes, government-required social insurance, etc. added about 1/3 to the cost of employing someone. Lowering the cost of employing people might encourage some hiring. But, I'm not sure any temporary measure really matters especially when employers are facing the cost of Obamacare.

The retired Treasurer wrote:

Regarding Unemployment Compensation, well, 99 weeks is a long time and I do not understand why, after 52 weeks they do not tail the amount to zero at 100 weeks--a glide path to some, a death by 1,000 cuts to others.

Regarding the cuts in the proposed package, also the media spin is that it is a cut giving people 2%. Well, going from 5% to 3% is a large cut in taxes. The rate is down by a much larger percentage than any of the other changes.

It is true that 1% of the people have 90% of the wealth. While that is scary, have you notice that 50% of the population does nothing other than live off the dole. Why should we tax you more so others can do less. Perhaps they need to show up at your house to wash the car and clean bathrooms, while your wife is out working, paying taxes, and contributing to SS for them.

The Hedged Economist wrote:

The alternative to weeks of Unemployment Compensation / Unemployment Insurance (UI) that I think would work best is some combo of X weeks and a lump sum. Then you're on your own. I haven't thought much about whether the lump sum should be up front. I think so. Years ago I had the option to take a severance as a lump sum or weeks of pay. I took the lump sum. Basically turn lemons into lemon aid.

Worked my butt off to find a new job in a week or two and thus was able to use the lump sum to pay my son’s tuition at college for a semester. Imagine suddenly getting laid-off with my wife’s college bills just ending and my son’s in midstream and making it into a blessing. Now days many companies are smart enough to realize that if the severance is guaranteed regardless of whether the ex-employee finds a new job, the ex-employee is motivated to get off of UI. That will save the employer the continuing claims.

But, UI is a sweet gig for some people who can’t budget and would blow the lump sum before they found work. I think the government just wants us all to behave like that.

As to the wealth distribution, the 1%, 90% figures seem close. I think the distribution is slightly less concentrated at the high end. Generally, the numbers aren’t too reliable. The only data on wealth that are anything other than propaganda are the results of the Fed’s Survey Of Consumer Finance. It’s only done every three years. The most recent one is almost three years old. So, the 1%, 90% is someone’s estimate. No one would go to the trouble of making the estimate unless they had an axe to grind (or can sell the estimates as we did at I’ve done this kind of work for my own edification, and it’s hairy. I did it only because I didn’t believe data I’d seen on the concentration of stock ownership. Sure enough, the estimates I made were adequate to prove to me that the data were wrong. The Fed’s survey confirmed my suspicion a year later.

The estimates are also very sensitive to how pension entitlements are handled. Some people assume the pensions are owned by the employer. That biases the numbers toward a concentration of wealth. Assume the pensions are owned by the employees and the results are different.

If one approaches it from the individual’s perspective, the pensions are also sensitive to the discount one applies to the cash flow. If you go to Http:// and plug in your and / or your wife’s pension entitlements, you’ll see what I mean. Every $1,000 of entitlement is equal to between 1 & 2 hundred k, about 150k. Increase the interest rate assumption and the number changes. But, you already know that from your work with pension funding issues. As an example, in NJ a change in assumptions resulted in a 9% change in benefits. In any case, the annuity verses pension is only a rough estimate; it’s approximate since there are differences in beneficiary treatment as well as prudent return assumptions.

But, for comparison, to get $1,000 over a comparable time frame requires about 3 hundred k in wealth, twice as much in wealth, and it carries no lifetime “guarantee.” But, when the beneficiaries die any remainder is passed on.

Did you know that your figure of “50% of the population does nothing other than live off the dole” is darn close? About 50% break even or make money on federal taxes paid, including SS. 20% pay almost all of the federal taxes, and 24% actually make money on their taxes. Many people don’t even know about the negative income tax effect at the low end. My FL friend points out that some of the break even taxpayers are SS recipients trying to get by on SS alone. But, the full 50% seems unsustainable even if some of it makes sense.

The Hedged Economist wrote:

It would be easy to misinterpret these comments. I don’t think the 2% SS contributions issue is about who gets tax cuts. For me, it is not even about deficits or stimulus. What gripes me is the total abandonment of any pretense that SS is supposed to be “self-financing” and a social insurance program.

I think it is dangerous to encourage the belief that individuals can ignore providing for their retirement. Even if SS doesn’t pay retiree’s payments that are proportional to what the individual contributed, at least everyone accepted the idea they contributed in order to get retirement and other benefits. By cutting contributions when the fund isn’t financially viable, the fiction is gone. The scramble to have someone else make the contributions is on. Further, it’s now just another welfare program. Next comes cutting off benefits to the politically weak. I think the middle class is wearing a bigger target than they know.

The Retired Treasurer wrote:

Today's thought however is the pyramid of poverty.

The very bottom is the under-six-year-olds who will be left with our debt for $$$$ and must have almost 985% of their needs given to them...i.e. parents, public schools etc The top 0ne % is the Hamptons and the top 10 percent are people we don’t know.

What gets my panties in a knot are some of the other layers... those who are stupid having learned nothing in school, and scam the system, pimp, sell drug and more,

Senior citizens who never saved and thought that they could live with family and get all they need from SS,

The often out of work...those who do as little as possible and then get benefits,

People, especially those under 40 who have a large debt load to cover the flat screen, two week vacation, two SUVs etc... and more housing than they need and big education loans.

You get the idea.

But 80% of this pyramid want to tax the upper 10 % to cover their wants and needs.

Hello, you are not entitled... but they vote themselves what they want from my pocket and the Dems tell them they are worthy of getting even more for free.

The Hedged Economist wrote:

To paraphrase:

What “gets your panties in a knot,” to use your phrase, is too many lazy a#*holes who
- think they're entitled,
- believe things should be given to them,
- think it's OK to scam the system and thumb their noises at society,
- expect others to provide for them,
- consume more than they produce and more than they need,
- and have figured out that politicians will accommodate them.

It doesn't gripe me that they want the top 10% to pay for whatever they want. I just think less of them for thinking that way. What gripes me is that they are too lazy to figure out that the top 10% can't give them everything they want. Or, perhaps they just want to continue believing in Santa.

Remember fully 50% carry the earnings-based part of the cost of Federal government. Now there are other tax sources, but the middle class is always the target for revenue raising. There aren’t enough rich, and the poor don’t have enough.

People just can’t figure out that the only way to determine the right amount to spend on government is to figure out what share of YOUR income should be spent on it. Then try to limit government, a perennial example of unbridled greed, to that amount. This entire class warfare nonsense the Dems and the media feed on…it is just a game the greedy play to get more, more, more.

The moral argument you made when we talked is too direct. I agree those who want to take from the rich need to be told: “It isn’t yours.” Unfortunately, the Old Testament teaching not to covet your neighbor’s possessions seems to be out of style, as does the basic principal of not taking things that aren’t yours or even treating others as you would want to be treated.

I am planning to use a different tact. I say that it isn’t something I can comment on since it isn’t mine. Then, I make an analogous point about something of theirs.

Sunday, December 12, 2010

Investing PART 2: Adjust the treble and base


Over more than a short time frame (i.e., a year) and less than a very long time frame (i.e., 10-20 years), re-balancing (i.e., re-allocating to a target mix) can increase returns for any level of volatility. But, the return as well as the volatility is very sensitive to how often the portfolio is re-balanced as well as the target mix.

The article cited in “Investing PART 1” suggests rebalancing once a year. Perhaps that’s because it is easy to remember, and it eliminates the risk of perverse timing. However, it also eliminates the possibility of more logical timing.

Logical timing has a lot to do with two things: your circumstances (e.g., your liquidity needs over time) and the state of the market. Each should be considered separately, but for reasons beyond me, people seem to feel a sudden increase in the need for liquidity exactly when asset prices are down. Don’t mix market performance and the subjective component of your assessment of your circumstances. Just keep them separate and you can beat annual rebalancing.

So, first let’s address your circumstances. If you are listening to some hard-driving rock and roll, you might want more base, but if you’re listening to some classical music, for goodness sake, rebalance. Similarly, if you’re young and investing for your retirement, don’t treat the investment allocation as if you were going to access the account next week. Rebalancing to maintain a target allocation without realizing that you are aiming at a moving target doesn’t make sense. Further, you should be moving the target according to some plan.

Once you start thinking about your circumstances such as your liquidity needs, you realize a year makes no sense for your total portfolio. Unless you’re totally myopic and only have one goal in life, your investments have multiple purposes. Every purpose (or objective) can’t have the same time constraints. The only condition where liquidity needs are uniform and don’t change over time is if you perpetually “live for today” to the exclusion of planning for a future. If you do that you’ll probably get exactly the future you planned for.

Further, every purpose can’t have the same annual cycle. In fact, individual years are irrelevant to most purposes. The irrelevance of annual cycles is widely known. For example, most mutual fund families don’t even offer “Target Date Funds” based on every year. For a good portion of ones life, individual years are largely irrelevant to retirement. What’s important to mutual fund families is selling their services. The funds they offer show that they know an individual year is irrelevant and they know potential customers know it.

Although the individual funds can manage the mix annually, or even daily if they want, the very offerings indicate a realization that for a good portion of one’s life, cash flow requirements, appropriate risk, and thus, the appropriate asset mix doesn’t really differ based on one year. Annual cycles, or whatever period the fund chooses for adjusting the asset mix, are an artificial construct. What the industry calls the “smooth glide path” just doesn’t reflect peoples’ reality.

One wonders whether the myth of the smooth glide path is just an excuse for more frequent trading, an artificial justification for management fees, or just an admission by the fund industry that they can’t understand asset market cycles. In any case, it is largely irrelevant and potentially dangerous if treated as gospel. Age (even within 5 or 10 year bands) is only one relevant influence.

Similarly, the amount of funds that one may need within a year is pretty stable (keep those funds in near cash equivalents). However, the portion of one’s portfolio that short run cash requirements represents is far from stable. In fact, for most of one’s life the dollar value of the funds one may need within a year is more stable than the portion of one’s portfolio that it represents. Unless you’re really screwing up your investments, the dollar value of short-run cash needs will usually shrink as a portion of your portfolio.

Here’s a wrinkle few people think about. If you believe you need to be able to “get to my money” at all times (i.e., always be liquid), you end up in one of two situations. Either you accept a low return on cash equivalents (and thus have less money to get to), or you risk and probably don’t achieve your goal of always being able to get to your money.

So, for two objectives, retirement and providing for short-run cash needs, annual rebalancing is irrelevant. Here are two simple and sensible alternatives. For money you may need (thus, most of your need for cash / liquidity needs), target a dollar figure. Ignore the portion of your portfolio it represents. For retirement, only look at data on returns over periods as long as the number of years you are away from retirement. There will be more on these topics in subsequent postings that address what to be rebalancing (i.e., what to buy as investments) and when to rebalance.

But, first let’s note that if an annual cycle makes no sense from the perspective of one’s personal perspective, it is even sillier from the perspective of market conditions. Annual is a convenient unit for showing the performance of different asset classes. However, what is convenient for communicating an idea is often over simplifying it for illustration. In this case, the point (i.e., different asset classes perform differently) is being illustrated using an annual period. However, annual has nothing to do with how long or how big the differences in performance are. Even more importantly, annual has nothing to do with why the performances vary.

If nothing else, this posting should have made clear that the reference to the article at the beginning of this posting wasn’t a recommendation. But, the article does provide a recommended approach that raises the right issues: what to buy, how to effectively diversify, when to rebalance, etc.. Also, the recommended approach is probably better than giving up and waiting for someone else to save you from financial hardship.

Monday, December 6, 2010

Jobs numbers verses reality

It’s just data

Given the importance of data verses interpretations, I thought this was interesting. Like people familiar with how data is manufactured say, "It's just a check on a form, not reality." (“Gyrating Numbers Are Misleading” WALL STREET JOURNAL, December 4, 2010, by Mark Whitehouse).

Meanwhile in the world of data, the issues related to seasonality of employment in the retail sector are interesting. The November seasonal adjustment to employment could be wrong, and probably is. But, is it December where it will be made up, or could the hiring have already occurred in October in an effort to jump start the holiday season? I lean toward a December jump.

What seems incredible is that no one has recognized the Obama effect. Hasn't the shift away from permanent hiring to temps been pronounced enough for anyone to make the connection? It’s been going on for a while, but seems to be the trademark of this administration for reasons that all but the most partisan observer can see. (If you don’t know what an employee will cost, how do you plan a new hire?)

The coverage in the media is interesting. They're all reporting an unanticipated jump in the unemployment rate. Do you know a single economist who hasn't said the unemployment rate would go up as the recovery proceeded? The wiser ones don’t say when, just that it will happen. Interesting thing is that while an “up-tick” in the unemployment rate was expected, the labor force participation rate is doing unanticipated things, at least unanticipated by me. But then, we aren't exactly reinforcing the work ethic.

Saturday, December 4, 2010

Investing PART 1: Background music

Asset allocation

Previous postings have advocated diversification across asset types. It isn't hard to see that diversification will increase returns for any given level of risk (when risk is defined as volatility in the value of the portfolio). But, for sure, it reduces the chance of (or potential size of) big returns. So, allocation makes sense for most of us. We may not have a crystal ball to see the future and aren’t gambling. But, allocation should be across all assets one want to own (house, durable goods, education) not just financial assets. But, don’t get silly and start pretending consumption is investment.

Don’t forget to include any defined benefits pension and expected Social Security payments into your thinking. If you can’t figure out how to wrap your head around mixing cash streams (pension, SS) and financial assets, go to ( and get a rough estimate of the present value (i.e., cost) of a similar cash stream. Think of it as an asset class of its own or plug it in as a bond substitute. Or, do the easiest thing: figure you’ll need SS and any pension, a home, and savings in order to retire. Then ignore SS and the pension and focus on your saving until you’re near retirement. That’s a form of diversification across time, a concept we all practice almost automatically, but seldom think about.

If diversification across time seems too abstract, ask whether you’ve ever thought, “That’s a problem for another day” or “I’ve got to focus on the here and now.” Once one stops letting diversification across time just happen and instead explicitly thinks about it and incorporates it into plans, new opportunities become relevant. Further, by ignoring SS and any pension, you’re focusing on what you can actually control. Ignoring things you can control isn’t always a good idea, but in this case it works.

Diversification across time was mentioned in connection with liquidity. Once you start thinking about diversification across time, liquidity falls into place and becomes far less important than many people make it. It also drives home the importance of retirement planning. If you have to plan for both today and tomorrow each time you plan, you can’t just delay it until it’s too late.

What most people think about when, and if, they think about diversification is alternative investments (commodities, real estate, and non-public businesses), stocks, and bonds. Diversification was already discussed in connection with the postings on “Angel, Entrepreneur, and diversification,” especially in “PART 2” and “PART 3.” The focus of those posting was non-public businesses. Of commodities, only gold has ever been discussed on this blog ( “Gold: Be sure you know what you’ve hedged” , “Gold again” , and “Worth repeating and, yes, gold again” ). That could be the case for a long time. Consequently, this series of postings can focus on two specific asset types. Specifically, it will focus on publicly-traded stocks and bonds.

A diversified allocation across those asset classes doesn’t ensure a positive return every year, especially when adjusted for inflation. Just in the last twenty years, there have been two or three years where every publicly-traded class of financial assets except one experienced negative returns. The one that didn’t lose money either barely kept up with inflation or didn’t keep up with inflation.

One common way of showing differences in asset class performance from year to year is a “quilt.” A quilt looks like a checkerboard on steroids. Every asset class is given a color. Little blocks are piled up from lowest return to highest, each with a different color for each asset class. The columns are years. If you want to see one, get the Charles Schwab On Investing Newsletter for June 2010.

Quilt charts are also called asset class periodic tables. You can find one at if you’ve never seen one. But, frankly, none is presented in this posting because it’s the concept that is important, not a specific example. Each example will show its own asset class breakdown. Most examples are marketing tools where the asset classes reflect the offering of the presenter. So, don’t go using a specific example as investment guidance. View them as what they are, useful background information. In other words they’re background music, not a dance tune.

The same concept can be conveyed by an asset class correlation matrix. They’re just tables showing the correlation of asset classes over some historical time period. If you’ve never seen one, try . They appear more sophisticated than a quilt, but they suffer from the same lack of agreed-upon definitions of asset classes. They also suffer from the arbitrary historical periods used to estimate the correlations. They’re probably a little less useful than a quilt. They’re just more background music.

The importance of the concept is the reason for pointing out quilt charts and correlation matrixes, but quite frankly, the best illustration I’ve ever seen took just three asset classes (i.e., US stocks, non-US stocks, US bonds) and plotted their annual return as a difference from the inflation rate. Unfortunately, I can’t provide a link since it was in a T. Rowe Price newsletter years ago.

To illustrate how a simple concept like diversification can be put to practical use, see “'Buy and Hold' Is Still a Winner” an opinion piece from the WALL STREET JOURNAL, November 18, 2010 by Burton Malkeil. I strongly recommend the article as a simple approach for those who don’t want to spend a lot of time managing their investments and don’t mine mediocre returns. I’d also recommend it to those who do spend time analyzing and managing their investments. With a little knowledge, very little in fact, one can do better than the approach shown, but ignoring the investment facts discussed in the article makes it much harder.

Monday, November 29, 2010

Something worth thinking about

What’s good for the goose may not benefit the flock.

Here’s an excerpt that highlights the issue. “The mutual-fund industry has come out firmly against securities regulators' efforts to change and cap certain fees now charged to some fund investors. The plans would see an overhaul of 12b-1 fees, renaming them ‘marketing and service fees’ and limiting their charges to 0.25% of assets.” It’s from a WALL STREET JOURNAL article entitled “Fund Industry Objects to Limits on Certain Fees” by SAM MAMUDI.

Limiting 12b-1 fees sounds reasonable to me as an investor. I wouldn’t pay a 12b-1 (nor a back-end load mentioned later in the article). They are a rip off from an individual investor’s perspective. (If you don’t know what 12b-1 and back-end loads are, either stay away from mutual funds or get help). Calling them marketing and service fees seems reasonable. To see the logic of the SEC’s position, assume 12b-1 fees represent “marketing and service” expenses. Well, seems OK if they charge for service if they actually provide it. But, why should existing investors pay to market to new investors?

OK so far; now let’s introduce Big Brother come to protect us. Here’s where it goes wrong. Some people need to be sold the idea that they should invest. It may be, probably is, in the interest of these non-saves to be sold, and they are probably the very people who can be sold. In any case, someone somewhere has to make the point that saving and investing makes sense from the individual’s perspective. It’s good for the goose; might turn the grasshopper into an ant.

What about the flock? If society needs savings (and the US can’t expect to keep borrowing from poorer nations forever), it needs to “sell” those very American people who are reluctant to save. Seems perverse; encourage those least inclined to save and invest by offering them opportunities where a part of their return is siphoned off. Not so good for the goose who isn’t getting as fat as it could before being served up to the mutual fund due to its own reluctance to save and invest. But, a skinny goose is better than no goose at all.

The flock, on the other hand, is flying high if 12b-1’s are left alone. More capital, a wealthier society (although paying a cost to those selling the idea of accumulating wealth), higher productivity, higher wages, less external debt, a more self-reliant population, probably a more equitable income distribution as a broader segment of the population shares in the wealth.

But, for those who wrongly believe investing is a fool’s game, an alternative justification may drive home the point. Is there a chance Americans are being sold on the idea of borrowing and spending? Has Big Brother ever done anything to control the amount spent selling loans, goods, or services other than investment services? If you don’t know, please don’t vote. Limiting what can be spent on selling investments and allowing unlimited expenses for selling borrowing doesn’t sound like a sustainable plan.

Thursday, November 25, 2010

On the news and other nonsense.

Under the "people say the darnedest things" heading

According to a friend, “Glenn Beck said that the government, using administrative rule rather than a law, had changed the index for CPI. As a result, people on SS would for the second year not get an increase, or COLA.”

If Glen Beck says the reason for no increase in SS is that food and energy are excluded, he is wrong. SS is based on the CPI which includes food and energy along with housing, entertainment, medical, everything in the "average urban basket of goods." The reason SS did not get a cost of living increase is because the CPI increase didn't exceed the threshold for an increase. Not to worry...there is a bill to send SS recipients $250 each since they got no COLA increase.

The practice of looking at the CPI excluding food and energy is common among serious analysts because of the volatility of food and energy. (To get at trends, they often smooth food and energy monthly numbers using a moving average). Consumers tend to do the opposite. They focus on food and energy way beyond their importance in a budget. Part of it is the fascination with things that move. The volatility makes it seem important. Just think about what the average consumer spends on housing, insurance, and total auto expense verses food and energy. (I know people who spend more on phone, cable, and other entertainment than on food). Food and energy seem important because they change frequently. Real estate taxes, mortgage, insurance premiums, or rent payments, the price of a new car or major repair to home or auto are less frequent.

The law has nothing to do with it. The CPI is subject to administrative changes. There isn't any law governing how it is calculated. The BLS does a survey to determine the basket. The basket determines how much changes in food and energy as well as everything else are weighted in the index.

The big changes, however, are: adjustments to the weights assigned to different things (food, housing, etc.) in the calculation of the index, and adjustments for quality changes. The weights matter because when the basket changes, the older historical data became useless, questionable, or fantasyland. Historically, since there wasn’t an alternative (other than the GDP or Consumer Expenditure deflator in the quarterly National Income and Products Accounts) people used fixed weight CPI anyway. So, BLS publishes a chain-weighted index, but people in the media use whatever index supports their story rather than the one that is relevant. Chain weighting involves a lot of mathematical gobbley-guck. Technically, chain weighting is more reasonable for longer periods of time.

The real problem is that people confuse the “cost of living” and “prices changes.” The CPI methodology has fallen into the same trap. The net effect has been to show that inflation was lower than what results from fixed weights. If you want a conspiracy, pick chain weighting. However, the real dirty trick is how they treat substitution and “quality changes.”

I, by the by, think the net result is masking short-run changes (i.e., month-to-month, year-to-year). Also, I am pretty sure the government did it intentionally. After all, one of the reasons for the switch to chain weighting and adjusting for quality changes was that ignoring quality improvements results in changes that are “too big.” But, that’s different from saying they did it with malice.

Which is real? Well, if the quality improvements matter to you, your answer will be different from someone’s who doesn’t care. I figure they knocked at least a percent off the CPI, maybe two. But, that judgment is subjective based on my assessment of the value of the quality changes and the relevance of the changes in the basket.

Regarding quantitative easing and hyper inflation, deflation, inflation and such, you’ve asked about the money supply from time to time. People insist upon believing the FED controls the money supply, even some people at the FED believe it. Simple fact is the FED lost control of the money supply, if they ever had it, many, many years ago.

To illustrate, one can call the extension of credit a measure of velocity of money or the creation of money, but it doesn’t matter in terms of economic impact. It creates more money. But, the FED only controls this through bank reserves. Banks are only half the story (quantitatively less than half). The shadow banking system’s credit extension passed depository institutions in about ’95 and by ’99-2000 had left it in the dust. With the financial panic, the biggest single creator of money, the bond market, stopped creating money.

Securitizations are still pretty anemic. Somewhere close to 6 trillion dollars in credit disappeared from the economy as a result of the decline in securitizations. I figure 600 million in QE2 is a drop in the bucket. If the FED can’t get people worrying about inflation, QE2 won’t help enough to be important. If they do get people worrying, they have to figure out how to undo it fast. The danger is people will wake up and realize the FED isn’t all powerful.

On the political right, there seems to be a concern about the FED just printing money. Well, that’s where money comes from. As to their buying government bonds, they buy short-term Treasuries to control the federal funds rate (i.e., set interest rates). That is what open market operations are all about. It’s not new.

What is different, and the issue with QE2, is that now they are playing with the shape of the yield curve (e.g., the spread between over night loans verses 5, 7, and 10 year bonds) since they are buying across multiple maturities. That’s dangerous, and they know it.

There are times I think the big tactical (i.e., political) mistake was couching QE2 in dollars. For open market, and thus short term rates, they announce it in terms of a target interest rate, not dollars.

So, my forecast is different from The Trader’s “inflation will inflate.” The risk is that the FED is pursuing self-contradictory policies. We’re in a much more unstable situation as a result. It’s like during the housing bubble when I just kept saying this is not a situation with a stable equilibrium. Quite frankly, however, I worry less about FED policy than the other nuts in the government.

Beck’s forecast of a lot of inflation doesn’t say much. Is 70’s style stagflation a lot, or are we talking 5%, or the central European wheel barrels of money stuff? Any one of them as well as deflation are possible outcomes of QE2. But, the FED could get it right and the recovery could just keep chugging along. I think they’ll overshoot slightly and inflation will have to be reigned in, but that’s based on a lot of ifs.

Regarding SS COLA’s, there is no provision for cutting benefits if prices fall. If you’re retired, “here, here, and three cheers for deflation.” But, for the rest of us: if you want a justifiable rant, try to figure your taxes THIS year, not to mention next year. You can’t!!!! The AMT will catch a big part of the middle class if they don’t pass a fix and soon. I’ve had to do tax estimates both ways. It’s a big difference. Now, which do I use to pay this quarters estimated tax? No one knows.

Think it doesn’t matter since you withhold. Well, as they say, “think again little grasshopper.” If they let it go to fix later, the IRS will have to calculate withholding rates for 2011 based on “no fix” and no extension of the current tax rates. Every wage earner will see it in their first paycheck of 2011.

Saturday, October 2, 2010

TARP: A success not being acknowledged.

Discussions of TARP are often a find example of ideology trumping facts, but not in these citations.

WSJ Blog’s Deal Journal, October 1, 2010, posting entitled: “Tracking Which Banks Have Paid Back TARP” by Stephen Grocer and the accompanying data should be a must read for all the pundits who want to talk about TARP. However, often pundits don’t feel obligated to know anything about the topic they are discussing. The lack of other honest reports is so bad that below you’ll find essentially the entire posting about TARP. Facts are so refreshing.

“Two years after its creation, the program cost far less than expected and largely achieved its goal of propping up the financial sector.
While more than 600 banks are still sitting on about $65 billion in government bailout funds, most of the nation’s largest banks have repaid the Treasury.
Here, courtesy of our friends at SNL Financial, is a breakdown of banks that have repaid the funds they received through Troubled Asset Relief Program funds, as well as the amount of the warrants they redeemed and dividends they paid.”

There’s a temptation to also reproduce a short, Heard on the Street, September 30, 2010 article entitled: “Overheard: Long Way to Go” which also discusses TARP. It deserves to be read, if for no other reason than that it is factual. It’s also a nice antidote for another article on AIG in the same paper where the reporter has been thoroughly spun by the Treasury and AIG. But, let it suffice to just quote the first and last sentences of the Heard on the Street article: “Beware the mission-accomplished moment. Thursday's plan to restructure the government's huge exposure to American International Group provides for quick repayment of money owed to the Federal Reserve Bank of New York….The AIG fiasco will be over only if, and when, cash is back in Treasury's pocket.”

If the quote sounds familiar to those who follow this blog, it may be because in the posting entitled: “Stimulus more or less? A failure not being acknowledged: PART 3,” The Hedged Economist gave a similar warning about the need to track the money flows. (While PART 3 was about stimulus, it is equally relevant to TARP). The posting stated: “It is especially relevant because of how it indirectly highlights the need to follow the money flows. Politicians will call the AIG loans a success or failure based on ideology, and given the lack of transparancy in government accounting, the ideologues will get away with it by including or excluding flows based on the argument they want to make.”

For a different perspective and a decent overview see the Saturday Journal article entitled: “Bailout Ends, Not Anger” by Deborah Solomon and Naftali Bendavid. It is almost as if the WALL STREET JOURNAL suddenly woke up to the damage being done by the journalist short hand use of “bailout” to describe a complex group of financial policies. One can hope.

Thursday, September 30, 2010

Stimulus more or less? A failure not being acknowledged. PART 6

Sometimes partisan defenses backfire.

Back when this multipart posting was beginning, a friend sent an article entitled “Recovery Act: How Obama's Stimulus Is Changing America” by Michael Grunwald TIME MAGAZINE

The cover email said simply: “This reads like it was written by the Administration, but it gives a good description behind the development of the stimulus package. The package has a significant 'investment in America' slant, maybe at the expense of adding jobs ASAP.”

The nice thing is that the article doesn't shy away from the fact that the Recovery Act was about advancing Obama's agenda, not stimulus. That TIME MAGAZINE considers that great isn’t surprising. Focusing just on the Recovery Act makes sense from a partisan perspective regardless of one’s partisan leanings, but it could just make stimulus a partisan issue. The article makes clear that the stimulus wasn’t about stimulus. That admission by TIME MAGAZINE is surprising. Given their partisan perspective, one would expect them to claim it is all things to all people. Perhaps their shrinking readership has been reduced to such a partisan crowd that they don’t feel that’s necessary. They gave up presenting news years ago.

My concern is that the public will judge the effectiveness of fiscal stimulus by the Recovery Act. Stimulus started with Bush's approximately 200 B tax rebates to middle and lower income tax payers. But, the total over the two administrations is going to come in being well over a trillion dollars, probably in excess of $10,000 per household. Some partisans will also stick in any deficit and come up with multiple trillions.

From my perspective, the issue is whether the multiplier stays linear as the size of the stimulus grows. From the public’s perspective, the issue seems to be how fast the multiplier kicks in. The two perspectives can lead to very different policy prescriptions. Further, the article points out just how hard it will be to evaluate fiscal stimulus when what we got was something else: an investment in America from one man’s perspective or a massive boondoggle from another’s.

In future postings the absolutely nonsensical aspects of some of the defenses this article advances will become apparent, but the postings won’t be on the stimulus. Rather, they’ll address topics like “Green” technology, venture capital and other topics where, for some reason, the author of the TIME MAGAZINE article fails to recognize what’s going on unless it has a partisan label. So, perhaps one might want to read the article simply for what it conveys: a good explanation of why the recovery is slow and anemic.

Wednesday, September 29, 2010

Stimulus more or less? A failure not being acknowledged. PART 5

Sometimes one can’t imagine an explanation for what has been said other than that it’s designed to conceal the failure.

In an article entitled: “Economists agree: Stimulus created nearly 3 million jobs” by David J. Lynch, USA TODAY, it is hard to explain the inaccuracies by any explanation other than personal partisan leanings. This example is used because the author clearly understands something about economics. That can’t be said for every reporter. However, there are unfortunate, almost deceptive, aspects of this report.

For starters: “Economists agree.” You know that’s wrong. Economists never agree on an issue as broad as the impact of the stimulus. The title is either unfortunate or designed to mislead anyone who doesn’t read the article. One of the things that makes Lynch’s article much better than most is that he does the research needed to report on a wide spectrum of opinions (both of economists and politicians). If one ignores the headline, the article is worth reading. He even cites economists who might strongly disagree with his title.

Sticking with the title, the Blinder and Zandi article discussed previously in this series on policy is one source being used for this media report. It states: “The fiscal stimulus created 2.7 million jobs…” (The previous posting pointed out some limitations of that statement). Even ignoring the limitations on that estimate, that’s not 3 million by 300 thousand jobs; 300 over 2,700 or nearly 11%. Doesn’t sound like nearly 3M any more than the Dow was nearly at it’s high for the year; it was down about 800 from its record for the year at the time the article was written; that’s 11,200-10,400 / 10,400 measuring it the same way as the jobs misstatement, or only 8%. Granted Blinder and Zandi might grant that an 11% range for an estimate of the impact isn’t unreasonable, but that is not the way the report is presented. The 3 million is close to the White House’s claim, not a point of agreement among economists.

Lynch points out that roughly one-third of the stimulus came in the form of tax cuts that will “eventually result in related hiring.” His quoting Paul Krugman’s unsupported and incorrect statement that “…tax cuts that would have a less-immediate impact on job creation.” doesn’t help. Timing is the issue. Being dead wrong on this timing issue is important. There is ample evidence tax rebates and cuts that meet certain criteria produce an almost immediate response. The critique is that it is very transitory or temporary. So, if timely and temporary are still criteria for a stimulus, what does that imply about the statement?

The article states “In the partisan war over the economy's performance, the word ‘stimulus’ has become synonymous with ‘boondoggle’…." Perhaps that’s because in the partisan world of journalism stimulus has become synonymous with Recovery Act. Even though, as Lynch points out, stimulus has been a bipartisan approach. The issue cuts across partisan lines. It’s a philosophical issue not a partisan issue. A bipartisan philosophical issue isn’t how Lynch presents it. Partisan isn’t how the Blinder/Zandi article presents it. In fact, a substantial portion of the tax cuts which Lynch implies don’t create jobs fast enough were not a part of the Recovery Act.

Zandi points out that the multiplier (the bang for the buck) is not the same at all points in the business cycle and is less than one over the cycle. Thus, Lynch is given a perfect opening to discuss some of the ridiculous assertion made by Klugman in a competitive newspaper. Instead the assertions are just cited without comment. In this case however, one should give Lynch a pass regarding intentional bias. More than likely he just suffers from journalistic intimidation by the competitive paper. Further, he reports what is being said. One can’t criticize him for not refuting it. He’s doing a good job of reporting and his article deserves credit for that.

It would be interesting to see a similar report surveying economists on the financial measures taken. Lynch cites Blinder and Zandi whose article states that they found the financial measures were “…substantially more powerful…” than the stimulus. Lynch also quotes Rogoff’s comment about the financial measures: “I think it was important for confidence. ... But fiscal stimulus was the least important of the three planks of the government's strategy.” Rogoff might consider the financial measure more important than the stimulus. The financial measures certainly targeted confidence.

The quote is from Harvard University's Kenneth Rogoff, former chief economist of the International Monetary Fund and coauthor of THIS TIME IS DIFFERENT: EIGHT CENTURIES OF FINANCIAL FOLLY by Carmen M. Reinhart and Kenneth S. Rogoff (a book The Hedged Economist strongly recommends). Clearly, Lynch has the contacts and the skill to write an interesting report on the topic.

Further, as Lynch reports “…the spending's impact was dwarfed by other crisis-fighting tools….” But, to do them justice, he’ll have to get past some inaccurate preconceptions. For example, he refers to “…costly efforts to stabilize crippled banks and the Fed's unconventional monetary policy.” Well, if he talks to people who made an honest effort to measure the cost, he might choose alternative wording like “arguably profitable efforts to stabilize crippled banks.”

Further, a broader brush than recent events shows the Fed’s unconventional monetary policy is only unconventional for the Fed. The same policies, even some of the same tactics, have been used for centuries, long before there was a Fed. They show up in many countries even in the pre-Fed monetary history of the US. In fact, one finds some of the policies were pursued in more recent history often over the objections of the Fed.

Tuesday, September 28, 2010

Stimulus more or less? A failure not being acknowledged. PART 4

The economic impact of fiscal stimulus isn’t a partisan issue. But, it is easy to be misinterpreted, intentionally or otherwise.

It’s time to turn to the actual article entitled “How the Great Recession Was Brought to an End” by Blinder and Zandi. While the previous posting focused on what The Hedged Economist thought was most useful (Appendix A of the article), this posting focuses on what is of interest to most people commenting on the article. Clearly, since it is also the focus of the executive summary, it is what the authors thought was most important. Unfortunately, it is also the source of a lot of misunderstanding and spin.

One has to read it closely and not extend the findings beyond the actual results. It is also almost essential to deconstruct how the results were derived. But, if one does, one finds it is fairly free of partisan nonsense. Further, the effort is rewarded by a sharper appreciation of the limitations of the analysis. It is to the credit of the authors that they frequently point out the limitations, but it seems legitimate to fault them for not always emphasizing the most important limitations.

There are aspects of the assessment that some might call methodological biases with partisan implications, but they could also be characterized as methodological assumptions. They will be discussed after pointing out some other reasons for citing just this one analysis.

First, The Hedged Economist has had the opportunity to walk through the details of the Moody’s Macroeconomic Model equation-by-equation and linkage-by-linkage. That’s either masochism or curiosity. It’s time-consuming in any case. The review was probably sufficiently recent to still be relevant. (Models evolve if you didn’t know). Equivalently detailed reviews of others models aren’t as current, and the investment that would be required to review the models used for every other assessment would challenge any realistic time constraint (certainly mine).

Further and probably more importantly, Moody’s Macroeconomic Model is well-documented and available for review. That doesn’t seem to be true of the models used for every assessment. Thus, it isn’t The Hedged Economist review that matters; it is that anyone could do the same thing.

The article contains a description of modifications to the model that were made for the assessment. Given an understanding of the model, they all make sense. If one was evaluating the model itself or wanted to use the Blinder / Zandi simulation as a starting point for their own assessment, one would need the actual equations for the modifications as well as all adjustments, but there’s enough information that is easily available to justify recommending the article. Authors make forecasts and do assessments, but the model is a tool that tells something about how the forecast was made.

Now, on to the article, let’s see what is says and what it doesn’t say. The executive summary of the Blinder and Zandi article provides their expert opinion. Those who only want the expert opinion of the authors should read it, but read it carefully. They never say what the impact of the policy was. Rather, they say what the impact of the policy would be relative to some other policy. Not stressing the unrealistic nature of the other policy is a major deficiency of both the executive summary and the article. With that in mind, one would do better reading the summary than reading most reports on the article. It’s only one page.

Also, a minor point, but the reader should note that in the executive summary some results are presented in terms of “payroll employment.” That is understandable given the accuracy of payroll data. However, it may overlook self-employment dependent on whether the self-employed person takes income as wages or proprietors’ income. It’s a minor point, but in previous postings The Hedged Economist has pointed out that over this cycle self-employment has behaved differently from previous cycles (or at least with a different lag).

The first section of the article is the assessment itself. It contains enough of an explanation of how the conclusions were reached to stand alone. It can stand alone for anyone who has a general understanding of how macroeconomic models work and is prepared to accept Blinder and Zandi’s modeling efforts without questioning. Appendix A was discussed previously, and Appendix B is a summary of the model.

The presentation of findings is only five pages of text and five tables, yet one suspects that many people who comment on the article didn’t even bother to read this section, didn’t realize its implications, or chose to ignore the implications. Maybe they read the Executive Summary and not very carefully. Perhaps they felt they could cite the article to support a conclusion they had already reached.

Most of the five pages of text in the first section of the article are used to explain how the analysis was done. That in itself is a reason to read it. The explanation of the approach provides the basis for an informed judgment about how to incorporate the results into one’s own assessment.

The basic technique is to run multiple scenarios assuming various policy responses. The definitions of the scenarios shed light on the uncertainty associated with the results of the analysis. The scenarios’ definitions also are essential to understanding what results could possibly be achieved and thus how relevant the results could be.

First, let’s look at what the definition of the scenarios says about the level of uncertainty associated with the results. It is worth noting the scenarios are not for a point in time or time from implementation to today. The scenarios are through the cycle. In other words, every scenario includes and element of forecast.

The primary scenario, common to each comment on impact, is the baseline scenario, the Moody’s forecast. The authors are quite open about the fact that “most private forecasters…misjudged how serious the downturn would be.” Although said in a different connection, it indicates the difficulty of forecasting. If the baseline is wrong, every impact assessment is wrong. But, they could all be wrong without their rank order changing. The authors go to some lengths to point out that they are making estimates.

The other scenarios are “counter-factual.” They are based on different policy responses. So, not only is the forecast an estimate, as the authors point out, all the scenarios are estimates. Estimates are what any assessment is about; so, that there are estimates shouldn’t be a great concern. If they are, one should read Appendix A and skip the article. Here we have two experts making estimates for us for free; life’s great. One shouldn’t begrudge them the effort required to understand what is being estimated.

Not defining what is estimated is the source of most of the misinterpretation and misrepresentation. So, let’s dive in. First let’s look at scenarios common to every estimate.

The forecast is one. That’s inherent in any estimate since we are not through the cycle. At best, we are in the recovery phase. Any assessment that clips the estimate at the present would, by definition, be short-changing any positive impact.

A second scenario common to the entire assessment is the “no policy” scenario. But, here’s the problem: “no policy” is NOT a realistic counter-factual. Using a “no policy” alternative comes off as setting up a straw-man in order to make the policy look good.

That impression is only reinforced by not responding to statements citing the article like Treasury Secretary Tim Geithner’s statement: “The combined actions since the fall of 2007 of the Federal Reserve, the White House and Congress helped save 8.5 million jobs and increased gross domestic product by 6.5 percent relative to what would have happened had we done nothing.” (emphasis added). The deceptiveness of Geithner’s use of “we” deserves comment. As the article points out, the policies pursued to stabilize the financial system and stimulate the economy involved two administrations, two congresses, and the Federal Reserve.

However, the flaw isn’t in Geithner’s statement; it is in the “done nothing” counter-factual which he and the authors are both using. Government exists and its very existence is doing something. Not stressing how ridiculously unrealistic the “no policy” alternative is, more than anything else, was a major oversight by the authors. One is inclined to wonder why the authors stress that the assessment involves estimates without emphasizing they are estimates from an unrealistic counter-factual. As an academic exercise, their “no policy” scenario makes sense, but not stressing this specific limitation of the analysis is truly unfortunate.

What is particularly unfortunate is that the authors make passing comments that could have been excellent points of departure for a discussion of a more realistic counter-factual. For example, they note: “Some form of fiscal stimulus has been part of the government’s response to nearly every recession since the 1930s….” They then describe a few without future comment.

Now, one need not be a genius to understand the logical reason for a no policy alternative. It’s easier, more dramatic, and appears less speculative. Why easier? It is easier to compare actual experience with one counter-factual than generate and justify two counter-factual scenarios. Why more dramatic? The difference between another policy response and the actual policy response would be less than between the actual policy and nothing (assuming a positive response to both policies). Why does it appear less speculative? Even if “no policy” is a ridiculous counter-factual that hasn’t occurred in close to a century, and to some extent because it is so ridiculous, one can’t mistake it for an advocacy position. More importantly, it doesn’t require speculation about what might have been the policy. “No policy” was never on the table.

Despite the clean alternative that “no policy” provides, it ducks the important question. The important question is what would have been the performance of the economy under a different policy response? The authors point out: “It is … not difficult to find fault with isolated aspects of the policy response.” They then go on to question some. So, they acknowledge the issue.

One debate that deserves comment is the discussion of whether the stimulus in particular was too much or two little. When looked at in detail, much of the argument for a better response from a larger stimulus is based on the absurd notion that the response to stimulus is dollar-for-dollar the same regardless of the size of the stimulus. It ignores decreasing marginal utility, or, at a minimum, subscribes to the purely ideological notion that decreasing marginal utility never applies to government actions.

The authors aren’t guilty of such absurd reasoning. They point out that as the economy approaches higher levels of resource utilization additional stimulus has a smaller beneficial impact. Similiarly, at the other extreme, in an interview about the analysis (to be discussed in a subsequent posting) Dr. Zandi mentions that the beneficial impact is greatest when there is slack in the economy. However, there is still one of those pesky methodological biases or assumptions lurking in the analysis. Namely, the non-linear response is achieved without addressing whether the actual responses are linear. The difference in the response is due to the state of the economy. It is equally likely the response is NOT independent of the size of the stimulus. But, let’s depart from squabbling over methodological trivia. Linear specifications in simultaneous models are a simplifying assumption that yields tremendous benefits.

There are more basic questions about potential alternative policies. Basically, the underlying philosophy of the entire policy response should be questioned. It is not the need for a policy response, but the assumption inherent in parts of TARP and most of the fiscal stimulus that is questionable. Both are predicated on the assumption a trickle-down approach is best. In essence: give the money to a government, an investor, an automaker, etc., and just count on it to flow to the general benefit of the population.

In the popular media, the trickle-down approach is most likely to be challenged in the area where it actually doesn’t apply: TARP loans. As an example, read postings like Ritholtz’s “2008 Bailout Counter-factual.” Alternatively, one only needs to turn on TV or talk radio (of either conservative or liberal leaning) to witness the total failure of commentators to differentiate between a loan and an out-and-out income transfer. One has to be awfully glad that people who consider a loan a bailout aren’t managing your personal finances. One also suspects their personal finances and certainly their investment advice is something to avoid like the plague.

The actual policies focused on where the problem built up or collected (financial industry balance sheets) and the resulting cash flows in the general economy (consumers forced to cut expenditures). Imagine as a counter-factual that instead of relying on a trickle-down strategy, the government had recognized that the problem had its origin in balance sheets. As a counter-factual let’s have the government focus on the ultimate source. Ultimately, consumers and investors hold the assets and have the liabilities. So, let’s focus on households rather than banks and governments.

As mentioned in the previous posting, a careful analysis of the content of TARP and the stimulus bills can yield a slightly higher estimate of the fiscal stimulus. It works out to just about $10,000 per household using a 2008 household count. So, instead of targeting governments, banks, auto manufactures and their unions, insurers, etc. -- as a counter-factual assume a one time $10,000 rebate to every household.

Since we’re aiming to reduce both TARP and replace the fiscal stimulus, earmark it as only useable to pay off debt. Since elected officials consider themselves such financial wizards, one has to allow them to prioritize which debts get paid first. But, clearly, one priority should be to get non-performing loans out of the system. Therefore, targeting debt in arrears makes sense. Also, since housing finance was a recognized problem, debt secured by owner-occupied residential real estate seems a likely target. Since elected officials are partial to the UAW and automakers, put auto loans as of the enactment date in there, too. Further, the government would have to take steps to ensure the rebates were actually used to shrink balance sheets rather than as a credit substitute. It’s doable.

Now, what about households with no debt? Well, to control the deficit, their rebate could take the form of non-transferable government bonds. Since the government is executing a massive transfer of liabilities from consumers’ balance sheets to their own, the bond idea appeals. However, just plain old money has a certain appeal as a stimulus. Each has its own appeal. Keynesians may prefer money that has to be spent while fiscal conservatives might like the bonds.

This is a weird counter-factual, admittedly, but no weirder than “no policy.” Further, it focuses the discussion where it belongs. Is a trickle-down approach like ARRA and TARP subsidies the best we can do?