Текст книги "101 Things Everyone Should Know about Economics: From Securities and Derivatives to Interest Rates and Hedge Funds, the Basics of Economics and What They Mean for You"

Автор книги: Peter Sander

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Why You Should Care

As an individual, particularly as an economically productive individual, you should favor the supply-side approach. It carries greater economic rewards for achievement, and makes hard work and investment more attractive. But before “buying” this approach from the politicians, make sure that the other end of the equation—government expenditures—are held in check. Otherwise, the additional tax revenues generated will not be sufficient and deficits will endure, putting America in a fundamental “box” of not being able to raise taxes if necessary. This mistake of the Reagan administration, and later the George H.W. Bush administration policy of “no new taxes,” took a lot of wind out of the sails of this promising approach. We saw it again in the second Bush administration, and though attenuated somewhat under Obama, the general concept remains in play.

61. TRICKLE-DOWN ECONOMICS

The “trickle-down” school of economics carries a set of principles and actions very similar to supply-side economics (see #60), but the goal is different. While the supply-side school advocates stimulating production to benefit the economy as a whole and pay for the tax rate decreases that stimulated the production, the trickle-down school goes on to argue that increased production and wealth accumulated at the top will eventually “trickle down” to the masses.

What You Should Know

The premise is based on the idea that more prosperous business owners and leaders will produce more and take more risks, providing jobs and higher incomes for the masses. Additionally, the supply-side premise that greater production at a lower cost will lead to lower prices for consumers also suggests better standing for the lower economic tiers of society. Trickle-down economics takes the supply-side approach and extends it to a premise and promise of greater societal benefit for everyone.

The problem, of course, is that the wealth created at the top doesn’t always trickle down so effectively. Many believe that quite the opposite happens—that the rich get richer, and not very much happens to anyone else. As William Jennings Bryan put it in the 1890s: “If you legislate to make the masses prosperous, their prosperity will find its way up through every class which rests upon them.”

Indeed, the trickle-down theory was never directly advocated by the Reagan and Bush leadership, but was a constant theme in the congressional debates on tax policy, which went something like this: The wealthy will get what they want, the budget will be balanced on the back of higher tax revenues, and it will help the lower classes too. Unfortunately, the second two parts of the scenario never really played out—government spending exceeded the new revenues, and the wealthy chose to keep a lot of their wealth. By almost any measure, the wealthy got wealthier through the period. Why that happened is a matter of conjecture. First, lower tax rates and especially capital gains tax rates encouraged them to save it for themselves, not create new production and thus jobs; or second, in the face of an economy where considerable production was moving overseas, there wasn’t enough job-creating activity to invest in.

Why You Should Care

Trickle-down economics, while attractive in principle, has still not met with measurable success in over 100 years of trying. When politicians declare that making the rich richer will help everyone, take that with a grain of salt. That said, the supply-side foundation that the “trickle-down” outcome is based on shouldn’t be dismissed as a bad idea.

62. REAGANOMICS

Reaganomics, the phrase coined for the economic policies of the Ronald Reagan 1981–88 presidency, was essentially an implementation of supply-side economics tailored for the times (see #60 Supply-Side Economics). The major premise and promise was an across-the-board reduction in income and capital gains tax rates to bolster an economy recovering from the stagflation hangover of the late 1970s (see #20 Stagflation).

What You Should Know

Ronald Reagan came into power in a particularly tricky economic period—one tricky enough that the traditional doses of monetary medicine would have made problems worse. The bulge in inflation in the late 1970s (see #18 Inflation) was caused by forces beyond monetary policy—that is, the supply shock and price escalation in the energy sector. Worse, inflation had become part of the daily mentality of consumers and business leaders alike; everyone expected it, and so raised prices defensively in advance of it. Inflation was a self-fulfilling prophecy.

The standard money-supply remedies for inflation were clearly not working. The Fed funds rate reached an all-time high in 1980 and led to the recession of 1981–82, but did not do as much to temper inflation or inflationary expectations as one would have hoped (see #21 Interest Rates). The challenge of the Reagan administration was to combat inflation and stimulate growth without relying on traditional monetary policy.

The solution was a hybrid of monetary and supply-side economics. The Fed began lowering interest rates to increase money supply; at the same time, supply-side initiatives of lower taxes and promises of better times spurred production. The increased production then consumed, or “mopped up,” the excess liquidity, or money, pumped into the economy. While more money chasing the same amount of goods and services leads to inflation, more money chasing more goods and services does not.

The Reagan administration, playing its “trickle-down economics” card to justify and pass the programs, used the expression “a rising tide lifts all boats” (see #61 Trickle-Down Economics). The economy rebounded while commodity prices fell at the same time—a rare combination that might be attributed to the combined policy. Detractors maintain that the high interest rates alone (they were declining, but still historically high—see Figure 3.1) brought the fall in commodity prices, but this argument seems out of place, because the economy was indeed rebounding.

Tax revenues—at least nominal, or not inflation-adjusted—grew. They fell as a percent of GDP, but that was intended and expected with lower tax rates. Real tax revenues did not increase, however, until 1987. It should also be noted that while federal income tax rates dropped, FICA taxes for Social Security and Medicare, as well as taxes in many states, increased.

Still, it looks like Reaganomics was indeed a dose of innovative medicine that worked for the most part. If it had been pulled off with a balanced budget, which did not happen, largely due to defense and certain other increases in expenditures, the case would be clear. A growing deficit stains the argument somewhat; one wonders what the economic outcome would have been without the additional government spending. Arguably, the Clinton years and the balanced budget they produced were more indicative of the benefits of Reaganomics than the Reagan years themselves.

Why You Should Care

The Reaganomics experience showed us all that creative approaches to solving economic problems and aiding prosperity can work. One should be concerned about budget deficits, but one should also not be led to think that tax increases are the best way to close budget gaps. The George W. Bush years (2001–2008) look more like reckless tax policy designed to favor the rich without hope of increasing revenues, and deficits increased widely while the seeds of the Great Recession—too much spending on overinflated assets, and a lax view of risk—were sown. The policies of the Obama administration haven’t been able to touch the rich so much as the president himself would have liked, and new spending has dramatically increased deficits, but there is some evidence that tax revenues are increasing even without major tax rate changes, Perhaps in the next edition of this book we’ll be able to say that Reaganomics and supply-side policies really do work, but for right now, the Reaganomics practiced during the Reagan administration appears to be a much more carefully considered experiment.

63. BEHAVIORAL ECONOMICS

What? You’ve got to be kidding. People don’t follow the economic rules? People do things that don’t fit neatly into demand and supply curves? People respond differently to different situations depending on stress, time, and what they see others around them doing?

You bet. And the presence of such “misbehavior” has given rise to a school of economics that combines economics with psychology, behavioral economics. This marriage of two subjects, both hard to research and quantify, has taken center stage in economic thought, as economists and policymakers struggle to fix and avoid economic problems.

What You Should Know

Behavioral economics applies social, cognitive, and emotional factors to better understand economic decisions by consumers, borrowers, and investors, and how they affect market prices and behavior. In short, it applies a human factor to decision making, a dose of “psychological realism.” Behavioral economists try to figure out how and why actual behavior differs from rational and even selfish behavior—that is, the lowest cost, lowest risk, or most profitable course of action.

Interest in behavioral economics has increased as a result of the recent mortgage crisis and real estate bubble. Why did so many unsuspecting citizens take on so much debt, so much risk, and so much cost, assuming all along that the real estate market was foolproof? People have been asking such questions for years, dating back to the tulip bulb mania of the early 1600s. But it happens again and again through history. The answer seems to lie somewhere in the “madness of crowds,” or the tendency for people to assume something is right because everyone else is doing it. Moreover, studies indicate that many people jump into these things because they fear being left out; not investing becomes the irrational decision.

In the fall of 2008, the U.S. economy went from an overdose of risk to complete risk avoidance in a matter of months. We went from lending 100 percent of value to a subprime customer to not lending anything at all.

Policymakers have begun to take such factors into account when making policy decisions—although they obviously have a way to go in truly understanding economic behavior, especially in crisis times.

Why You Should Care

Next time you think about “going along with the crowd,” make sure you’re acting in what economists would call “rational self-interest.” Not all economic or financial decisions can be approached with rigid, mathematical, dollars-and-sense precision; surely your color preference in a car has little to no rational basis. That said, as an individual you are better off for the most part by adhering to economic reality. For society it’s good to know that economists no longer assume that everybody is completely rational; that will lead to less costly policy and to fewer overcorrections in the business and boom-bust cycle. If you want to dig deeper, Dan Ariely’s Predictably Irrational: The Hidden Forces that Shape Our Decisions (Harper Perennial, 2010) is a fascinating read on the subject.

64. NEW DEAL

At the height of the Great Depression, with unemployment rates exceeding 25 percent, a broken banking system, and rampant business failures, the newly elected President Franklin D. Roosevelt and his staff developed a complex set of economic programs to deal with these problems. In fact, he called the set of new programs and laws the “New Deal,” and the name stuck. Until 2008, anyway, the New Deal was by far the largest coordinated government effort to deal with the effects of an economic bust; the New Deal was broader in reach, if not as expensive as the economic stimulus and bank bailout programs recently undertaken.

What You Should Know

The programs and laws, largely initiated between 1933 and 1935, were aimed at providing economic relief for citizens, and particularly the unemployed, and with the reform of the business practices that gave rise to the bust in the first place. It was really a deal, as it traded off certain kinds of government spending in favor of other programs to revitalize the economy. A balanced budget was a goal, although many economists, particularly from the Keynesian school, maintain that it was a mistake to balance the budget in the depths of a depression.

Roosevelt, his Treasury secretary Henry Morgenthau Jr., and Congress started the New Deal by cutting government spending on military, the post office, general government salaries, and veterans’ payments by a total of about $500 million (the total U.S. budget in 1933 was about $5 billion).

Employment relief came in the form of the Works Progress Administration (WPA) and similar agencies created to provide jobs building public buildings, parks, schools, and roads, which added numerous cultural assets to our landscape. Laws standardizing collective bargaining, providing minimum wages, and eliminating child labor were passed. Social Security (see #50) was part of the New Deal, as were other prominent economic institutions still in place today, such as the Federal Deposit Insurance Corporation (FDIC), the Federal Housing Administration (FHA), the Securities Acts of 1933 and 1934, the Securities and Exchange Commission (SEC), and government-sponsored lending enterprises like Fannie Mae.

The whole point was not just to stimulate the economy but also to provide a fair and predictable base within which it could move forward with a degree of confidence—public confidence as well as confidence between businesses, labor, and government. Many deride the New Deal as tending toward socialism, believing it has left too strong a legacy of government intervention and regulation. Others say the New Deal didn’t go far enough, that it was too conservative, and that we were only bailed out of the Depression by the advent of World War II. What is certain is that the New Deal was enormous in scale and creatively constructed to solve a lot of problems and serve a lot of interests at once. Seldom if ever have we seen a government action or program with this much effect or historical significance.

Why You Should Care

Not only was the New Deal historically significant as a remedy for the Great Depression—it has also left a legacy of programs that are just as important to today’s economy, if not more so, than they were at the time. The New Deal is also a model for economic remedies being attempted or discussed today, although today’s remedies are larger in scale and less constrained by budgetary considerations.

65. PLANNED ECONOMY/SOCIALISM

Mention the idea of a planned economy to almost anyone and you’re likely to get a look of concern in return. Yet during the Great Recession the federal government clearly got more involved in the day-to-day fortunes and operations of the economy—by necessity, some say, or by choice, as others complain.

So, what is a “planned economy,” anyway? And do recent government interventions represent a brush with socialism?

What You Should Know

The various levels of “planned economy” that may occur in practice go from “least to most” in terms of planning and control:

In a planned market economy, the state influences the economy through laws, taxes, subsidies, and outright infusions of cash, but does not force or compel economic outcomes. It is the “invisible hand” we all learned about in high school economics and has been more or less the state of American economics over the centuries.

A planned economy is an economy in which the government, by edict, controls production, distribution, and prices. Governments don’t own private entities, but they must comply with the plan and report all activity. While the U.S. government took control of the railroads briefly in World War I, this model has been more common in other countries, particularly in the Eastern Bloc, but also in places like China and India before relatively recent reforms.

In a command economy, the government not only controls but also has substantial ownership of commerce and industry. One thinks of the current and former communist countries, but the model is common in Latin America; Venezuela and Cuba are examples.

Socialism does not fit neatly in this continuum but is regarded as having the broader political and socioeconomic objective of equalizing the distribution of wealth and income. That is accomplished through the means of direct income redistribution policies, central economic planning, and ownership or the formation of cooperatives. The state plans or controls the means of production toward achieving the egalitarian objective.

The interesting debate today is to what degree government actions in the wake of the Great Recession represent a move toward more of a planned economy. Economist and investment company manager Axel Merk, in his book Sustainable Wealth (Wiley, 2009), put it thus:

More than most other world nations, the United States has “walked the walk” of capitalist freedom and self-determinism, although policy at its highest levels has acted as an “invisible hand” and to “lean against the wind” to move toward politically acceptable economic outcomes. But in the aftermath of the credit crisis that hand has started to become more visible. The fear is, of course, that once that process gets started, once trust is replaced by government intervention, it can spin out of control; the world has ample experience with the iron hands of socialism and communism.

As the credit crisis was dealt with, major sectors of the economy—the financial industry, the auto industry—effectively became wards of the state. They became dependent on the U.S. government for financial sustenance and even for leadership through the crisis. The state went further into the private economy by granting credit to specific industries and businesses, something which had almost never happened before, certainly not on such a large scale, in U.S. history. It was, in short, a brush with a planned economy.

Merk goes on to argue that a severe recession “ought to be the lesser evil than a planned economy,” and while we are still a far cry from communism, we “must keep our eyes open and not be blinded by the perceived ‘help’ of money printed by the Fed.”

Why You Should Care

It’s important to understand today’s economic actions and reactions, and those observed before, during, and after the Great Recession, in the context of government influence and control. Whatever your philosophy and acceptance or rejection of this intervention, you should understand how it fits into the greater context.

CHAPTER 7

Finance and Financial Markets

Most of what we’ve talked about is the “macro” sector of the economy, the big picture, the government and its role, the greater economy in which we all participate. While these macro pieces provide the economic framework to produce the goods and services—the food, cars, and wine—you choose to consume, our capitalist system also requires private enterprise.

Private enterprise produces the goods and services we all want, and hires the majority of us as labor to produce those goods and services. It also depends on capital we supply as savings and investments. But the allocation of labor and especially capital between millions of households and hundreds of thousands of private-sector businesses is a vastly complex enterprise. The need to move money around to the right places gives rise to the financial markets and the financial services industry.

The history of the financial markets and the financial services industry is full of success and failure, and as we emerge from the Great Recession, the pendulum has clearly swung from success to failure and back in the direction of success. The financial services industry grew beyond its traditional role as facilitator of the public and private economy into a large part of the economy in and of itself. Newfangled financial instruments and an excessive liberalization of credit served to fill the coffers of the industry to the point where in 2005 the industry made some 40 percent of all profits made by America’s top corporations. This distortion came home to roost in a big way when the resulting real estate bubble popped. It’s enough to make you or anyone else mad, but that energy would be better spent understanding what happened, why, and what should be done to prevent a repeat performance.

As we move forward, the financial industry has retrenched, and new regulation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (see #39) will likely serve to curb the excesses of the past. That said, most of the markets and instruments of the financial services industry will continue to exist and play an important part in capital allocation and economic growth. What follows takes a look at these important private-sector building blocks of the economy.

66. DERIVATIVES AND DERIVATIVE TRADING

Anybody who’s read even the slightest bit of economic or financial news in the past couple of years has run across the term derivative. Derivatives have been in the news a lot ever since the early days of the 2008–2009 financial crisis.

So what is a derivative, anyway? Simply, it’s a financial contract or asset whose price is determined by the price of something else. Want to buy a thousand barrels of oil as an investment, or to use in your business, or to resell? You can, but you’d have to pay the full price for the oil, perhaps $100,000, and you’d have to find a place to store it. As an alternative, you can buy a derivative based on the price of oil, perhaps a futures contract, specifying delivery of that oil at a future date at a specified price. If the price of oil goes up, the price of your derivative will go up too.

What You Should Know

Derivatives can be based on almost any kind of underlying asset—a physical asset like a commodity, a financial asset like a stock or mortgage or bond or some other debt security, an index like a stock or interest rate or exchange rate index, or just about anything.

There are three primary types of derivatives:

Futures specify the delivery of a fixed amount of something at an established date. Futures are traded on agricultural products, energy, metal, stock indexes, interest rates, currencies, and an assortment of other assets on futures exchanges, and represent relatively large bets on these items (see #80 Commodities, Futures, and Futures Markets). Note that you don’t have to (and most people don’t) wait for the expiration of a futures contract to settle; you can sell or buy it prior to that date based on market prices at the time.

Options are contracts giving the right, but not the obligation, to buy or sell something on or before a future date, usually a stock, but sometimes a futures contract. Equity options are traded on thousands of stocks, and can also be traded on futures contracts; options are relatively smaller investments in size or total outlay, but can be very highly leveraged for large gains (the concept of leverage is described below).

Swaps are a contract to exchange cash on or before a specified date based on the price of a particular asset. They differ from futures in that you don’t actually buy the item; it is a contract simply to settle with cash on or before the settlement date. Additionally, swaps are more of a “one-off” contract custom-made between private parties; they’re not traded as established securities available to the public on a securities exchange. A “credit default swap,” which guarantees payment only in case of a credit default, is a bit different (see #69 Credit Default Swap).

Derivatives can be used to hedge or to speculate. Farmers will hedge against the decline in the price of wheat, for example, by selling a futures contract on what they are producing. That allows them to pocket some cash now, giving some insurance against a price fall, or even a crop failure. On the other side of the trade, a brewery might hedge by buying a futures contract to protect against price increases, or even to guarantee supply in times of shortage.

As a tool to speculate, investors not in the brewing or farming business may also “play” the wheat futures market, betting on a rise or decline in wheat prices based on a host of factors. Derivatives offer leverage. Leverage allows you to enjoy the price gains or suffer the declines of the underlying asset with as little as 5 or 10 percent of the value invested, a key attraction for speculators. You can buy that interest in $100,000 of oil for a tenth of that, but if it goes down, you’ll lose your entire investment, and sometimes more.

Aside from helping farmers and brewers, the existence of derivatives gives investors and financial institutions ways to invest in things, and ways to manage risks. They also help bring more participants to any given market, making that market and its prices more truly reflect supply and demand. However, the broad array of derivatives and the opaque nature of some of the customized derivatives created through “financial engineering” in the last decade have caused considerable trouble. Additionally, derivatives traders overplayed their hands, writing more contracts than they could possibly cover. Forthcoming regulation will likely standardize trading and trading rules for some of the exotic derivatives, particularly swaps (see #69 Credit Default Swap). This will give a more favorable name to these instruments and help them move away from the “financial weapons of mass destruction” moniker assigned by billionaire investor Warren Buffett in 2002.

The size of the world derivatives market is phenomenal, estimated at some $1,200 trillion face or nominal value (although some estimates claim it to be higher). To put that figure in perspective, it is about twenty times the size of the entire global economy.

Why You Should Care

With so much bad news circulating about derivatives, it’s a good idea to understand what they are, and know how they can cause trouble. That said, certain derivatives like stock options can actually be used to reduce your risk—that is, to hedge on your stocks. That can make a lot of sense for ordinary investors who know what they’re doing.

67. ASSET-BACKED SECURITY

Asset-backed securities (ABSs) were once a dark corner of the financial world, a financial tool most people wouldn’t commonly know or care about. But the 2008–2009 financial crisis put ABSs center stage, particularly the real estate versions known as mortgage-backed securities (MBSs) and so-called collateralized debt obligations (CDOs) (see #68). For the most part, ABSs aren’t consumer products—they are bought and sold by large financial institutions—but in the interest of understanding the financial news, and understanding how “engineered” financial products like this can affect you, read on.

What You Should Know

An asset-backed security is a specially created financial instrument, or security, custom-built upon a pool of underlying assets. Those assets serve as collateral, and the income they generate is passed on to the ABS holder. Individually, the assets contained in the ABS, like mortgages or car loans, are small and difficult to sell in the open market. The ABS is designed to package them into a single, larger security so they are large enough to interest institutional investors, and if packaged clearly and carefully, to spread risk. If one asset in the portfolio fails, it will be only a small fraction of the portfolio. ABSs were created out of mortgages, car loans, credit card financing, and commercial loans and leases.

ABSs played a key role in the mortgage crisis. To lend more money on mortgages, banks engaged in the mortgage market learned to package mortgages into ABSs (or MBSs) and sell them as a package. The process is known as securitization—the offering institution created a security out of a number of individual assets. This accomplished two things: first, it helped the banks get funding for the loans, and second, it transferred the risk of default to the buyer. Investment banks and institutional investors (see #28 Investment Bank and #75 Institutional Investors) bought these securities because it was a handy way to tap into the mortgage market and chase higher returns than currently offered by the bond market or other fixed-income securities.

Prior to the crisis, as it turns out, the idea of ABSs caught on rapidly as a way to expand the mortgage market and lend into the real estate boom. In fact, this helped cause the boom, because it became easier to get funds to lend. Unfortunately, the buyers of ABSs did not fully understand the underlying risks in these securities; neither they nor the ratings agencies (see #77 Credit Rating Agency) factored in the notion that real estate prices might decline, and didn’t perform a “due diligence” on the credit risk of assets that lay beneath the covers of the ABS. The result was a collapse in the value of ABSs held on bank and institutional books, and that as much as anything else led to the banking crisis. This was made worse by the fact that all ABSs are unique. Each is constructed on a specific batch of assets; no two are alike, so there is no market to value them, and little “transparency” as to their true worth.

Why You Should Care

The expansion of asset-backed securities led to “easier” lending terms, but also ultimately led to the financial crisis when the tide washed out on underlying asset values. The 2008 banking crisis led to a severe contraction in asset-backed security markets, which in turn caused a severe contraction in credit extended to businesses and consumers. It’s a big part of why it got very difficult to get a loan during that period. Today, the ABS market has loosened somewhat, but tighter standards for underlying asset quality, necessary to make the markets work, has caused it to remain somewhat difficult to borrow if you have bad credit—and that’s a good thing. Bottom line: ABSs are not necessarily a bad thing if risks are properly assessed. There is also a well-placed call to standardize ABSs and create more liquid, transparent markets to trade them.