Author: tylerdynamist

Post-Lehman: The Banking Oligopoly Reigns Supreme

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Today marks the one-year anniversary of the Lehman Brothers failure, which led to the subsequent rescue actions by the Fed and the Treasury.  Many look at the rescue of AIG, the forced marriage of Merrill Lynch and Bank of America, the TARP, the conversion of Goldman and Morgan Stanley to bank holding companies and the massive increase in the Fed's balance sheet and think that the financial system was utterly transformed.  My view is that the crisis only served to accelerate trends that were already in place, and have been for the last 40 years.  Ironically, the reforms proposed by the Obama administration will mark the final destruction of the old New Deal financial framework and will lock in place a large-scale financial oligopoly.

The battle over the very banking and money is as old as the Republic.  The traditional battle lines are between the Hamiltonians that favored a banking oligopoly to control the money supply and rein in speculation, and the Jacksonians that were suspicious of power being concentrated among an East Coast banking elite and instead favored a "free banking" model of small banks spread throughout the country.  Between the Civil War and the Great Depression, the Hamiltonians (mostly Northeastern Republicans) held sway and banking power was concentrated among the big New York banks led by JP Morgan.  During the New Deal, FDR smashed the New York "Money Trust" and created a fragmented banking system that (1) spread banking power throughout the country by prohibiting interstate banking and even restricting bank branching and (2) separated the types of banks into thrifts, savings & loans, commercial banks and investment banks.

The diffuse nature of the banks limited large scale banking and resulted in the development of the securities market, which is why the US securities markets are much more robust than those of other countries such as Japan and in Europe that have traditionally relied more on bank financing.  It also meant that the US didn't have any global-scale banks as the world economy was becoming more globalized.

Starting in the 1970s, the US government embarked on a piece-by-piece dismantling of the New Deal regulatory framework.  As the commercial banks grew very large and were permitted to enter the securities business in the late 1990s, the investment banks, who traditionally had much smaller capital bases than commercial banks, felt the need to expand their balance sheet to compete, which meant taking on more leverage.  Couple the high leverage with over-confidence in financial innovations such as modern portfolio theory, derivatives math and value at risk measures, the investment banks got overextended and finally succumed to a classic run-on-the-bank.

The result was the forced merger of the investment banking system into the money-center commercial banks.  We now have sitting atop our national financial system an oligopoly of six massive firms: JP Morgan, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.  These six firms together dominate the market for securities underwriting, syndicated loans, derivatives trading, prime brokerage, non-agency mortgage securities underwriting and credit cards.  The federal government now effectively controls the mortgage market and is in the process of pushing private lenders out of the student loan business.  Oh, and at least temporarily it now has a huge chunk the market for US auto loans through its ownership of GMAC and Chrysler Financial.

Given the trends that were in place, this turn of events was unavoidable, unfortunately.  The reforms proposed by the Obama administration are the logical culmination of this system.  Creating a unified regulator, bolstering capital levels, limiting risk-taking, even the proposed consumer protection agency all have the effect of locking-in a conservative financial oligopoly.  Viola, you have the re-creation of the concept behind Alexander Hamilton's Bank of the United States.

Personally, given the choices on the table, I favor this outcome.  The current system of privatized profits and socialized losses is preposterous and literally threatens our democracy by turning the public against the business community.  The banking system, as long as it operates under a fractional reserve model (i.e. with leverage) is intertwined with the money supply in such a way that we can't pretend that it can exist as a truly free market.  The size of the banking system's liabilities relative to its assets is so large, that unless the government is willing to risk the aftermath of a massive debt deflation it will always be forced to step in to bail out the banks when they run into trouble, which they periodically will do.  So Obama's Hamiltonian vision should be supported by centrists as the least extreme potential outcome.

The Republicans, now the naturally the party of the South, the Mountain West and Sunbelt, will likely migrate into the Jacksonian camp.  There is just no upside for the Republican Party to continue to support the current system, as the financial industry is clearly trending Democratic and is based in the super-blue states of New York, Connecticut, New Jersey and Illinois.  You see glimmers of this trend with the (at the time irresponsible) refusal to support the bank bailout, but we have yet to see a positive reformist vision emerge.  My Jacksonian solution would be to force a downsizing of the big six, not in scope, but in scale.  Jacksonians should favor a the migration away from large scale banking and to the securities market.  Just because the CDO math was wrong for the last ten years doesn't mean that securitization itself is a bad idea.  Perhaps moving to a "covered bond" model, where the bank holds 20% of the securities it underwrites, would strike the right balance.

The debate over the nature of banking and money has been raging in the United States has been for a long time.  Jefferson vs. Hamilton, Jackson vs. the Second Bank of the United States, William Jennings Bryan vs. the Gold Standard, FDR vs. the Money Trust…these great ideological battles over banks and centralized financial power have occurred periodically throughout our history.  Ironically, it appears that the parties are switching sides as they have switched their traditional North-South alignment.  While the battle lines between left and right are still blurry, they are clearly being redrawn with the Democrats slowly embracing the vision of their ancient enemy, Alexander Hamilton.

We don’t spend enough on health care?

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Craig Karpel writes today in the Wall Street Journal that we don't spend enough on health care.  Basically, he writes that as the economy has evolved, we have gone from focusing on food (in the agricultural and mercantile revolutions) to clothing (in the industrial revolution) to shelter (in the late 20th century and this decade).  It is only natural that we would now turn to focusing on our health and longevity.  It's an interesting argument, if different from the viewpoint I have expressed in my previous health care pieces.

One reason that I do believe it is in fact unfair to compare the cost of care in the US to that in other countries is that the rest of the world free rides off the medical innovation that mostly takes place in the United States.  The entrepreneurial medical culture in the US incentivizes the use of advanced technologies, which eventually spread throughout the rest of the world.  Other countries use their monopsony buying power to push down prices so that, in effect, American workers subsidize the health of the rest of the world.

The benefit of spending money on health care versus other items like consumer goods or petroleum is that it is a domestic industry.  In addition, the accumulated R&D that takes place in the United States translates to a large amount of net exports.  Better health care and advances in longevity should also allow for a long term rise in the average retirement age, increasing the productive life of an American worker and boosting the long term potential growth rate of the economy.

The health care conundrum is the classic "on the one hand, on the other hand" situation that permeates economics.

Market Valuation Model

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I have been working on a stock and bond market valuation model, and have been updating it a little more than once a quarter.  The links are below:

How to Value the Stock Market (8/25/08)

The Stock Market is Overvalued, Potentially by alot (11/6/08)

First Quarter 2009 Market Update (3/31/09)

Revising my Stock Valuation Model (4/24/09)

The Recent Market Rally Explained (6/15/09)

Q2 Market Update (7/7/09)

Q3 Market Update – A low return world (10/2/09)

Year End 2009 Market Update (1/6/10)

The Long Term, Real Return on Stocks is Only 4-5% (2/9/10)

Predicting Inflation: Gold versus Bonds (3/28/10)

Q1 Market Update: The Stock Market is Now Overvalued (4/16/10)

Q2 Market Update: Sometimes cash is the “least bad” option (7/14/10)

Q3 Market Update: The Fed’s War on Savings (11/14/10)

2010 Market Review: Beware an Emerging Market Inflation Crisis (2/6/11)

Q1 2011 Market Review: It’s Time to Raise Interest Rates (4/10/11)

Get ready for a Dollar Bull Market (5/17/11)

Q2 2011 Market Update: The “Rounded Bottom” Scenario (4/6/11)

Are stocks Cheap? Not Quite, But Close (8/10/11)

Q3 ’11 Market Update: The Beginning of the End (10/8/11)

Q2 2012 Market Update: Have Corporate Profits Peaked? (7/1/12)

2009 Economic Analysis

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I am a top-down analyst.  My first instinct is almost always to look at the long term trends and patterns.  I’ll go back hundreds of years if I can.  Sometimes the easiest way to make money is to grab on to the “one big trend” and ride it.

2009 Annual Outlook (12/08-1/09)

Part I – The Depression’s Long Shadow – The economic policies that were put in place in response to the Great Depression and built upon since that time…promoting housing investment, personal consumption, rising indebtedness, monetary stimulation…have run to their logical conclusion.  We are now in the period of transition that will likely lead to the reversal of those trends.

Part II – The Trade Deficit and the US Debt Machine – How periods of tight monetary policy lead to a strong dollar, which leads to large trade deficits leading to a weak dollar policy, leading to foreign intervention which leads to high US indebtedness.  The only sustainable way out of our debt problem is to start running a trade balance, or preferably, a trade surplus.

Part III – Shrink the Stimulus, Triple the TARP – Economic crises are always banking crises.  The health of the financial system is critical to stabilizing the economy.  The Obama stimulus is more of a sideshow.  The banking system needs another $1 trillion to properly absorb the projected losses.

Part IV – The Recession’s End is not Near – Given the state of the housing market and high consumer indebtedness, the US consumer is tapped out.  Business is in OK shape.  The federal government does have capacity to lever up while the consumer pays down debt.  The aggressive fiscal and monetary policy response should produce a spurt of growth by early 2010, but it will likely be unsustainable without borrowing more demand from abroad.

2009 – Interim econ posts

Progress on the Financial Rescue (1/29/09)

Shock and Awe from the Feds (3/26/09)

Good News on the Trade Deficit (4/6/09)

Hot and Cold on Obamanomics (5/15/09)

The Economist on the Stress Tests (5/17/09)

Inflation is not a problem (yet) (5/25/09)

The truth about US trade deficits and US manufacturing (6/2/09)

Bill Gross on the Coming Fiscal Train Wreck (6/3/09)

More on American Manufacturing (6/4/09)

The Nature of the Economic Recovery (10/28/09)

Assessing the Quality of Q3 GDP Growth (10/30/09)

Government Deficits are Necessary (for now) (11/04/09)

Invest in infrastructure to stimulate jobs (11/20/09)

Health care is killing the American worker

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In the "everything is connected" category, I was reading Michael Santoli's column in Barron's this week and he brought up something interesting:

"There may be no position of more comprehensive agreement than that the U.S. consumer is shot — earning less, spending less, saving more, repayng debt. How many times have we seen the same numbers trotted out, about how consumer spending jumped from a long-term average of below 65% of gross domestic product to a recent 70%, and must fall back; how household debt soared from 64% of GDP in 1995 to 100% of GDP, and must retrench; or how the savings rate that used to average 7% to 11% before 1992 has just lately popped from zero to 6.9%?

It's all true, and should be expected to restrain spending and economic activity over time. But the nuances within the numbers — and the unknowable trajectory and degree of adjustment — helpfully complicate the picture.

The consumer as 70% of GDP needs a footnote. Almost all the growth in personal consumption as a share of the economy has been health-care spending — even though government covers half of health expenditures. As strategists at Citi and Barclays have noted, personal spending ex-health-care as a share of GDP has been flat for decades. This suggests there may not be too much frivolous shopping to cut out."

I'll admit expecting consumer spending as a percent of GDP to fall has been one of my core economic theses. So I pulled the numbers myself. And lo and behold, the economists at Citi and Barclays are mostly right.

If you exclude medical care, personal consumption as a percent of GDP is only slightly above where it has been since the early 1960s and is below where it was in the 1950s. Half of medical care expenses are paid for by the government and close to half are paid for by employer-based insurance. Please note that these statistics are for medical services. Drugs and medical devices are classified as goods.

This chart really emphasizes my point:

Another statistic that's often bandied about is how the median worker's inflation-adjusted wage has stagnated since the early 1970s. The stat is usually cited by the left as proof that greedy corporations have been raking in all the profits and holding down workers' pay or that all the economic benefits have been flowing to the rich. It turns out that what has actually been happening is that the rightful fruits of worker's productivity gains have been Hoovered up by the medical-industrial complex.

The Clinton era is hailed by the left as a time when more progressive taxation and such finally allowed the median worker's wage to rise after its long stagnation under Nixon, Reagan and Bush. It turns out, the 1990s was also the age of the hated HMO that "rationed" health care. Health care as a percent of GDP fell slightly from 1993 to 1999 and the average worker's wage surged.

Source: Minneapolis Fed

The following calculation, which includes benefits, shows that American wages have actually risen quite a bit since the early 1980s.

In other words, HMOs created the great Clinton-era wage boom.

Not to pick only on the left. The right (or at least the Wall Street Journal editorial page) is constantly raising the bugaboo of "health care rationing" as the threat of Obama's proposed health care reform. Of course health care needs to be rationed. What else doesn't get rationed in some form? The big question is how to ration health care. Is it done by insurance companies, like under the HMO model? Is it done by the government, like in Canada and Europe? Is it rationed by changing incentives for doctors and hospitals, like what was suggested in my previous health care post?

If health care doesn't get rationed in some form or another, Americans' standard of living (ex. health care) will stagnate. For a while Americans borrowed against their houses to pay for increases in their standard of living. That option is now gone.

Our expensive health care system is robbing American workers of the fruits of their labor. Bring down the cost of health care and more workers will be able to afford coverage. Bring down the cost of health care and more workers will receive pay raises. Bring down the cost of health care and the US can close its trade deficit. Bring down the cost of health care and reduce the future Medicare liability. Bring the cost of health care and reduce US indebtedness to the rest of the world.

I can imagine no more important issue facing voters today.

Q2 Market Update

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This Q2 market update builds on the analysis in my Q1 Market Update and my updated revision to my stock market valuation model and market rally analysis.

I've updated the S&P earnings estimates and S&P valuation level (which has only dropped slightly from my most recent update). The S&P earnings estimates have actually be reduced from the Q1 estimates, even though people have been getting more optimistic about the economy. Since I use long term trend earnings, I use as-reported earnings as a base calculation. I arrive at forward trend earnings of $53.46, which is slightly higher than the top-down operating earnings estimate.

The market is currently pricing in a 6.9% long term return, in keeping with its post-Lehman norm.

The 30-year inflation assumption is down slightly from the June 15 peak of 2.5%, which has dragged down the S&P value accordingly. I personally believe that at current tax rates the equilibrium return for stocks should be 7.6%. Obviously, there is more risks that dividend and capital gain taxes will rise than fall, which means there is more risk for equity return compression.

At various (pre-tax) return targets, I arrive at the following target S&P levels:

I have 7.6% as an equilibrium return. To achieve such a return, I think the market would need to fall by 19%.

Looking at bond yields (Treasuries by actual yields, the rest as represented by Vanguard bond funds), we have the following levels:

It looks like intermediate and long bonds other than treasuries are fairly valued, long treasuries are roughly fairly valued, and the shorter end of the bond curve is overvalued. I am still in the deflation camp over the inflation camp, meaning I find more relative value being short the inflation hedge (long bonds) rather than long the inflation hedge (long stocks).

In terms of our other inflation indicators, gold at $929/oz. remains above my $1,000 inflation warning threshold, and the dollar is in the middle of its long term trading range against major currencies and is at the top of its range against all currencies.

There appear to be no glaring mis-pricings in the markets today. Boring…

Must-read health care article from the New Yorker

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Everyone thinks we need to do something about our health care system, but there's not much agreement about what needs to be done.  I am far from an expert in this field, but have come across some interesting articles recently.  I am a big picture guy, mostly, so I'll start from the top.

The Democrats generally focus on providing coverage for the uninsured and the Republicans generally focus on the high cost of our system (if they aren't defending the status quo, which they also do).

This chart from the Economist tells us alot:

On the basic question, the Republicans appear to be more correct, the US clearly has a problem with costs, without providing better outcomes.  The fact that there is a high number of uninsured is a symptom of the fact that health insurance is expensive, not the core failing of the US system.

RULE #1 – WE SHOULD BE SPENDING LESS ON HEALTH CARE, NOT MORE

What is different about the US system that results in high costs?  Here are some possiblities:

  • We waste money on the bureaucracy of private insurance – maybe, but the chart shows that we spend as much as or more than other countries publicly, even though most people get their insurance through the private market…besides since when are government bureaucracies known for being efficient?
  • Other countries free ride on our innovation – true, but I doubt that makes up the whole difference
  • Other countries don't have large medical malpractice claims – also true, but also unlikely to make up the difference
  • Since everything is free, people overconsume – true, but it is free in other countries too, and besides, do consumers really stand a chance of figuring out what they should pay for procedures, how to negotiate prices and what is necessary and unnecessary?
  • Our care, for those insured, is better – this is true in some ways…we are more likely to make use of cutting-edge technology but our outcomes are not necessarily better in key measures
  • Other countries ration – also true, but they do not necessarily have worse outcomes…besides everything else in the world gets rationed in some way, why not health care?  Since when do we expect to get unlimited free anything?

This article from the New Yorker looks in depth at the cost issue by comparing two Texas cities with similar demograpics, similar health outcomes, but vastly different healthcare spending per capita:

http://www.newyorker.com/reporting/2009/06/01/090601fa_fact_gawande?yrail

Supposedly, Obama is making this article required reading for his staff.  Obama talks about the cost problem all the time, like he totally gets it, but then he rolls out a plan that involves spending over a trillion dollars more than we already do.  It's mindboggling.  Why, Obama, why???

Anyway, what is the punchline?

RULE #2 – LIKE WITH MOST THINGS, IT'S ALL ABOUT INCENTIVES…IT IS THE DOCTORS THAT ARE OVER-CONSUMING, NOT PATIENTS

The system incentivizes doctors to order expensive procedures, incentivizes the use of specialists, incentivizes the use of expensive drugs, incentivizes the use of tests, incentivizes the use of expensive technology, and disincentivizes the use of general practictioners, collaboration between doctors and preventive care.

The difference between the two Texas cities is that one has an entreprenurial culture among doctors whereby they rack up huge costs and the other doesn't.  Supposedly, if the high cost areas of the US were brought down to the levels of the better low-cost areas (like the Mayo Clinic), the gap between the US and other countries would vanish. 

I do suspect, however, that there is a vast medical-industrial complex that will fight this sort of change, thus we will end up just poring more slop into the trough for the health care pigs to feed off, with little actual reform.

As an final note: an article in this week's BusinessWeek highlights the medical-home model that may serve as an antidote to our health care boondoggle:

http://www.businessweek.com/magazine/content/09_27/b4138034173005.htm

On the question of how do we incentivize for outcomes (quality) rather than quantity of care?  Honestly, I have no idea.

The Recent Market Rally Explained

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On April 24, I updated by stock market valuation model and noted it's sensitivity to the assumed inflation rate.  It was fitting that I made that observation, because it appears that virtually 100% of the rally in the S&P 500 since the March 9 bottom can be explained by a rise in market inflation expectations.

Constant assumptions:

Inflation-adjusted 2009 Trend Earnings: $54.94
Normalized Payout Ratio: 50%
Inflation-adjusted Earnings/Dividend Growth Rate: 1.6%

March 9 Inputs:

S&P 500 Level: 680
Implied dividend yield: 4.0%
Implied real return (dividend + growth): 5.6%
Market Inflation Rate (30-year): 1.3%
Total Implied S&P 500 Return: 7.0% (rounded)

June 15 Inputs:

S&P 500 Level: 921
Implied dividend yield: 3.0%
Implied real return (dividend + growth): 4.6%
Market Inflation Rate (30-year): 2.5%
Total Implied S&P 500 Return: 7.1%

This is why the stock market, treasury yields and gold prices have all been positively correlated with each other for the past year.  The stock market hates deflation and adores mildly positive inflation.  To the extent that the Fed and Treasury seem to be successful in promoting reflation, the stock market goes up.  While the market will dislike runaway inflation, as I noted in my post from May 26, that is not currently a threat, despite what many commentators are saying.

So it appears that the market's equilibrium S&P return is 7%, not the 8% that I have been assuming based on historical return premium calculations.  So what changed to reduce the return premium?  Almost all of the drop in return expectations can be explained by the decrease in dividend taxes in the Bush tax cuts of 2003.  It appears that the stock market targets a 2% spread over the equilibrium after-tax return on 10-year corporate bonds.

More on American Manufacturing

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In my previous post on US trade deficits and manufacturing productivity, I discussed how US manufacturing has actually thrived, even in the last three decades while manufacturing employment was plunging. 

Such numbers might prompt one to ask how it can be, when their are abandoned, crumbling factories all around us, particularly in the old industrial cities of the Northeast and Midwest.  There are two answers.  One is that alot of manufacturing activity has moved from the unionised North to the right-to-work South and West, where factories are allowed to be run with fewer employees that cost less.

Another is that the US has been abandoning lower tech, mostly labor-intensive, manufacturing and reallocating capital to higher tech areas.  While this is no consolation to former textile workers in the US, it's the natural evolution of things.

This chart from the Economist illustrates it nicely:

Economist mfg chart

Most advanced nations have been shifting away from low tech manufacturing and such manufacturing is being picked up by developing nations like China. In the US and Britain, where capital has been allocated the most freely, the trade balance is most positive in high tech manufacturing.  South Korea has also made great advances in high tech. 

I think the most interesting aspect of this chart is that Germany and Japan, the two largest advanced economies besides the US, have huge surpluses in mid-high tech but deficits in high tech.  I would argue the reason for this is that Germany and Japan have been among the most aggressive in promoting an industrial policy to build up the old mass market manufacturing economy (exemplified by autos) and have financial systems dominated by commercial banks.  They have very conservative systems that were great at building up the post World War II economy, but lack the venture capital/ IPO/ public stock/ high yield debt/ private equity culture that, for all its faults, relentlessly reallocates capital to the highest-return investments in innovative sectors.  They are also the two developed countries most manifestly in danger of being in secular decline.

I realize that sometime the US system gets its capital allocation very wrong, like with the recent housing bubble.  But I would like to bring up the fact that housing is the sector most heavily promoted by our government.  This "industrial policy" was successful for years, but eventually it got taken way too far and will be difficult to unwind, given all of the powerful constituencies that are now invested in promoting real estate speculation.

Housing in the US and the long term stagnation of Japan and Germany are warnings to those that would promote the heavy involvement of the US government in the economy to protect declining industries and to conduct industrial policy in growth sectors beyond the early R&D phase.