Friday, December 20, 2013

Socialism in One City (Seattle)

Opening the Seattle Times this morning, I was surprised to see a photo of Seattle’s new Socialist Councilmember, Kshama Sawant, standing alongside the City’s new Mayor, Ed Murray, who was announcing the formation of a new Income Inequality Committee.  The Committee will consider minimum wage legislation, which Ms. Sawant would like to set at $15/hour, the level recently adopted through initiative by the City of SeaTac.

The paths leading to a more Egalitarian Seattle are cluttered with obstacles.  A former UW political scientist, Paul Peterson, insists that egalitarian initiatives, "redistribution" in Peterson's jargon, are pursued more effectively by countries than cities.  The title of Peterson’s book, “City Limits,” captures the main idea, which is that businesses and well-to-do residents aren’t trapped within the City’s boundaries; they can relocate to more “hospitable” jurisdictions, as Boeing is threatening to do.

In a more perfect world, minimum wages would be raised in concert nationwide (or worldwide), we’d have a more progressive tax code, and there would be better educational opportunities for less advantaged citizens.  But we don’t live in an ideal world, and so Seattle must seek out the next best alternatives.

There are some egalitarian policies Seattle can pursue without running up against the “city limits.”  Ms. Sawant isn’t the first Socialist elected to the Seattle City Council.  A hundred years ago, the Socialist Party was an active participant in the political battle to create Seattle City Light.  At the time, the existing electric utility was owned by a Boston syndicate and charged 20 cents/kWh.  When City Light started delivering power, it charged 8 cents/kWh, forcing its private competitor to reduce its rate to 8.5 cents/kWh. Now that's public power!

But I digress.  Today, Seattle has a chance to follow the excellent lead of B.C. Hydro, British Columbia’s publicly-owned electric utility.  B.C. Hydro charges its larger customers a carefully designed electric rate that doubles the financial incentive to conserve.  Each customer receives a block of low-cost power based on their past consumption, but pays a much higher rate for additional consumption.  In the long run, this electric rate alternative will reduce total energy costs, which are borne disproportionately by low-income households.  Perhaps our new Socialist Councilmember can nudge Seattle City Light in this progressive direction.

Here’s another question for Ms. Sawant: Do you approve of the City’s Retirement System's plan to triple its investment in Private Equity?  Thanks to the so-called “carried interest” tax loophole, Private Equity owners (remember Mitt Romney) pay a lower tax rate than most City Employees.  Seattle’s Liberal Councilmembers seem content to allow the City’s Private Equity holdings to be sharply increased, even though Private Equity lobbying groups are now pressuring Congress to maintain a tax loophole that benefits the highest echelons of the top 1%.  Surely a Socialist can’t support such investments!

Since I’m gathering up my holiday spirit, let me express the hope that our new Socialist Councilmember will bring the Liberal members of the City Council to their senses on these issues.  More efficient and environmentally-friendly utility pricing used to be a Liberal battle cry in Seattle, and the argument that it won’t work, or will drive business away, holds no water in light of B.C. Hydro’s success.  And if our Liberal Councilmembers can’t be persuaded to halt the City’s indirect support of Private Equity’s “carried interest” tax break, then perhaps their new Socialist comrade will occasionally remind them about the City’s $20 million investment in a Cayman Islands private equity firm, which is now worthless.

(I've created a new blog, "Socialism in Seattle,", in hopes I'll have something interesting to say about the issues raised by Socialist City Councilmember, Kshama Sawant.)

Friday, May 10, 2013

Seattle's $20,000,000 Loss on its Private Equity Investment in Epsilon

Dear Mayor McGinn, Council Budget Chair, Tim Burgess, & Council Members

Subject: What Can Seattle Learn From the Epsilon II Calamity?

I’m writing in regard to the May 5, 2013 Seattle Times article entitled “Seattle City Pension Investment Mired in Legal Limbo,” which describes the regrettable misadventure of Seattle’s $20 million investment in the private equity fund, Epsilon II, which is now worthless.

A little more than a year ago I sent you a letter outlining the conflicts of interest that make the City's pension system vulnerable to the sort of investment losses described in the Times article, and I explained why Seattle’s continued practice of betting on investment managers who insist they can “beat the market” has a very low probability of success.

I was gratified to read Councilmember Burgess’s admission that “our private-equity investments have been very problematic, and Epsilon is clearly one of those.  We need to get a better handle on this part of our portfolio and better understand the risks as well as the rewards.”

This analytical commitment marks a significant improvement over the rather blasé attitudes expressed by some City officials, elected and unelected alike, regarding the City Pension System's investment practices.  The calamity of Epsilon II is, in fact, a symptom of a more general problem, which is the City’s continued reliance on financial consultants who, as a matter of temperament and self-interest, offer advice that is inconsistent with some of the most well established findings of financial economics.

In the Spring 2013 issue of the Journal of Economic Perspectives, there’s an article entitled “Asset Management Fees and The Growth of Finance,” in which Burton Makiel details the underperformance of actively managed investment funds compared to index funds. Moreover, the largest underperformance gap is in small capitalization stocks, where Seattle's financial advisors claim they can exploit market inefficiencies to achieve superior returns.  In light of these findings, which have been confirmed by many other studies, Makiel concludes,“Perhaps the greatest inefficiency in the stock market is in ‘the market’ for investment advice.”

Seattle's pension system has been a willing buyer in “the market for investment advice” and has paid dearly for it.  Between 1988-2011, Seattle's investments have underperformed a risk-equivalent index portfolio by 0.9%/year, not including fees.  This performance gap, which does not depend on hindsight, cost Seattle's pension system more than $500,000,000 (2011 dollars).  

According to the Times article, Seattle is considering the possibility of turning its investment decision making over to the Washington State Investment Board because the State’s investment performance has been superior to the City’s results.  But this is the wrong standard of comparison.  The performance of the Washington State Investment Board has been significantly worse than the performance of a risk-equivalent combination of index funds.  The last figure in the attachment displays the performance of 24 state pension funds versus 7 index portfolios for the 10-year period, 7/1/2000 to 6/30/2010. At every risk/return combination, the index portfolios outperformed the state pension funds by at least 2%/year. Washington State underperformed the risk-equivalent index portfolio by more than 2%/year.

The problem facing Seattle is that very few financial advisors would recommend an index portfolio because: 1) there’s more money to be made in active asset management than in the construction of an index portfolio; and 2) virtually all financial advisors believe they can outperform their competitors, but, unless they all live in Lake Wobegone, they can’t all be above average.  

It’s time for Seattle to consider a new approach to investing, one that draws on the mountain of academic research showing that active asset management is a losing strategy.  Continuation of the current approach will only deliver superior returns if Seattle's pension board can pick those few investment managers who can “beat the market,” a premise that implies a good deal of hubris, especially in light of the Epsilon II catastrophe.

Sincerely Yours, Greg Hill

Thursday, April 4, 2013

Biting the Hand that Fed Me: UW Political Scientists on Deficit Reduction

Dear Professors Mark A. Smith and Rebecca Thorpe
I read with interest your brief essay, “Perspectives on National Government Spending,” in the Political Science Department’s Spring 2013 Newsletter.  Your point about the contradictory views of the public regarding “spending in general” vs. “spending on particular programs” is, indeed, helpful in understanding why it’s difficult to make significant cuts in government spending.
But several other claims you advance regarding the prospects for deficit reduction seem misleading if not mistaken. 
1.  To begin with, legislation adopted since the beginning of fiscal year 2011 reduced projected deficits by $2.4 trillion between 2013-2022, with 75% of this reduction attributable to spending reductions and interest savings.  These measures, which don’t include the recent sequester cuts, are forecast to reduce Federal debt as a percentage of GDP in 2022 from 93% to 83%.  In short, significant reductions in projected deficits have already been achieved.
2.  The proposition that long-term deficits “are driven mainly by entitlement spending” is correct, but misleading.  Social Security is not in bad shape; it can pay full benefits until 2033 with no changes to current law.  And Social Security’s long-term “problem” can be solved by modest changes phased in over time.  (See Social Security aside, then, the remaining large entitlements, Medicare and Medicaid, are really symptoms of problems with the American health system.  Our per capita health care spending is, on average, twice that of other advanced economies, yet our health outcomes are worse on many dimensions.  The challenge is not to “reduce entitlements,” e.g., by increasing the Medicare eligibility age from 65 to 67, but to fix our health care system. 
3.  It’s not true that “both parties have resisted offering any cuts to entitlements.”  President Obama’s ACA reduced Medicare costs by over $700 billion.  And Obama has agreed to adopt the chained CPI for Social Security and to reduce subsidies for high-income Medicare recipients.  In addition, the “Stimulus Package” and the ACA include many investments and cost-effective practices that will reduce health care costs.
4.  Although it may be true that “Republicans seem more committed than Democrats to deficit reduction,” Republicans, in fact, aren’t more committed to deficit reduction (my stress).  Consider the following Republican policy choices: 1) the Bush tax cuts; 2) the unfunded Bush prescription drug benefit; 3) the two wars not paid for; 4) Republican unwillingness to raise taxes even though revenues as a percentage of GDP are very low by historical standards; and 5) the Paul Ryan budgets that include large tax cuts and only achieve balance by assuming implausible supply side elasticities.
5.  Finally, you seem to accept the argument that reductions in government spending will reduce the government’s deficit.  The problem is that cutting spending reduces income while increasing expenditure for unemployment benefits, food stamps, etc.  The disappointing effects of the spending reductions in Europe and the U.K. on public sector deficits raise serious questions about the virtues of austerity.  You might find this post interesting:
Sorry to drone on.  I do appreciate your willingness to write for a general audience and, as you can tell, I found your piece thought provoking.
Best regards, Greg Hill (Ph.D. in Political Science, UW, 1982 (or 1981, I can’t remember)

Monday, February 18, 2013

Stephen Williamson Does *Not* Sort Out Keynesian Economics

Stephen Williamson took a break from haranguing Paul Krugman to post a working paper about Keynesian economics.  A newer version of the paper, entitled “Sorting Out Keynesian Economics: A New Monetarist Approach,” can be found on Professor Williamson’s academic website here.  (All citations below are from the newer working paper.)

Williamson is puzzled by the persistence of Keynesian economics given the “revolution in thought” that took place after 1970. “However, to be fair to the Keynesians,” Williamson allows, “we should at least try to understand what they are up to, and evaluate the work,” an evaluation which culminates in Williamson's judgment that “there is nothing about [my] paper that should make us any more comfortable with Keynesian analysis.  All of the basic questions remain unanswered." 

Williamson claims his model is closest to the model developed by Roger Farmer in his 2012 Economic Journal article, "Confidence, Crashes, and Animal Spirits."  
“We can imagine a world – Farmer’s Keynesian world - where a matched worker and producer in our model have difficulty splitting the surplus.  Then, there exists a continuum of equilibria, indexed by wages and labor market tightness.  In general, an equilibrium with a high (low) wage is associated with low (high) labor market tightness . . . In this static model, the equilibrium can be suboptimal, in that labor market tightness is too high or too low. Indeed, the unemployment rate could be too high or too low.”
Later, Williamson modifies his simple search model to include a dynamic framework, consumers, and money.  Throughout these refinements, Williamson’s basic conclusion holds:

“Inefficiencies arise in Keynesian models because private sector economic agents somehow do not get the terms of exchange right.  In our model, what goes wrong is that there are no incentives determining how producers, workers, and consumers split up the gains from trade.”

Although this putative market failure seems to invite corrective policy, a successful policy, according to Williamson, requires civil servants who can see things that aren’t visible to market participants.  
“As in typical Keynesian policy analysis, those agents who are assigned the job of working out optimal monetary and fiscal policy somehow see through these inefficiencies and are able to design policies that correct the problems.  In this sense, our analysis is no more, and no less, sensible than what the average Keynesian does.” 
 Quite a devastating assessment it would seem.  Yet, in spite of the paper’s self-assured tone, there’s much less here than meets the eye.  To begin with, Williamson’s characterization of Farmer’s model as one “where a matched worker and producer . . . have difficulty splitting the surplus” actually bears very little resemblance to Farmer’s Old Keynesian model.  Here’s Farmer’s own characterization,

In this article, I propose a new approach.  Instead of searching for a fundamental explanation to close an indeterminate model of the labour market, I close the model with the assumption that firms produce as many goods as are demanded. Demand, in turn, depends on beliefs of market participants about the future value of assets.  By embedding the indeterminate labour search market into an asset pricing model, I show that the unemployment rate can be explained as a steady-state equilibrium where the indeterminacy of equilibrium is resolved by assuming that the beliefs of market participants are self-fulfilling.”

In other words, Farmer assumes: 1) firms produce goods to meet demand; 2) demand, in turn, depends on beliefs about the future value of assets; 3) these beliefs are self-fulfilling, which means; 4) the unemployment rate is determined by self-fulfilling beliefs about future asset values.  Thus, unemployment in Farmer’s model, far from being the consequence of “not getting the terms of trade right,” as Williamson suggests, is, in fact, due to a lack of aggregate demand that’s rooted in self-fulfilling pessimism about future asset values.  In short, Williamson has stripped away the most Keynesian element in Farmer’s model, viz. the role of beliefs, or “animal spirits,” in determining the level of employment via their effect on asset values, which, in turn, influence demand.

The bearing of Williamson’s modeling exercise on “Keynesian economics” is also put in question by the particular search model he’s chosen to work with.  In Williamson’s model, producers, workers, and consumers must find one another and then come to agreement regarding the “terms of exchange.”  This agreement is the subject of bargaining, which, in the absence of certain constraints, won’t produce an efficient outcome.  

By contrast, Farmer builds on Peter Diamond’s search model, where an increase in the availability of potential trading partners raises the profitability of engaging in trade, thereby generating externalities and multiple equilibria.  In fact, Farmer sees “no reason to treat the search model differently from any other competitive model with externalities,” adding that he views “the addition of the bargaining equation as arbitrary.”  So, the externalities that are the centerpiece of the search model Farmer employs have also disappeared in Williamson’s version of Farmer’s model.

We are now in a better position to evaluate Williamson’s conclusion:

“There is nothing about this paper [i.e., Williamson’s own paper] that should make us any more comfortable with Keynesian analysis.  All of the basic questions remain unanswered.  Why are private sector agents so bad at determining the terms of exchange, while public sector agents are so good at it?  How could such seemingly small difficulties in setting prices and wages lead to such large aggregate problems with the allocation of resources?”

Not to put too fine a point on it, but the reason there’s nothing in Williamson’s paper “that should make us any more comfortable with Keynesian analysis” is because the paper has very little to do with Farmer’s Old Keynesian model (and even less to do with Keynes’ own theory).