• "Kee Points" with Jim Kee, Ph.D.

    So much for “repealing and replacing” the Affordable Care Act (i.e. Obamacare) of 2010. Republicans pulled the bill to do so, the American Health Care Act, on Friday due to lack of support. Obamacare was passed without a single Republican vote, and President Trump was unable to muster a single Democrat vote (or 100% Republican support) for its repeal. It is in that sense that the bill’s failure is perceived as a Trump failure, and in response the President has argued that “The best thing we can do politically speaking is let Obamacare explode. It is exploding right now.”


    What does he mean by that? Well, the shortest explanation of this starts with the recognition that the Affordable Care Act (ACA, which remains law) walks a pretty thin line by mandating that insurance plans cover certain essential benefits and by forbidding explicit exclusion of individuals with pre-existing health problems (Analysis Group). In order for an insurance company to make a profit, those customers with diseases like cancer and HIV whose annual costs exceed the annual premiums they pay, must be offset by healthy customers whose annual premiums exceed their annual costs. This creates what economists call “adverse selection,” meaning the system attracts fewer healthy individuals and more unhealthy individuals, and that makes the system less sustainable. It is why you need the individual mandate, which requires healthy individuals who might not buy insurance to “opt in” and purchase health insurance (whether the government is legally allowed to compel people to purchasing something was part of the controversy resulting in the 2012 Supreme Court decision upholding the mandate as a “valid tax”). But the mandate has exemptions, which has led even Republican commentators like Wharton’s Kent Smetters to argue that the problem with the Act right now is that the individual mandate isn’t stringent enough.


    This leads to challenges for insurance company profitability (which is why they are charging higher premiums), and is causing many insurers to exit ACA markets. It is one thing to tell people that they are covered, and quite another to provide the resources to serve them. Markets either equilibrate the supply/demand imbalances (more people demanding care than is being supplied) by price rationing (paying higher prices) or non-price rationing (i.e. waiting in line). We are seeing some of each, which will probably continue. I wrote some years ago in Kee Points that the Affordable Care Act will probably morph into something more sustainable, but in a way that allows both Democrats and Republicans to claim some victory, and I think that is what we are witnessing right now. Once a benefit is promised (guaranteed healthcare coverage) it is very hard to take it away – we just saw that – which makes modification more politically viable than repeal.


    And how are markets reacting? Not well right now, partially because this episode calls into question Trump’s ability to push through regulatory reform (e.g. Dodd-Frank) and tax reform, and partially because the market was already pricing in the elimination of the Obamacare surtax on capital gains for high income earners. I don’t think a pullback after such a huge post-election run-up in stocks is very surprising at this point, particularly with the coming uncertainty around tax reform and budget constraints, which are next on the agenda. Stocks in the short-term are riskier than a 3 month t-bill, which of course is one of the reasons why investors can achieve higher returns by investing in them. But the key lesson of last year (and of 50+ years of peer-reviewed research) still applies, and that is that you jeopardize long-term gains when you view markets through a short-term lens.


  • "Kee Points" with Jim Kee, Ph.D.

    Three economic topics worth mentioning from last week involve Europe, health care, and the Federal Reserve. I’ll discuss Europe and the Fed briefly this week and health care next week - health care reform is just too big a topic to combine with others!


    Europe: Back in 1999, British historian Paul Johnson wrote a piece in Forbes titled, “Why Britain Should Join America.” He made the point that Britain had much more in common with the US than with post-WWII Europe, a theme he reiterated following the June, 2016 Brexit vote (the UK referendum on whether or not to leave the European Union). In other words, he argued that Britain was fundamentally different than other “core” European countries like Germany, France, Spain, and Italy (there are 28 European Union member countries, 19 of which use the euro as their common currency). This implies that what happens in the UK isn’t necessarily what will happen in other, more European countries. So far that analysis seems to hold, as Geert Wilders, a proponent of the view that the Netherlands should exit the European Union, had a disappointing showing in the parliamentary elections there on Wednesday. France is up next, with Marine Le Pen of the National Front party, one of the four leading candidates, in favor of exiting the European Union. There will be two rounds of voting, with the first vote taking place on April 23rd, and the second vote (between the resulting top two candidates) taking place in a run-off on May 7. Le Pen is expected to make it to the second round and then get defeated. As an aside, I’ve always found the verbiage of European politics somewhat confusing, as the meaning of terms like “populism,” “far-left,” “far-right,” and “extremist,” etc., aren’t always intuitive or consistent.


    Market indicators, like stock market indices (US, Europe, Emerging Markets, Global), global risk measures (e.g. St. Louis Fed Financial Stress Index), and currencies don’t seem to be expecting or pricing in a big shock like a Le Pen win and/or a potential break-up of the European Union. However, expectations are high for serious modifications of the existing governance structure of the EU. In that sense I continue to think that Nobel Laureate Thomas Sargent was on the right path in his 2011 Prize Lecture (“United States Then, Europe Now”). Sargent pointed to similarities between the early history of the US, which over a period of years abandoned the Articles of Confederation (1781) in favor of the Constitution of the United States (1788), and Europe today. That suggests a multi-year re-evaluation or “updating” of the European project, which feels like what we’re in the middle of right now [note: Scotland voted in 2014 to remain in the UK but a majority also wanted to remain in the EU, so a referendum there - on remaining in the UK - is possible as well].


    The US Federal Reserve raised rates 25 basis points last week, making the Fed’s target range between .75 percent and 1 percent. This was largely expected and in-line with prior guidance from the Fed, and in fact, two more rate hikes are expected over the next 6-12 months. The Fed mentioned improving labor markets and inflation moving upward towards the 2 percent long-run target as justification for the move. The Fed statement also mentioned that the Fed will continue to reinvest the principal payments it receives from its holdings of debt securities (i.e. continue to buy securities) until “normalization” of short-term rates (somewhere in the 2% go 3% range) is well under way. That is consistent with former Fed Chair Ben Bernanke’s blog post from January (“Shrinking the Fed’s Balance Sheet”) in which he argued that the Fed would and probably should wait until rates were closer to normal before attempting to reduce the size of its balance sheet (i.e. stop reinvesting debt principal repayments in other debt securities). This ostensibly gives the Fed some ammunition or leeway to cut rates in the event that a balance sheet reduction causes problems. It’s hard to talk about the impact of small incremental rate hikes when rates have been at or near zero for so long, because there just isn’t any real historical precedent. But overall the Fed’s position is still considered to be loose or “accommodative,” because short-term rates at .75% - 1% are still well below inflation, which is closer to 2%. Think about it kind of like this: You can borrow money from me at a rate that doesn’t even compensate me for inflation, so you are really paying back less than you borrowed. It is hard to call that tightening.


  • "Kee Points" with Jim Kee, Ph.D.

    Is it too late to get into stocks? Should I take some money off the table? Those are always common questions after a pretty big stock market run-up like the one we’ve been experiencing since the November elections (up about 11%). The response should be equally common, which is that there is no credible, peer-reviewed research that suggests anyone can answer those questions that really imply the ability to time the market. When the market looks expensive it can stay that way for a long time (years), and when it looks cheap it can do the same. That’s because valuation tends to be “period specific,” meaning that different periods involve different levels of interest rates, inflation rates, taxes rates, and regulatory regimes (all of which influence valuations levels). That makes valuing the market difficult, as it involves forecasting a raft of variables. But there are a few data-driven ways to get your arms around the issue of stock market valuation levels that don’t require a huge amount of mathematical modelling and forecasting.


    For example, I have mentioned in prior Kee Points the insightful research published some years ago by the Financial Analysis Lab at the Georgia Institute of Technology titled, “Seeking Guidance for the Dow? Try GDP.” The piece follows the Dow Jones Industrial average and nominal GDP (in billions of dollars) since 1916, and demonstrates that, over time, the Dow tends to move with GDP. The Dow exceeded GDP by 200% on the eve of the 1929 stock market crash, but by 1932 the discrepancy had pretty much been erased. And in the early 1980s the Dow was over 70% below GDP, but that discrepancy too was erased over time. The Dow has traded above GDP (1920s, 1950s-1960s) and below GDP (1940s-1950s) for multi-year periods, but for the past 100 years those two episodes – 200% above and 70% below - have been the valuation extremes. Currently, the Dow at 20,921 is about 8% above GDP, not cheap but certainly not an extreme.


    Another approach to market valuations and subsequent stock market performance is to look at the correlation between valuation levels today and future shareholder returns. Crandall, Pierce, & Company performs this analysis on a regular basis using the Standard & Poor’s 500 price-to-earnings (p/e) ratio as a measure of valuation. Going back 45 years and correlating the market’s p/e ratio (high is expensive, low is cheap) with subsequent total returns (dividends plus price appreciation) over the next month to 15 years, they find the following: There is little correlation between valuation levels and stock market returns over the next year or so. But there is a very strong correlation between valuation levels and returns over the next 11 years. In other words, the more expensive stocks are right now, the lower the annual returns to investors over the next 11 years (the highest correlation). But there is significant variation, depending upon the period under consideration. If we applied these historical relationships to the p/e ratio for stocks today (i.e. at the beginning of the current quarter), investors could expect an average annual return of about 7.75% over the next 11 years. That would be below average but still doubling your money about every 9 years. Variation is huge, with the lowest annualized returns (given today’s valuation levels) of about 2% per year, and the highest being about 16% per year.


    These two data-driven approaches to market valuation levels and expected investor returns should cause you to question anyone who tells you that “now is the time to buy,” or “now is the time to sell.” Current valuation levels are well within historical norms, so such statements imply an ability to outguess the market’s current estimate of economic and earnings growth, interest and inflation rates, tax rates, and regulatory developments. I’ve been a professional economist for over 20 years and I’ve never met anybody who could do that!


  • "Kee Points" with Jim Kee, Ph.D.

    Concerns regarding automation and worker displacement, which have been around for centuries, are currently making a comeback. Here are the basic economics of the subject (I apologize for the length!):


    Most people have heard some version of a Milton Friedman story in which he was visiting an Asian country (it was China) and watching a canal being built. Amazed that the men were working with shovels instead of modern excavation equipment, he asked his government tour guide why, and the response was, “because it is a jobs project.” To which Friedman responded, “oh, I thought you were trying to build a canal. If it’s jobs you want, you should have the men dig with teaspoons.” The story does a pretty good job of making a few often-overlooked points in economics. The first, which goes back to Adam Smith (circa 1776), is that the wealth of a country consists of the output of goods and services that its countrymen have access to. Capital equipment such as excavation machinery allows fewer people to be involved in the building of a canal, which makes them available to produce other things, hence a greater output of goods and services, i.e. greater wealth. Since the world is characterized (by economists anyway) as one of unlimited wants and limited means, more machines assisting labor should be welcomed, because wants are never satiated, but the supply of labor is always limited. More people digging canals means fewer people building, say, aspirin factories. Another way of saying this is that the fear that automation will destroy jobs fundamentally rests upon the assumption that there is a fixed amount of goods that buyers want, so machines that increase the output of goods per worker leads to fewer workers employed. I’ll go with 20th century economist Frank Knight on this one: “The chief thing which the common-sense individual actually wants is not satisfaction for the wants which he has, but more, and better wants.” Figuring out what those never-ending “better” wants are is a key function of capitalist economies. That is, figuring out what to do, according to economists, is at least as important as figuring out how to do it.


    Farming is a common but nevertheless relevant example. In the 1870s agricultural workers comprised half of the work force. Today that figure is closer to 1.5% (St. Louis Federal Reserve: US Census). That means fewer people working in agriculture (but greater output) and more people are producing other things (like semiconductors, software, turbine engines, etc). And, we are wealthier (i.e. more of all goods and services). The reduction in manufacturing jobs (but not manufacturing output) over the past 40 years is somewhat similar - fewer people required for manufacturing means more people available to produce other things.


    As an aside, there is a human element here as well, because machines relieve human beings from much burden. An example is the horse-drawn plow replacing human-drawn plows, and tractors replacing the human walking behind a plow. Human beings are always in the sights of being replaced by mechanization, as machines operate without breaks and with a high degree of precision. In fact, the “alienated worker” turning bolts on an assembly line (for example) is always in danger of being replaced by a machine to the extent that her job is like a machine’s. In a sense capitalism forces workers to either pursue “humanized” functions (requiring interaction, communication, judgment) or face being replaced by a machine. You probably weren’t taught that in history or social science class but, as economists say (e.g. Nobel Laureate Frederick von Hayek), capitalism’s history was written largely by its critics. In fact, economist Deirdre McCloskey points out that the term “capitalism” itself was coined by critics of decentralized, price-directed market economies. McCloskey prefers the term “market-tested betterment” over “capitalism,” which is worth a few moments of contemplation.


    M.I.T economist David Autor has elaborated on automation by asking why, “despite a century of creating machines to do our work for us, the proportion of adults in the US with a job has consistently gone up for the past 125 years?” He uses the example of US bank tellers, the number of who have roughly doubled in the 45 years since the introduction of the first automated teller machine (ATM). That’s because, while the number of tellers per branch fell by a third, it became cheaper to open more branches, so more branches meant more tellers. But they are doing different work than they used to do, becoming less routine clerks and more, “like salespeople, forging relationships with customers, solving problems and introducing them to products like credit cards, loans, and investments: more tellers doing a more cognitively demanding job.” That’s the pattern of thousands of years of history, from an axe replacing people digging/chopping with rocks, to nets replacing catching fish by hand, to traffic lights substituting for traffic cops and smartphones replacing AAA travel route services. These are all “robots,” argues McCloskey, designed to abridge labor: “Any contrivance substitutes for labor, equivalent to a robot.” She argues that if such substitutions resulted in permanent unemployment, then the unemployment rate would be 95 percent and headed up, rather than below 6 percent and headed down. That’s technological advance, and as UCLA economist Armen Alchian argued 50 years ago, more people are alive today because we are not trying to survive on the technology of 1870 or 1970.


    Another aside: It was Alchian (who’s economics textbook is almost a cult classic) who pointed out that wage policies tend to hasten automation. Referring to elevator operators, he noted that union demands for higher wages at first (given the current elevators in place) improved the well being of the operators. But as the machines wore out, and given the now higher operating costs with the higher wages, it made sense to invest in more expensive, automated elevators that required no operator. As operators were laid off, their plight was blamed on “automation,” when it was, in fact wage policies. Interestingly, Alchian also pointed out that elevators are faster where people’s time is more valuable (city office buildings) than they are where it is less valuable (e.g. rural parking garages), the idea being that high speed elevators are more expensive to install and have higher maintenance costs.


    But none of this helps the person being replaced by capitalism’s innovation. That’s the trade off, or, “the deal”: Higher standards of living that come with capitalist innovation, but at the expense of continually displaced workers. In fact, it is helpful to think of any new automation or technical advance that replaces the old in terms of three groups of workers affected: (1) the group making the new, like televisions and computers (replacing radios and typewriters), who gain because their skills and knowledge are in high demand, (2) the group of workers unrelated to the industry and unaffected in their employment, but who gain because of the newer/lower cost/better performing product or innovation, (3) the group of workers in the displaced sector (e.g. radio/typewriter workers). So the focus should be how to help that last group, the displaced workers, which shouldn’t be rocket science.


    One suggestion is a universal minimum or basic income (UI), formerly referred to as a “negative income tax” or NIT (recently resurrected in a 2014 paper by the Federal Reserve Bank of St. Louis). That solution is conceptually easy to administer but ignores the familiar economic problem of how to provide assistance without creating dependency. That’s why economists have favored some form of unemployment insurance, though it is hard to monitor, subject to fraud and abuse, and not really insurance. There are probably 1001 ways to structure it, but I am partial to proposals that are more akin to whole life polices, i.e. that contain an insurance component and a cash value or investment component. For example, workers could pay into such a plan at the beginning of their careers and basically be covered by the insurance component, which might include 3-6 months of unemployment benefits. Over time, as their pay-in increases and if they’ve stayed employed, used savings in tough times, or otherwise avoided making a claim, they start to build a cash value component that can be used any time…to change jobs, retrain, or even take a work sabbatical. The idea is to create better incentives by invoking some form of true ownership of benefits.


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