Tuesday, July 28, 2015

Time and Politics

Forget politics. It is all about time. I know a lot about time. You don’t need Wikipedia to define it for you.  It seems like just yesterday I was playing basketball and almost touching the rim. Now I am lucky to ride my bike up the 2% grade coming out of my neighborhood. Tell me about time!

So we know what time is. But it is how we use it that counts, right? Honey, I don’t have time to do the dishes right now. Fox Business News is on and they have some really hot babes on that show. I can't watch them later. President Obama tells us that giving Iran ten years to build a bomb is okay. Today no. In ten years, fine. Paul Krugman says that if the Fed raises interest rates today, then it will be catastrophic. He says it would be better to wait. Russia invades neighbor Ukraine. Ukraine can’t easily remove the invaders. We promise help but it seems  it will come later. The US federal debt doubled and yet we  have not mentioned even the tiniest bit of austerity or reform that might reduce the debt. Nope, we seem content to let the debt permanently increase as a share of GDP. I guess we can worry about that later. Greece should worry now. We should wait.

In all these examples and many more it seems that there is an agreement that there is a problem and something should be done. It is just the timing that matters. Let’s do it later. What is behind this penchant to wait? Probably lots of things. Maybe we don’t have enough information and we wait to learn more? Maybe things have to happen in a sequence and therefore it is impossible to start sooner? Or maybe the issue is simply that we’d rather push a negative consequence off into he future. We know there will be a negative impact from our decision. Let that negative impact come later. Maybe I will be out of office when that impact comes?

We don’t want to wait for everything. Some of us want stuff now. You want that shiny new Hyundai and you buy it despite the fact that you can’t really afford it. You want the government to provide more help for the homeless and other people and you want global warming killed as quickly as possible. Notice that in many of these cases – the immediate impact looks good. In these cases we don't wait.  But in these cases, it is the unintended consequences that come later. We seem very willing to take good stuff now and let the bad stuff come later. 

So it is pretty clear that time often means waiting – and waiting because the real and known negative consequences are hard to swallow today. Push it off. Kick it down the road. Let’s make today as nice as it can possibly be. I can sit on my porch and read another book now – I can always water the lawn later.

Interestingly most of us do not behave this way in our private lives. Our parents taught us to face up to our responsibilities. They drilled us on responsibility. Do your homework now! Mow the yard today. Get your degree before you run off to visit Europe. Get a good job and save some money.

But collectively we act as if Superman was there to pull Timmy out of the well. Or was that Lassie? Anyway, in our political behavior we buy hook, line, and sinker that we can do really good things today and never have to encounter the negative effects. Is it not amazing how little is said by Obama about the risks of Iran having nuclear weapons and us not finding them. 

He even said that the Middle East would be less stable later if Iran did not have a nuclear weapon. What does he smoke to make these things up? When Hillary wants to increase the minimum wage she never talks about one negative thing that might happen after we raise it? Its all to the good!  Krugman explains that if we wait to raise interest rates there might be a modicum of inflation but we are not to worry. Where does he get that stuff?

Why don’t we good citizens hold these folks’ feet to the fire? Sure they can pontificate all they want about the benefits of doing some things now while pushing other things off to the future. But every time they do that they should be required to explain all the risks of things that will surely happen tomorrow. Does that sound so extreme to require them to tell both sides – and then have to support why the future negative impacts would be negligible?

Is it that politicians are incapable of rational analysis? If so, we need to start electing people who have the right capabilities. Or would we as people prefer to have the colorful and often entertaining dueling banjos of Rs and Ds? Maybe it is us who can't calculate and prefer the excitement of chaos. Or maybe we just can't see beyond the ends of our collective noses? It seems so moral to not inflict harm on anyone now...and to hope bad things won't come tomorrow. Is it?

Tuesday, July 21, 2015

The Medical Device Tax and the Theory of the Firm

Sometimes when a party gets really good and the guests have had one too many schnapps I am confronted by an eager inquiring mind with the highly perceptive question – What is the theory of the firm and how does it relate to medical device companies? With so many eyes and ears eagerly waiting for an answer I am more than willing to clear my throat and pontificate until the last ounce of Jack has been poured over the last extra-large ice cube.

The main idea of my answer is that the theory of the firm is the economist’s way of explaining many behaviors of firms. And it turns out that the Medical Device Tax issue is a perfect application of how public policy affects US firms. Professors are always looking for examples to help amplify what they teach. The Medical Devices Tax is a great way to teach economics!

A part of the Obamacare Legislation, the Medical Devices Tax levied a new tax of 2.3% on the value of medical devices sold in the USA (devices exported to other countries are exempted). So if a medical device manufacturer sells a $1000 ultra-hip Elvis-shaped hip to a hospital in Florida, they will net $977 instead of the full $1000. That does not sound like a major deal. But it is estimated that this tax will bring in about $30 billion in revenue to the government to help pay for Obamacare. This $30 billion will be taken from the revenues of medical device firms who received it from consumers or insurance companies. 

Ever since its passage, there has been a push to eliminate the tax and to find other ways for Obamacare to raise that $30 billion. The push goes on today. I stole much of what I am writing today from an excellent report written by Senator Dan Coats of the Joint Economic Committee, dated July 7, 2015 and cleverly entitled “An Economic Analysis of the Medical Devices Tax.” http://www.jec.senate.gov/public/_cache/files/b1537d7e-df45-450f-a32f-512a865119dd/an-economic-analysis-of-the-medical-device-tax-final.pdf

The government’s case is as follows. Because more people are being covered under Obamacare – more people will get hip replacements and buy more medical devices in general. That means the demand for medical devices will increase. The Theory of the Firm says that firms will respond to that increase in demand in one or more ways:

·        Increase the price of medical devices
·        Increase the amount of medical devices produced.
·        Increase hiring of workers and other inputs to produce the extra devices

Despite the extra costs associated with raising output, the theory would generally conclude that the increased revenues generated by higher output and/or prices would increase revenues more than the costs – and thus profits would rise. This leads to the conclusion that Obamacare raises profits for medical device makers and thus these companies can afford to pay some of that back to the government. And of course – Old Uncle Sam needs the money to pay for Obamacare because so many people cannot afford to pay for medical services.

Notice that these firms already pay taxes on profits and lots of other things but the belief is that they can afford another $30 billion that would go to the government from the newly imposed sales tax.

To complete the analysis, therefore, we have to calculate the impact of the extra $30 billion tax on these companies that make hips and knees and so many other medical devices. If we find that the tax is too much – that is, the tax raises company costs more than Obamacare raises their revenues, then the firms (and their many customers) may have been harmed by this tax. Since I am running out of Jack and since this thing is getting too long, let me be brief here. Take a look at Coat’s report for more details about the below points.

First, the revenue effects may be smaller than expected since those folks newly covered by Obamacare probably will not be intensive users of medical devices as opposed to general health care and drugs. Us older folks who love to shop for the coolest hips and knees are already covered by Medicare. So we don't count.

Second, the freedom of firms to raise prices according to the increase in demand is much constrained by regulation in the Obamacare. Those prices have already been pretty much influenced by Medicare – this is not like a market for Midwestern corn.

Third, taking the first and second points together means not much improvement to profits of medical devices makers. If neither output nor prices are improved by Obamacare, then there is little to cover the extra costs imposed by the tax.

Fourth, while a 2.3% tax on revenues seems small – the impact of that tax on profits could be a much bigger hit. A company with a million dollars of sales might only have after tax profits of $23,000. Notice that in that case 2.3% of $1 million of sales is exactly the amount of profits. So while the hit on net sales is small, the impact on profits could be very large. In this example it would wipe them out. Of course, the impact on profits depends on the actual firm, whether it is small or large, diversified or not, etc. But clearly, for firms that need a lot of sales to generate a dollar of profits – this kind of tax is a killer.

Fifth, if profits are dinged then companies have to adjust. Postponing research and development is one possibility. Replacing labor with robots might save a buck or two. Reducing pension benefits is possible. Perhaps finding a production location with lower income taxes is yet another. Ireland has both lower profits taxes and wonderful Irish Whisky.

Sixth, none of this bodes well for the rest of the economy. As we are taxed more and pay more for fewer medical devices, that leaves less money in our collective pockets to stimulate the private economy. We struggle to improve employment opportunities in the USA and this tax does nothing but impede that process.

On that note let me end. There are other ways to raise $30 billion to support Obamacare. I am in favor of a tax on Donald Trump’s hair. But that’s just me. Read Coat’s fine report because it lists a number of good ideas for how to fund Obamacare without inflicting harm on an industry, its workers, and on the US economy in general.

Tuesday, July 14, 2015

Riding the Bull in China by Guest Blogger Buck Klemkosky

Remember the dot.com era in the U.S., especially 1999 to March 2000? Technology stocks ruled, valuations were outrageous, the economy was entering a new paradigm and “this time is different” justified prices. The Chinese markets have experienced the same hyperbolic price increases in the last 12 months.

What most U.S. investors don’t realize is how large the Chinese stock markets have grown in the last decade in terms of listed companies’ market values. The Shanghai Stock Exchange, which has more blue-chip companies, is ranked third in the world; the Shenzhen Stock Exchange, which has more technology and healthcare companies, is ranked seventh. Chinese A shares are listed on the Shanghai and Shenzhen exchanges. Chinese companies can also list H shares on the Hong Kong Exchange, which is ranked fifth in the world. Several hundred Chinese companies have also listed their stock in the U.S. In total, Chinese stocks had a market value of $10 trillion at the end of May, second in the world to the U.S. with $27 trillion.

The Chinese exchanges had a previous stock market bubble that deflated in 2007 with stocks dropping 72 percent and languishing for seven years. Starting in mid-2014, stock prices started to increase steadily and experienced hyperbolic moves in 2015. The Shanghai Index was up 60 percent and the Shenzhen Index 122 percent when prices peaked on June 12, 2015. Since then both exchanges have technically fallen into bear markets, defined as a market decline of 20 percent or more. The Shanghai Index has fallen 28.6 percent from its peak and the Shenzhen Index 33.2 percent. It was a 12-month bull market and a three-week bear market thus far. $3 trillion of market value has been wiped out to date.

Where the market goes from here is anyone’s guess. Chinese citizens have accumulated $21 trillion of savings, thus the Chinese markets are retail-driven as opposed to institutional; individuals account for 90 percent of stock trading. The Chinese government seems to have encouraged the bull market as they reduced lending rates four times since November 2014. And Chinese investors have not been shy about using margin (borrowing money to buy stocks) as it increased from 400 billion yuan to 2.2 trillion yuan ($354 billion) in the last 12 months. China is a big country of 1.13 billion people, but over 40 million new accounts were opened in 2015. Although there are now about 250 million brokerage accounts in China, it is estimated that there are fewer than 100 million investors – less than 10 percent of the population. The typical account trades once a month so the Chinese are more speculators than long-term investors.

Why would the Chinese government encourage its citizens to invest in the stock market? Property prices have started to deflate in most cities so this is an alternative way to create wealth. Also, Chinese nonfinancial corporations have some of the heaviest debt balances in the world; higher stock prices would allow them to replace debt with equity and reduce risk. Higher stock prices would also allow private or state-owned companies to go public; initial public offerings (IPOs) set new records in 2015. In fact, many Chinese companies that had listed in the U.S. and Hong Kong are delisting and listing on the Shanghai and Shenzhen exchanges because of higher valuations there.

Deflating prices in the property and stock markets could also deflate domestic confidence and hinder China’s policy to become more of a domestic consumption-driven economy as opposed to investment and export-driven. It certainly will not help China sustain its 7 percent economic growth objective. It may also delay China’s stocks being included in world market indexes such as the MSCI Emerging Market Index, which was one of the reasons for recent Chinese investor enthusiasm. Beijing has some policy tools to help stabilize the markets, such as raising margin requirements and restricting short-selling and new IPOs. Time will tell whether they can prevent an all-out collapse of the market.

Tuesday, July 7, 2015

Fed Tales

Those of you who can count will notice this is my third post in recent weeks about the Fed. Okay – I am a Fed-O-Holic and I have to observe a three drink limit.  So I promise not to write another one about the Fed for at least a week unless they deserve it.

I love to write about the Fed. I spent my career teaching, researching, and writing about monetary policy. I am still capable of emptying a perfectly good room when I start to pontificate about Fed policies. But that hardly stops me. Since I am old, that means that I have seen a lot of change and witnessed, if nothing else, the disconnection between Fed policy hopes and realities.

As smart modern people we believe that learning is natural and possible. We watch a two-year-old fall down repeatedly only to finally learn how to straddle even the tallest bar stool. It is only in the realm of federal institutions, however, that it seems learning is next to impossible. And the Fed is a federal institution. While it is technically independent from governmental institutions like Bob Dole and the Supreme Court, The Fed is obviously impacted by hopes and dreams and Nancy Pelosi.

I was motivated this week to write about the Fed because of the many articles being written these days about how the Fed is going to fine tune the coming increases in interest rates. That sounds hopeful doesn’t it? Imagine Janet Yellen and her colleagues standing behind a large high tech machine. Janet yells out – interest rates up 20 points this week. Aye Aye Capn says the FOMC and magically all the newspapers report a rise of exactly 20 basis points. Capn Yellen is hoisted onto Michelle Obama’s ample but sexy shoulders and they all march out of Washington singing Federal Reserve Drinking Songs. We raised the interest rate 20 points hurrah hurrah (to the tune of Johnnie Comes Marching Home Again).

Seriously. Can it be possible that we lived through millions of years of Federal Reserve policy and we still believe it when the Fed Chair tells us they are going to manage the upward (or downward) movement of the interest rate? It is not dissimilar to believing in the tooth fairy. Jimmy says – Mommy, is the Tooth Fairy going to bring me a new Harley Davidson if you put my bloody tooth under the pillow tonight? Of course, honey. The Tooth Fairy wants to know if you want saddle bags or not.

No I am not drinking JD (at the moment). Then why all the silliness about such a serious topic? The answer is that somehow because Fed policy is both technical and complicated we are prone to believing the largest fibs since Bill Clinton said he didn’t get busy with that person.

Why even worry about Fed fairy tales? Fairy Tales are wonderful. We love reading them to our kids. But somehow they don’t injure most of us. We grow up somehow understanding that we won’t all be saved by the Handsome Prince because we left our glass slippers at the counter at the 7/11. But Fed Tales are dangerous and subject us to very poor forecasts that can lead us into making very poor decisions. Yes, honey Ms Yellen is going to raise the rate by 20 points this year. No honey – rates will not rise by 21 points this year. Don’t worry your little ahead about that.

Let me make two points to support my lunacy. The first point has to do with what actually determines interest rates. Let’s call that point theoretical. Snore. The other one has to do with reality – looking at the data. Last week I presented inflation data. This week I look at interest rates.

Because some of you are already sleeping in your Lucky Charms, I will make the theory part less than the 1000 pages it deserves.  Any self-respecting economics textbook explains that interest rates are determined by the interplay of saving and investment. Whenever saving exceeds the needs for investment, market forces push interest rates downward. On another day when saving is insufficient for investment needs, rates rise to ration out the scare supply of funds. Point: interest rates are generally driven by private sector decisions.

With the US economy expanding and expected to expand even more it is natural that investment and interest rates will rise. Notice that the above story about simple supply and demand says nothing about the Fed. So let’s add them into the story. In times of a weak economy investment demand is low and rates fall. But sometimes they don’t fall enough to quickly resuscitate spending. Thus the Fed adds more money into the equation. This amounts to adding artificial temporary savings to the market and this action pushes market rates even lower.

When the economy starts to expand, investment and interest rates will rise with the economy. If the Fed is a worrywart they believe that the rising rates will prevent the economy from expanding and they pour in even more money thus keeping rates down. 

The Fed can keep doing this as the economy builds momentum but notice that their policy amounts to keeping a heavy hand on the lid of a rapidly bubbling pot. As the temperature rises what do you think will happen to the lid when the Fed lifts its hand? Yup – it will pop up. The longer the Fed holds its heavy hand on the lid – the higher the lid will eventually fly.

Interest rates rising is just like the lid rising. The longer Ms Yellen holds interest rates down the more thrust is building to push interest rates up. She thinks she can hold her hand on the lid a wee bit longer. She believes rates will then rise gradually.What if she is wrong? The below graph proves nothing but is illustrative. 

Below is a graph of the Federal Funds Rate. The FFR is the rate that the Fed directly controls through its policy instruments. Other rates, like government bond rates or mortgage rates seem to go up and down with the FFR. So when the Fed changes the FFR it often affects many or most rates.  The shaded areas are all the US recessions since 1970. 

I am sure the Fed never said anything like this -- yes we are starting to let the FFR rise and we hope it will begin slowly and then take off like a rocket until it causes a recession. But history does not lie. Except for the last recession (2008/2009) which was caused by a housing and financial crisis, virtually every recession followed a time period in which the FFR rose much more than just a little bit. Rates rose before 2000 or before the dot com crisis -- but that one is less clear than the previous recessions. Typically interest rates do not rise gradually. Ms Yellen is telling a tale that's as slippery as a bar of soap on a bathtub floor.