Economics 13/02/2010: On benefits of marriage to investment

Feeling marital around the Valentine's Day? Well, how about investing in some stocks?

A paper just published in The Review of Financial Studies (2010, 23(1) pages 385-432) titled: “The Effect of Marital Status and Children on Savings and Portfolio Choice" by David A. Love (not kidding there) looked at the impact of marital status on optimal decisions about saving, life insurance, and asset allocation. It turns out, quite predictably I must add, that changes in marital-status and the number of children can have “important effects on optimal household decisions”:

• Widowhood induces sharp reductions in the portfolio shares in stock, and the impact is largest for women and individuals with children.
• Divorce causes men and women to reallocate their portfolios in different directions; men choose much riskier allocations, while women opt for safer ones.
• Children play a fundamental role in the optimal portfolio decisions. Men with children, for example, increase their shares in response to divorce by less than half as much as men without children.

Obviously, this might have something to do with the fall-off in disposable income and wealth, induced by a divorce when long-term child payments are involved. “…Imagine that a couple with two children living at home gets a divorce. Depending on the legal assignment of custody, the mandated level of child support, anticipated earnings, and the division of household wealth, the ratio of wealth to the present value of future income for each spouse will almost surely differ from the level previously observed in marriage. …this ratio is key to understanding optimal asset allocation because it summarizes, at least in part, the exposure of future consumption possibilities to fluctuations in financial markets.”

In addition to wealth-to-income ratio, divorce and portfolio choice are linked through changes in financial background risk as “the former spouses move from living on a combined income to each relying on a potentially more volatile single stream. …Uninsurable background risk, arising, for example, from labor income, business income, and housing, can have a quantitatively large impact on optimal portfolio decisions.”

A final way that the divorce might influence optimal portfolio choice is through its effect on savings “as the former spouses update their desired consumption of housing, food, transportation, and childcare.” Divorcees from a single car household buy a new car. They also increase childcare expenditure in most cases, unless large divorce settlements induce one parent exit from the labour force. Food consumption expenditure and volume rise, as all other consumption of both durables and non-durables.

Contrast the economic implications of divorce for the two-child couple with those of a childless couple. Members of the childless couple will still experience a change in wealth and income in the event of a divorce, “but there will be no additional shock to resources due to child support, college expenses, or differences in scale economies related to the assignment of custody. Given this differential impact on resources, it is reasonable to expect that the childless couple will respond differently to divorce in terms of saving and portfolio choice. In addition, children may also alter households' responses to widowhood. For example, depending on the strength of the bequest motive, surviving spouses with children will tend to have larger amounts of wealth relative to income compared to those without children, leaving them more exposed to market risk.”

All of these conjectures are supported by evidence, but there are some surprises in findings as well: “We find that households with children tend to accumulate substantially less wealth during the working years but that their slower rates of drawdown in retirement leave them with more savings toward the tail end of life.” Does marriage really mean life-long prudence?

“This trajectory of wealth accumulation is mirrored, in part, by the evolution of portfolio shares. Earlier in the life cycle, households with children hold riskier portfolio shares (by about 10 percentage points) than households without children, but the relationship reverses in retirement.” So no, risk aversion is lower for married couples probably because their dual incomes act as hedges against single income volatility.

Instead – it is bequest motive that drives them to become more conservative in older age. “…a riskier allocation for these younger households is optimal because their consumption streams are less dependent on the performance of financial markets. In retirement, however, children provide an incentive to maintain wealth for bequests, and the resulting increase in the wealth-to-income ratio makes households increasingly sensitive to stock market volatility.”

Hmmm, this brings us to taxes, then. A rise in inheritance tax during the wealth accumulation period of household life cycle implies a reduced incentive to save for bequest. This, should then result in lower risk aversion for older age households. And that, in turn, will lead to greater volatility of investment and also to higher cost of borrowing by the sovereigns. How so? Because if older households become less risk averse, their share of government bonds in total investment portfolio will drop. This means lower demand for bonds and higher yields on new issuance. Cost of sovereign borrowing goes up and the benefits of higher taxes to Government revenues are cancelled out, at least in part.

Imagine that – some say there is no such thing as Laffer Curve… not even at 100% marginal tax rate?

Economics 13/02/2010: Inflation targets and What's in a name?

One interesting observation – Oliver Blanchard in yesterday interview with Wall Street Journal suggests (here) that “If I were to choose inflation target today, I’d strongly argue for 4%. But we have started with 2%, so going from 2% to 4% would raise issues of credibility. We should have a discussion about it.”

I have argued for some time now that a combination of

• continued tightness in the credit markets,
  
• long-term stickiness of European unemployment and
  
• massive national deficits and debt issuance since 2008 imply the need for inflationary reductions in debt levels accumulated by the euro area states, especially those members of the APIIGS club

will mean continued need for unprecedented liquidity injections by the ECB through 2010. The three forces mean that the ECB will have no option but to shift away from its current ‘below 2%’ target for inflation and move on to 4% target.

Good to see serious heavy hitter in policy economics, like Oliver Blanchard, also thinking the same.



Now, to more ‘fun’ economics.

Remember Shakespeare’s “What’s in a name? / That which we call a rose by any other name would smell as sweet.” (Romeo and Juliet).

In the world where information moves much faster and where uncertainty is much higher – in other words, in the world we inhabit today – this view is no longer true, for what is in the name does tell us much about what is in the name bearer.

A recent paper by Aura, Saku and Hess, Gregory D., What’s in a Name?, Economic Inquiry, Vol. 48, Issue 1, pp. 214-227, January 2010 (link here) shows exactly this.

“Expectant parents lie awake at night, consult books, and some even hire a consultant to choose their new child’s name. Is it similar to the process that manufacturers undertake when branding a new product? Viagara pretty much speaks for itself, but to what extent does Gregory, Saku or even Jamaal convey information and/or meaning.”

The study attempts to answer two main questions:

1. does a person’s name convey information about their background?
2. does a person’s name have an impact on the person’s long run economic outcomes, such as income, education, fertility, social standing, happiness or prestige?”
   

“In our dataset, this would mean comparing the outcomes of otherwise similar individuals with a name like Mark (exclusively a white name in our data) with Marcus (exclusively a black name in our data) or comparing Alice (white name) with Tanisha (black name)…

…More specifically, we investigate the extent to which a respondent’s first name features affect his or her years of formal education, self reported financial relative position as well as social class, to have a child before 25, and occupational prestige. …we can examine the gender differences between lifetime outcomes and first name features.”

There are broadly speaking three main findings:

1. there is a strong empirical relationship between an individual’s first name and their background;
2. there is a weaker (but still significant) empirical relationship between an individual’s lifetime outcomes and their first names. Taken together, these first two findings imply that names do convey information about an individual’s labor market productivity. A rose is not quite a rose by any other name.
3. both non-black non-whites with ‘blacker’ names as well as blacks with more popular (i.e. predominantly ‘whiter’) names have significantly worse financial outcomes. “This last piece of evidence can be interpreted in light of a subtle form of discrimination: namely, while black names come with discrimination and identity costs and benefits for black individuals, non-black non-whites with ‘blacker’ names face the costs of such names though not the benefits. A similar identity/discrimination channel would also hold for blacks with more popular (i.e. whiter) names, …though it does not provide conclusive proof of discrimination.”
   

First, names indicate a great deal of information on

• gender (and this conclusion is not based on linguistic gender of the name, but on standard phonetic characteristics);
• the year when one was born,
• a respondent’s higher parental education background "can be partially inferred from higher popularity, fewer syllables, more standard spellings, fewer ‘oh’ endings, not starting with a vowel, ending with a consonant and having a lower Blackness Index (the extent to which a given name is race-specific). This latter result …is actually quite large: moving from a purely non-black name to a fully black name is associated with a Father having 2 fewer years of formal education and a Mother having 1 year less.”
• more popular names are associated with better lifetime outcomes: that is, more education, occupational prestige and income, and a reduced likelihood of having a child before
• names with higher values for Blackness Index are “associated with poorer lifetime outcomes: that is, less education, occupational prestige, happiness, social class and income, and an increased likelihood of having a child before 25".
• ‘ah’ and ‘oh’ ending sounds in a name are also related to poorer lifetime outcomes, though popularity is related to better lifetime outcomes.
  

So first names just by themselves convey information about a respondent’s lifetime outcomes. But does "your first name features affect one’s lifetime outcomes after learning information that may be readily available in a job resume".

It turns out that when this is controlled for,

1. Name popularity remains a significant explanatory variable in education outcomes, but not in financial outcomes;
2. Blackness Index is statistically significant again in the class determination, and whether or not a person has higher happiness quotient in the future, as well as in educational attainment: “Higher values for BIND lead to a lower assessment of social class, happiness and an increased chance of having children before 25. However, as with POPULARITY, BIND is now no longer statistically significant in the income responses. Again, the role of education and labor market experience is clearly soaking up the role that POPULARITY and BIND played in the income response” in earlier analysis.
   

“It would thus seem that first names retain a strong role overall in determining lifetime outcomes even after controlling for a respondent’s labor market experience.”

“There is the further possibility that these quasi economic outcomes may also be correlated with labor productivity: simply unhappy workers and those that feel that they are lower class (or even upper class) may have differential labor productivities. Based on the findings… controlling for a myriad of exogenous family background characteristics, a first name’s popularity and/or ‘blackness’ appear to have an impact on intermediate economic outcomes that are likely correlated with labor productivity but not on actual economic outcomes. It would thus appear that …the ‘blackness’ of a name is correlated with factors that can affect labor productivity which could in turn be reflected in discrimination at the resume level [but not at face-to-face level]. As we demonstrate, however, this potential channel of discrimination does not have an impact on pure economic outcomes in our sample.”

In general, this explains why past immigrants to the US – from Europe and elsewhere – tended to automatically adopt most popular local names for their children to ‘assimilate’ into the American mainstream.

It also shows that, for example in the case of Ireland, one would expect past emigrants to be selected on the basis of those with more common names experiencing more favorable in outcomes. Furthermore, currently, within the country, Irish first names might provide for better outcomes - as they serve as more acceptable norms here, while at the same time placing children at relative disadvantage to their peers if they should emigrate out of Ireland.

Lastly, when looking at the trends in names, since the onset of recession, more mainstream names have moved up the popularity chain in Ireland with more Gaelic-derived names becoming less popular. This too might be explained by the findings - when times are tough, implicitly, parents tend to focus more on real economic and social outcomes than on the feeling of being in tune with Eamon O Cuiv's 'national culture'.


Overall, instead of the Shakespeare’s idea that it is the inherent subject characteristic that matters, not the name, is no longer true. Instead, modern relationship between the name and the person is probably better described by a different quote – from Johnny Cash’s (1969), A Boy Named Sue: “So I give ya that name and I said goodbye / I knew you’d have to get tough or die / And it’s that name that helped to make you strong”.

Economics 12/02/2010: Crisis pressures in broader debt markets

And so the Greek saga continues, with yesterday’s announcement that the EU has a worked-out rescue package for the country now turning out to be yet another wishful thinking piece of poorly prepared PR. No package details, and the markets are not impressed.

But forget Greece for a moment. The good news is that just as in Autumn 2008, the last couple of months have been the case of “bad news = good news”. The markets have finally started to turn their attention to the completely reckless ways in which majority of Governments around the world have been managing their finances, both before the crisis and during it.

The new line of fire is now directed at Turkey and Japan.

Japan, pushing for well over 200% of GDP ratio of debt is in a league of its own. And the current Government is hell-bent on raising the debt limits higher with aggressive spending targets and Napoleonic plans for shifting even more public expenditure into largely unproductive investment (for a country with already extensive public capital stock, the diminishing marginal returns on new public investment have set in some time ago). Debt ratio to working age population is now well above USD100,000 and is rising at accelerating pace. Savings rate has fallen to below 4% while the fiscal deficits are now much higher than they were back in the days when the savings rate was around 18%. Current account balance has declined from the peak of 5% in 2007 to under 1.5% today and is set to fall further. With these dynamics in mind, Japan is going to account for roughly 11% of the total global expected issuance of new bonds in 2010.

Turkey is a serious basket case, although it might not appear to be such from the simple debt levels comparisons. Like Ireland, Turkey has low debt to GDP ratio (45% as opposed to Greece with 113%, Portugal with 77%, Spain with 54%), It is in line with Ireland current 46.2% debt levels (although in Ireland’s case, a GNP base would work much better, bringing out true public debt to a much more formidable 57% of GNP). But it is not the level of debt that is worrisome. The awesome rate of debt increase, along with hidden debts that the public sector underwrites are the real concerns here.

An interesting chart from Turkey Data Monitor:
shows just how bad Turkish debt dynamics are. In the environment where it is currently yielding over 8% with an average maturity being around 2 years, the problem for Turkey is the following:

• Can a country with history of past debt problems and rising deficits really roll-over some USD125 billion worth of debt? and
• Can such a country do this in the environment where worldwide, national governments are expected to issue some USD4.5 trillion worth of bonds in 2010 - three times the normal volume of global debt issuance?

Now, think of it this way – Turkey debt is held by domestic banks (roughly 60%) and the remainder – by foreigners. This, normally, presents the point of stability. Alas, if the banks are not operating in the liquidity saturated markets for funding (and they are clearly not doing so) the Turkish Government cannot default on the debt without risking destabilizing its banking system. And if it does destabilize the banks, the Government ‘solution’ to default will imply demand for massive banks rescue package, adding further to the debt mountain. In other words, unlike with other countries that have heavier exposures to international lenders, Turkey simply must refinance the roll-over debt.

So dynamics matter. And they matter for Ireland. Which got me thinking – just how bad is our debt position going to get and what costs will this impose on the economy. Here are few charts:
Start with gross debt as percentage of GDP and GNP. Above chart shows figures for the official debt estimates from Stability Plan Update, December 2009, issued by the Department of Finance. Additional lines show the ratio of debt to GNP and also extension of debt figures to include Nama's €59 billion allocation, plus expected €12 billion in post-Nama capital injections into the banks. Finally, the last line shows the above, accounting for a lower growth rate in GNP scenario than the one forecast by the DofF for 2012-2014 period. The important issue here is that our debt to GNP (the real measure of our economy) is going to breach 100% even under DofF own rosy assumptions.

Next, consider the growth rate in our debt:
Pretty dramatic, especially when you compare the rate of growth in 2009-2012 against the tiny rates of decline predicted for 2013-2014. The rates of decline in fact will be about half the rate of interest we will be paying on this debt.

So expect no respite in terms of the cost of debt financing in sight:
The above are pretty big annual numbers - up to €14 billion going to feed the debt monster annually! Crazy stuff for an economy worth around €130 billion in terms of its GNP. Alternatively, €14 billion is roughly 30% of the total Government expenditure that this country can afford if we were to stay on structurally balanced fiscal path!

And thus, cost of debt financing as percentage of our economy is going to be excruciating - up to 9.5% of the annual economic output at the peak (under the most pessimistic scenario). Which means the total cost of the current fiscal crisis is also going to be astronomical:
By the end of 2014, thus, we are looking to have wasted between €50 billion and €80 billion in total on sustaining that which is simply unsustainable - our gargantuan public sector overspending.


Incidentally, this pretty much explains why I do not believe that marginal reforms of the public sector, such as 'productivity improvements', 'reduced spending on external consultants' and 'staff re-allocations' will be enough to address the issue. In real world we inhabit, we need a massive cut in terms of overall spending on public sector and this can only be achieved by slashing numbers employed in the public sector and cutting pensions and wage expenditure on the remaining staff.


PS 1: given chronic lack of skills, aptitude and capabilities present in many areas of the public sector, an idea of using internal expertise to reduce reliance on external consultants advice and expertise, while hoping for improved efficiency is simply absurd.


PS2: A year ago, myself and Brian Lucey wrote an article for the Irish Times about the massive debt overhang in the Irish economy. Using IMF statistics we established that Irish economy stands out as the second most indebted economy in the world in terms of ratio of debts to GDP, the most indebted economy in the world when it comes to applying our real measure of economic activity - GNP, and one of the most indebted economies in absolute terms.

In response to the article, we were told by the Irish officials that 'total debts do not matter, only public debt does'.

In the real world, total debts of economy do matter because they show structural composition of economy itself, revealing the extent to which economic growth is being financed by reckless borrowing.

This month, Hayman Advisors weighted in on our side:
The above debts cover public debt, plus 5 top banks per country, with Iceland figure showing pre-crisis conditions. Forbes magazine reproduced this chart in their cover story for February 8 edition with a tag line saying "It's the Total Debt, Stupid".

I agree.

Economics 10/02/2010: Can Labour Party lead?

Does a coalition involving any party in partnership with Labour makes sense?

Unfortunately, despite Labour Party having in its ranks some very talented and economically literate senior politicians (Joan Burton and Ruairi Quinn come to mind), there is a legacy of the LP being largely captured by the Trade Unionist movement. In times of economic expansion, this risks the party pre-committing itself to the policy platforms that:

• expand public sector beyond economically efficient levels;
• make the above expansions permanent in nature (i.e. irreversible); and
• commit the state to correcting any potential funding shortfalls out of tax revenue increases.

In this context, it is irrelevant whether or not the Labour Party can or cannot commit to a credible path of public sector productivity reforms. It is simply a party that will find it impossible to impose fiscal discipline on its own constituency.

For example, consider the current situation with public sector wages and non-wage earnings clearly being out of line with private sector and with the reality of economic crisis on the ground. Two past policy dimensions, each one sufficient enough to rule out Labour's ability to impose fiscal discipline on the state, that come to mind:

1. Labour consistently supported increases in the lower tier wages, thus advocating a compression of wage distribution from the left tail. In current environment, Labour could cut upper tier public sector wages, further compressing the distribution, this time from the right tail. But it cannot commit to shifting the entire distribution left. And this means that any savings achieved will be poultry and will not go far enough to address the existent wages gap between public and private workers to the left of the median wage.
2. Labour also persistently advocated minimum wage increases. A cut in a minimum wage, therefore, is not an option for Labour. But absent cuts in minimum wages, what policy can promote jobs creation at the bottom of the skills distribution? A cut in the cost of employing workers - aka a cut in employer PRSI - is also out of question for Labour. Training and state subsidised employment simply cannot deliver sustained jobs for this category of unemployed.

The legacy of traditionalist approach to class politics is tainting Labour party platforms today. Their current proposals for dealing with unemployment virtually invariably require the State to find new funding to expand existent programmes, such as investment in education and training, a jobs fund in the Budget and a new National Development Plan. Funny thing is, Labour party seems that propping up the same programmes that failed to deliver jobs in the times of the boom (aka all mentioned above) will somehow, once expanded, deliver jobs in a recession.

There is also a strange belief, on behalf of Labour party that extending a place in a university to everyone who applies (see here), regardless of their merit or ability, is a jobs-supporting policy as well. In following this, Labour commits two cardinal errors:

• It implicitly beliefs that getting a college degree improves ones ability to gain employment; and
• It explicitly assumes that providing tertiary education for all is necessarily net-additive economic and social activity.

In other words, Labour party fails to recognise that education can yield diminishing social and economic returns and it fails to recognise that the rate at which social and economic returns diminish is unrelated to the quality of graduates.

So there you have it - despite having some very good people in its ranks, Labour party is simply not a credible contender for economic crisis management.

Economics 10/02/2010: Minumum wage and unemployment benefits

Two weeks ago in my Sunday Times article (see here) I wrote about the long-term effects of the minimum wages. Instead of dealing with the losses of economic competitiveness from Irish high minim wage, I elected to focus in the article on the distorted incentives and reduced training for potential and actual minimum wage recipients. Interestingly, these adverse effects are nearly identical for minimum wages and unemployment benefits.

Last week’s research paper from Zafar Nazarov of RAND, academic think tank in the US and Europe, titled The effect of the unemployment insurance wage replacement rate on reemployment wages, showed that higher unemployment benefits lead to lower wages commanded by those who manage to re-enter employment. In addition, higher wage replacement rate under unemployment benefits ‘depresses depresses the prospect of finding full-time work while increasing the prospect of finding part-time work”. To summarize, therefore, higher unemployment benefits paid hurt those unemployed who find a job in the future and lead to lower quality of jobs available to the previously unemployed.

Qui bono, then from higher unemployment payments? Those on permanent welfare, of course. Since they do not face a prospect of gaining a job in the future, they face none of the costs of higher unemployment benefits. But as their own pay is linked to unemployment benefits through social fairness arguments, there is all the upside of higher rates. Oh, the bizarre world of state-controlled wages, unemployment insurance and welfare benefits. Makes banks’ s shenanigans sound pretty banal.

Economics 08/02/2010: Nama v IMF revelations

Fair play to the Irish Times' Simon Carswell (here) for unearthing through FOI request that IMF note which back in April last year told the Irish Government that Nama will not restore lending in the economy.

This, of course, is the old news to many of us. You can search this blog for 'restore credit' and other key words and see posts going back to April 2009 with exactly the same analysis. Outside of this blog, I warned on the matter in my columns in Business & Finance and in the Sunday Times, in articles in Irish Mail, Irish Independent, Irish Times, in numerous appearances on BBC, Bloomberg, RTE, TV3, Newstalk, TodayFM and so on. Even in the likes of Wall Street Journal and numerous international print outfits. Several other analysts - namely Professors Brian Lucey and Karl Whelan, banking specialist Peter Mathews, economist Ronan Lyons and others - all have done so as well.

But what is new is the fact that this IMF opinion was known to the Government and its advisers who, having buried it from public view, have gone out on a prolonged PR campaign, in effect liberally treating the truth about Nama. Ditto for NTMA and Nama officials. That public representatives and officials engaged in such an act is a betrayal of public trust. It is, simply put, a deception of public opinion.

Quote from Irish Times: "Speaking at the publication of the Nama legislation last September, Mr Lenihan said Nama would “strengthen and improve” the funding positions of the banks “so that they can lend to viable businesses and households”. Taoiseach Brian Cowen had said the Government’s objective in restructuring the banks was to generate “more access to credit for Irish business at this critical time”"

But there is more to Simon's article (my emphasis):

"In an internal e-mail dated June 6th, 2009, ...senior department [of Finance] official Kevin Cardiff warned against making public any official estimate for the losses faced by the banks, saying that the department had not made this information public. “We naturally shared with the IMF team our informal views on the range of possibilities, but would be uneasy about seeing these formalised,” said Mr Cardiff, who has since been appointed secretary general of the department."

This is uncomfortably close to an admission that the DofF willingly withheld crucial information about Nama from the official communications in order to avoid this information being disclosed publicly through future FOI requests. Again, I am not a conspiracy theorist, but what else does one need in terms of proof that the Government and its officials knowingly engaged in acts of public deception when they were making claims about

• Nama's expected impact on credit supply;
• Nama's expected costs and losses.

Tellingly, IMF estimated that Irish banks will face losses of up to €35 billion and that the DofF was informed by them of this figure. If you look at my posts on Nama Trust, expected Nama losses and the cost of nationalizing the banks - my estimates from early 2009 on consistently show that the at risk assets of Irish banks covered by Nama are around €32-37 billion - bang on in line with IMF's estimate. Again, I wasn't the only person providing these estimates.

The Government, Nama, NTMA, DofF and the Central Bank - all have elected to completely ignore all independent analysis that has been performed by myself, Brian Lucey, Karl Whelan, Peter Mathews and others. And yet, not a week goes by since September 2009 in which the Government is forced to admit that we were right in our estimates and forecasts.

While the Government continues to spend hundreds of thousands of our euros on PR spin doctors and 'advisers'. At the same time, the entire staff and executive structure of Nama have been loaded with either 'quiet men' of 'I have no interest in defending taxpayers' type or outright 'yes men' for the Government.

Let me reproduce here few quotes that a reader posted in his reply to one of my earlier blog posts:

"The government did an "A1" job in their spin on NAMA, they persuaded the shareholders into voting for NAMA so that the banks would avoid nationalisation. Blindfold nationalisation is inevitable. Memorable brainwashing quotes:

• "NAMA is the only game in town"
• "there is no easy way out"
• "We need NAMA to get credit flowing into the economy"
• "Ireland is getting "NAMA Money" from the EU"
  
• "There will be no more 100% nationalisations"

And so on...

Disgraceful, really!

Do send me other quotes from public officials that you feel might have been outright deceiving in nature and I will post them on the blog!