Hodak Value

Actually, he writes an article called "Statistics can mislead as easily as they can enlighten" published in CSM. It points out a useful distinction akin to the fallacy of division, hearkening back to one of my favorite books of all time, "How to Lie with Statistics."

The French figure prominently in his examples, but the title is misleading. (Extra credit for anyone who can identify the title's fallacy.)

Am I the only person in the market who is baffled by the fact that investors seem to react well to falling prices of oil, metals, foodstuffs, or other commodities, but seem to panic at falling housing prices? Isn't property value an input into business processes and the overall cost of living? If the answer to these questions is affirmative, then why should we care about falling property values?

Personally, I don't care. In fact, I like falling property values, and not just because it rewards my view of the market when I sold my home a couple years ago and became a renter. I celebrate the decline in property value because it means that property will be cheaper for everyone, and cheaper stuff is a good thing.

But won't all those owners in our ownership society be worse off? Only if they've speculated in multiple properties. Speculators are supposed to bear risk, and those who can't are flushed out in a downturn, and that's not all bad. People who live in their dwellings, however, shouldn't care because they have to live somewhere, and if they decide to change where they live, they will be able to get a new place cheaper.

What about homebuilders and real estate agents? Aren't they hurt by the drop in prices, and aren't they an important sector? Sure, but no more so than oil companies hurt by falling oil prices, or gold mining firms hurt by falling gold prices. However, the pain of one sector is generally more than offset by the lower prices enjoyed by the rest of the market. Our overall economy would be much better off if steel cost a penny per ton, as long as the producers grumbling about it could stay in business at that price. And unlike mining firms, homebuilders can always build more homes to meet the higher demand associated with lower costs.

That's where I spent the latter part of last week. Here were some highlights:

Stanley O'Neal, Merrill Lynch's CEO, spoke about his inspirational rise from a rural Alabama farm to the pinnacle of Wall Street, touching on different topics along the way. Regarding the fall of the Berlin Wall:

"Everyone said it would herald the spread of democracy around the world. I think the experts and pundits got it wrong. Democracy has made inroads, to be sure. But what really took off was the spread of capitalism. It was the opening of markets that has made the most difference to the most people, lifting millions out of poverty."

Regarding the Wharton School itself:

"Joseph Wharton was a protectionist. He was appalled at the lack of sympathy from politicians for tariffs on the steel products he was trying to make and sell against vigorous foreign competition. He founded the Wharton School, in part, to create a learned basis of support for trade barriers." Joe would have been alternately thrilled and horrified at the intellectual trends promoted by Wharton's faculty over the next 125 years in regards to trade.

Rajit Gupta, head of global consulting powerhouse McKinsey & Co. was a little more disappointing. Like a good consultant, he identified a MECE* list of 10 trends that businessmen should be aware of. These trends fell under the general areas of macroeconomic, business, and social factors. Each of the three areas had three trends associated with it; mostly related to demographics and globalization. It would have looked sharp in a powerpoint, which he thankfully spared us.

OK, I know that three trends in each of three areas equals nine trends, and I said he identified ten. His capstone trend was the continued suspicion of business, which he felt was important to overcome. Although I agreed with his diagnosis, I quite disagreed with his prescription; he advocated that businesses should get more engaged with the public on social concerns. When I asked him how business should address a public as ignorant of market processes as they are distrustful of them, he responded:

"I don't think the public needs to understand the mechanics of how markets work. They need to believe that business cares about them."

Hmm.

Here is what I read in Economist's View yesterday. It's part of a dialogue between an 'economist' and Joe Public about globalization:

Economist: "You're right, I and almost all other economists think there have been gains. We debate the size of the gains, but not their existence. So it turns out that globalization has, overall, increased the amount of goods and services that we have. If we distribute the gains right, then everybody, every single person, could have more today than they had in in the past."

Joe: "Who cares what everyone could have. I could have a yacht if Bill Gates gives me one, but that ain't gonna happen. I don't live in your imaginary world."

Econ: "But here's the point, the costs of globalization that have fallen on you and others don't have to be so large, but somehow we have to redistribute..."

Joe: "Yeah, yeah, whatever, I've heard all that before. Take from the winners, give to the losers. You guys ever actually look at who owns the politicians? What were economists thinking in the 1990s when they were pushing this stuff?"

Me, I like maintaining a distinction. An economist constructs a model that says A leads to more B. The model is presumably based on theory and evidence. Once one begins to discuss the desirability of B or A, regardless of what the model says, competing values enter the discussion, and it transforms into a political discussion.

So, the Fed is watching the meltdown in our credit markets, feverishly pumping billions into the economy to keep the dollar in the target range of their arbitrarily chosen prime rate, and now deciding to cut its discount rate on bank loans. Does this sound like the sober, measured response of a technician adjusting some dials--the image of the Fed we have all been led to believe?

To me, it looks like my kids reaction when they placed marshmallows in the microwave. It was cool when they put in one, and it swelled up. Then they put two. Then four. Finally, as the marshmallow mass expanded out of control, they were feverishly trying to manage it with the "Start/Stop" button to prevent it from either deflating into a crisp cube of sugar, or blowing up in a big mess. The incentives were pretty weak on this trade-off, considering who would actually be cleaning up any mess.

The story machines we call our newspapers are labeling this the "sub-prime" mess. For months now, when the market has gone down, the headlines have been, "Markets Weighed Down by Sub-Prime Woes." When markets went up, we'd read, "Markets Shrug Off Sub-prime Concerns." It's like the story-writer's union has decided that this whole market is about "sub-prime," and they created a serial based on that character to feed to AP, Reuters, etc.

For those of you who'd prefer financial news to financial entertainment, here's the scoop: It's not a "sub-prime" mess. It's not even a sub-prime mess "spreading" to other markets. It's a credit bubble that every banker and deal maker has seen slowly blowing up for the last four years. There was never any question in their minds about whether or not the thing would pop, only when and how bad. Well, when is now. How bad remains to be seen.

It never really mattered that the people over-borrowing were the folks in plaid shirts who couldn't afford the home (or second home) they were trying to buy, or LBO artists in $5000 suits with those wonderful track records, i.e., somehow managing to make gobs of money by leveraging up during the recent bull market. All that mattered were that those loans were ultimately all based on one key thing--the underlying asset values would keep going up.

Now that they have stopped going up, people are all surprised. The first assets to get hit were the most vulnerable--low-end housing--so the economic geniuses in press are reporting that is where the problem "started." (Have I complained enough about the lack of economic education among the press?) The problem of course started with the first marshmallows, in a world awash with sugar, blowing up nicely, and the kids trying the experiment getting a tasty treat.

Now, the Fedmeisters are standing in front a microwave that has been shoveled-pumped with marshmallows, and all they have is that "Start/Stop" switch to try to keep things puffed just the right amount. Good dad that I am, I'm putting on my gloves and getting out the cleaning fluids.

The AP story begins with the silliest possible headline: "Stocks End Up on Bush, Bernanke Speeches."

Actually, stocks opened higher, well before either speech, and drifted sideways through the day. So, there is no basis for implying that the stocks were up because of the speeches, unless you assume that the market got copies of the speeches before they were actually given by Bernanke and Bush.

Even if that were true about the Bush speech, let's look at what he actually proposed to deal with mortgage problems:

1. Expanding FHA lending to a number of home-owners not previously covered
2. Supporting legislation to change tax law on forgiven debt
3. Strengthening lending standards for loans to low income individuals

Here is the translation:

1. Shifting more of the risk from private banks to the taxpayers
2. Inserting into our 67,000 page tax code another couple of lines that read like, "Enter on line 16g the total interest expense (including interest equivalents under Temporary Regulations section 1.861-9T(b)). Do not include interest directly allocable under Temporary Regulations section 1.861-10T to income from a specific property..."
3. Insuring that whatever steps the market would naturally take to prevent something like this from happening any time soon is associated with additional regulatory paperwork, risks, costs, and constraints so as to artificially depress the number of loans that will be available to the poor on any terms.

That's what the AP reporters thought the market was applauding?

Oh, we don't get far into this story before encountering this nugget:

McKinsey people strike me as real smart. And they dress well. And they make impressive presentations. And then they come up with this stuff:

How to choose between growth and ROIC:

One key to creating value is understanding how to manage the subtle balance between growth and returns on invested capital. Empirical evidence suggests that companies enjoying strong ROIC can afford to let it decline over the short term to pursue growth—and that companies with low returns are better off improving ROIC than emphasizing growth.

Or, you can choose to maximize EP. That always gets you the right answer. EP is the excess return scaled up by the amount of investment:

EP = (Return on capital - Cost of capital) x Capital.

So, is McKinsey stupid? Don't they know this? Of course they do. But telling clients whether to pursue growth or returns is like giving them a fish. Giving prospective clients the right measure that balances growth and returns so they can figure it out themselves is like teaching them to fish. McKinsey didn't become the biggest fish by teaching their clients how to fish.

A Wharton professor, Joel Waldfogel, has just published a book called "Tyranny of the Market," a play on Mill's notion of the tyranny of the majority. Waldfogel's thesis is this:

- Everyone think markets provide what everyone wants in the right amounts
- Everyone thinks that governments are grossly inefficient at providing what people want
- Markets, in fact, sometime leave minorities behind because their preferences cannot be profitably met for high fixed-cost products or services
- It may be efficient to not always let the market decide what or how much to produce

I think Waldfogel is making a thoughtful argument, here, but I don't like it on several grounds:

- Far from everyone, including most economists, thinks that markets are all that great, let alone perfect
- Far from everyone, especially those dealing with voters, considers government to be grossly inefficient
- The idea that high fixed-cost products don't permeate as easily into minority populations makes sense in theory, but is vastly overstated
- Many economics professors, including those with a high profile, continuously and exhaustively make the claim that market inefficiency provides some rationale for government intervention

Although a lot of good stuff has been written about that last point, none of those writings, including Waldfogel's, provides a decent explanation, or even convincing examples in the real world, of how government imperfections can be sufficiently overcome to make their remedy of market imperfections an efficient solution.

In fact, history speaks with one voice when it comes to comparing government remedies for market imperfections versus market evolution around those imperfections. Government interventions, even if they seem to work for a little while, almost invariably become a story of waste, fraud, or astronomical costs--and often all three. Most things that people historically said the market couldn't do have been done, including private mail, private toll roads, an explosion of products and services accessible to minorities of all types, even the poor (still not "perfect," but a generation ago non-existent, like cell phones and mortgages).

In fact, government intervention is a powerful reason that minorities and the poor don't have more choices. Nearly every business is subject to regulatory costs that are a huge source of the overall fixed costs that Waldfogel properly laments. How much of our uninsured are that way because well-intentioned minimal coverage regulations make health insurance unaffordable for so many people?

Franklin Allen, Elena Carletti, Robert Marquez raise the age-old question, "Shareholders or stakeholders?" in this study. When finance and economic professors resurrect this popular dichotomy, they invariably blur a much more useful distinction: short-term vs. long-term. From their study:

A surprising finding is that "some companies may choose to become stakeholder-oriented because it increases their value and benefits shareholders," according to Allen.

In my other world, the real world, I have to tell managers what to do day-to-day. (Actually, I create incentives to encourage certain behavior.) And I know that managers, like all of us, have this inherent limitation--we can have many objectives at one time, but we can only maximize according to a single rule when they come into conflict. So, when a conflict arises between the interests of the shareholder's and those of, say, the workers, how do we decide what to do? One has only four choices:

1) Maximize for the shareholders
2) Maximize for the workers
3) Sometimes maximize on (1) and sometimes on (2)
4) Maximize according to some objective function that accounts for both according to some decision rule or formula

"I'm optimistic, as I've seen this economy, you know, go through periods of uncertainty," the president said. "I like the fundamentals, they look strong, but there are new signals that should cause concern. And one of the signals is the fact that the housing market is soft."

This was President Bush, who appears to be talking about the economy quite a bit recently. Here's the proper way of interpreting this statement:

I'm optimistic, as I've seen this economy, you know, go through periods of uncertainty.

I like the fundamentals, they look strong, but there are new signals that should cause concern.

And one of the signals is the fact that the housing market is soft.

Personally, I don't think I could do it. I don't think I could come up with creative ways to say nothing, day after day, like your typical politician can, especially when talking about the economy. This is a kind of art form. A dark, improvident, cynical art.

That was the headline I saw from the WSJ on a story about the Supreme Court's decision to restrict lawsuits against corporations. The actual article explains that the Supremes decided that:

investors can't bring private lawsuits against third parties in corporate-fraud cases unless they relied on actions by those parties when making investment decisions.

* Part of the definition of fraud is reliance on information that led to harm. The Supreme court is simply upholding this age-old common law interpretation of what constitutes fraud.

I've been so freakin' busy this week, I've barely been able to get food and sleep, but I heard that NYU was offering a free lunch to hear Robert Frank. The irony alone would have compelled my attendance, but also I needed a break. Yea, listening to an economist over lunch is what I consider a break.

So Frank gave his spiel on how the arms race for conspicuous consumption, or positional gain as he calls it, is economically inefficient. Everyone trying to keep up with the Joneses leaves everyone at the same place, relatively speaking. Fair enough? Actually, I don't buy that there are no net societal gains from the dash toward nicer things, but I guess someone does because he's selling books.

Anyway, during his talk, Frank concluded with his pet policy--a sharply progressive consumption tax. Frank basically believes in the incentive effects of this tax, which makes sense, and that otherwise diverting funds from wasteful consumption to productive infrastructure would be a great economic deal, which I consider a little more hopeful, to say the least. Frank specifically mentioned that he was hoping to hear a good libertarian rebuttal to this idea since, I guess, he hasn't heard one yet. Well, this sounded like a personal invitation since I am NYU's resident libertarian, though I couldn't imagine what I might say that he wouldn't have already heard from the GMU mafia, which I know he's encountered.

So, question:

Barbara Corcoran wrote two books subtitled "...and other business lessons I learned from my mom."

The lessons themselves are interesting and useful, but Corcoran, who boasts straight D’s in high school and college demonstrated that there were some important economics lessons that were missing or forgotten. The other morning on the Today Show, she gave her take on the current crisis of foreclosures: the big financial institutions lured poor suckers to buy homes they couldn't afford in order to make a buck, and the government wasn't doing enough to help these poor people. Some of you might recall that real estate brokers were involved somewhere in the this process...hmm, what was that? Oh, yea brokering the transactions. Hey, Corcoran is a broker!

Apparently, one of the lessons her mom taught her was, "always cast blame in every direction but yours."

Corcoran established her credibility on economics, as it were, beginning in November 2005, when she was pooh-poohing economists who were warning about the unsustainability of the housing boom:

It's funny what's happening right now - there's so much uncertainty in the market, and everybody's been spooked by all the media coverage that's out there that it really is a great time to buy. It's a great opportunity right now, and I don't think it's going to last very long...This 'bubble babble' is baloney, and it's scaring people away and making buyers "think about it", and while they're "thinking about it", the house prices are going to go up, and I truly believe that.

If you look at the actual sale prices, the deals that are happening now, prices have already come down, and they've come down by a lot.

Buffet says he likes Obama. Icahn says he doesn't trust him on the economics.

"I personally think he would be a terrible president,'' Icahn said, arguing that Obama would probably go on a "huge spending spree'' that "the country can't afford right now.''

So, the economic bundle that goes with Republicans versus Democrats is too unwieldy to provide any clear comparison between the two. For example, Icahn presumably would have felt more comfortable about Bush than he does about Obama on economics (so would I), yet Bush oversaw a huge spending spree that this government couldn't afford. That's not damning to either Bush or Icahn; the spending spree is a built-in fact of life for any president given the powerful incentives toward irresponsibility that drive Congress.

On the other hand, if Buffet is so sanguine about the higher taxes and the capabilities of his Democratic buddies promising to bring them on, then he has a choice at the margin about that. So, why isn't he giving any of his surplus wealth to the government instead of to a place like the Gates Foundation? Another billionaire offers a good answer to that.

Congress is big on legislating based on speculation, particularly against speculators. Academics almost universally agree that speculation generally increases liquidity, and therefore decreases volatility in markets. But populist politicians continue to ignore that consensus, more recently with accusations that speculators are responsible for the recent volatility in oil prices. In this case "volatility" is read as "increase" since we never hear concern about sudden, significant decreases in commodity prices, except for land.

Fortune writer John Birger has done some real journalism rooting around to find this story about onion speculation: There isn't any. It was banned in 1958 by a law pushed by a young Michigan congressman, Gerald Ford.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings.

HT: Alex T.

I often wonder what is going through the heads of auto executives. It's a habit gained from my years of working with them. I don't think they're idiots. Idiocy can't be that widespread or that sustained over such a prolonged period as the decline of U.S. auto companies. I have to think they are intelligent, educated people operating under perverse incentives. And then I see decisions like these:

1) Cutting revenues without due regard for what happens to costs. GM and Ford each tried to cutting sales to fleets in the late '80s and early '90s because those sales weren't "profitable." How did they know they weren't? Because their cost accountants told them. They looked at the average revenues they got for the vehicles and subtracted the average costs and, voila, losses. What the cost accountants didn't tell them was how many of those costs would remain after those revenues disappeared--the fixed costs of plant operations is remarkably high. Both companies reversed their decisions within a year after suffering what were then record losses. Now, the U.S. (but not Japanese) auto makers are again trying this management by the numbers experiment, led by Chrysler and their by-the-numbers chief. This time, the excuse is resale price maintenance, but the cash flow end will be the same. I guess sometimes the only way to know the stove is hot is to actually touch it.

2) Cutting costs without due regard for what happens to revenues. American manufacturers are the master of this. GM recently announced that they will cut $10 billion from their cost structure. That's a lot of paper clips. The logical question, at least to a consultant with some finance savvy, is: "Why now?" If the $10 billion was there to cut, why wasn't, say, three or four billion there to be cut last year? Or a few billion the year before? I'd be concerned about two possibilities. First, I'd wonder how much worse the cars will be after these cuts. GM cars have always seemed a little tinnier than Toyotas or Hondas. Even if the cuts don't show up in the cars themselves, how much of this $10 billion is fat rather than muscle? Second, maybe the fat was there, but the attitude was "hey, we're so screwed, what's another few billion." I've met many managers, and more than a few individuals outside of the business world, like this. Most of them met a bad end.

There's a lot of clucking about GM's $15.5 billion loss. (That may sound like a lot of golf balls, but it understates the true level of value destruction when one accounts for the opportunity cost of equity.) There seems to be two big questions being debated about all this: (a) whose fault is it? and (b) will GM survive?

Easy one first: GM will fail. It's not 50% in 10 years. It's 100% in less than five. In fact, GM has been economically bankrupt for nearly a decade, with liabilities far exceeding productive assets; it simply hasn't run out of cash yet. Yet.

As to fault, the press seems to be geared entirely as if their readers want to know who to blame. Well, the leading contenders for villain in this game are management and the unions, primarily the UAW. And the correct answer is...

Both. Unions were the irrational response to irrational management in the late 1930s. Once in, the unions steadily undermined GM's productivity--and their profits--especially, once they were faced with essentially non-union competition. Reduced profits meant cost cutting. Cost cutting meant reduced quality. No, I don't mean just "Monday morning cars," although that didn't help. I mean lower quality everything, including management. GM eventually reached a point where it wasn't exactly attracting the best and the brightest. Their retarded management was constrained by their retarding union, and the problem became self-reinforcing. GM became an idiocracy.

What we are seeing today is the logical end of a union that didn't give a damn about the future of the company that hired them. Management, who was charged with fighting for the shareholders, had their weapons taken away from them by the Wagner Act, and replaced with squirt guns and rubber knives. At a point, management simply said, "Screw it. It ain't worth it." What became a pointless fight with shareholders in the cross-hairs ended up as a murder-suicide. Once the trajectory became clear, the shareholders bailed out. There was no one left to hurt but future managers and workers. Incumbents on both sides agreed on all kinds of promises that couldn't be met.

Here we are.