Allison's Ode to the Second Moment

Hello,
Welcome to the 39th issue of Allison’s Ode to the Second Moment, a newsletter that has an unshakable faith in semi-strong form market efficiency. If being rational is wrong, then this newsletter does not want to be right.

Things people say to sound smart
When you are feeling intimidated in a social situation, there exists a few timeless observations you can say that will make everyone think you are smart and engaged with the world.

  1. Every model in economics is fundamentally flawed because economists assume everyone is rational. That is crazy. Everyone, but economists, knows people aren’t rational—when will economists finally realize people don’t behave the way Robert Lucas thinks they do? Extra points for naming an economist who is not Milton Friedman or Paul Krugman and extra bonus points for bringing up loss aversion.

  2. The economy is totally messed up because CEOs are more focused on short-term instead of long-term profitability. They will do anything to boost current stock prices and don’t make capital investments. Extra points for tying this phenomena to either income inequality or passive investing.

Matt Levine, who is very smart, throws some water on the second observation (bonus points for quoting him at the next smart-person party). He points out that stock prices are (or we think they are, no one has any better ideas) based on discounted expected future cash flows. An increase in long-term profitability projections means an increase in stock prices. Ergo, if you are an active trader who cares a lot about current stock prices, you also care a lot about long-term profitability, even if—especially if—you plan on selling the stock next week. Perhaps, in equilibrium, the short and long term aren’t really in conflict after all.

So perhaps we don’t need Silicon Valley people to come in and create an exchange that rewards shareholders who are in it for the long term with “tenure voting.” BTW, are these really the people we want to return order to the markets? The VC market is hardly a paragon of efficiency. Besides, the Dimensional Fund Advisors model already rewards investors who swear allegiance to long-term investing.

On that note, Paul Singer defends activist shareholders. He doesn’t think they encourage short-termism. They just keep markets honest by holding managers accountable. He thinks we need people like him, more than ever, in an increasingly passive world.

Whither 401(k)?
The rumors are true. The Republican tax plan does include lowering the tax deduction on 401(k) plans. Who knows if anything will come of it.

I think it’s a bad idea. I am not convinced a lower limit will mean less saving. But it is taking tax revenue from the future to pay for stuff today. It is remarkable how often people in the media use the expressions “tax-deferred” and “tax-free” interchangeably—a sign of these times.

I guess you can’t blame them. The estimated benefits, from eliminating the tax-deferral, assume the government would receive all this forgone tax revenue. But this is based on budget projections ten years into the future. An assumption that doesn't make much sense because most 401(k) contributions are taxed 20 or 30 years from now. So effectively, from a budget perspective, tax-free and tax-deferred appear to be the same. This drives us Pension Geeks crazy. We assume the world will exist in 10 years, why doesn’t the JCT?

In sort of related news, here’s an obituary for MyRA, a federally sponsored individual retirement account. It was not a great program, but I still feel wistful for what it could have been if it had a better design...

Will a crash prove how messed up markets really are?
Where were you on Black Monday? I was in the fifth grade and heard about it from my best friend, Jody. She was very upset about it. I didn’t understand, then or now, why the stock market deeply shook a 10-year-old girl in rural Connecticut—but it was a big deal.

Anyhow, the FT has a more interesting take. They argue the drop was so big because of portfolio insurance. They wonder if certain products (ETFs, volatility derivatives) that are popular today could cause another crash. Alternatively a crash today might not be that bad because, unlike the go-go 80s, people are pessimistic about markets and wary of high stock values. I am not sure why that’s good news. Besides, with low interest rates these days, where else are people going to put their money?

Any strategy has two types of risk: one easily visible and one difficult to see. A new instrument comes along that neutralizes the visible risk. People then scale up the strategy until the previously difficult-to-see risk rears its ugly head.

Who knows? That’s the thing about new innovations that are supposed to make us safer but actually amplify risk. You never know which innovations worked, which were used incorrectly, or which one were just bad until it is too late. My prediction is someday the stock market will drop, some financial instrument will be blamed, and people will talk about how stupid that instrument was at cocktail parties.

A crisis we did see coming
The city of Hartford is on the verge of bankruptcy. Moody’s expects Hartford to default on its debt next month! It is unclear if they will file for chapter 9. The government is scrambling for concessions. But two of the biggest financial strains are pensions and health-care benefits for retirees. Good luck cutting pensions, as their benefits are guaranteed in the state constitution.

To be fair, Moody’s says Hartford has a long history of funding its pension adequately. Though that doesn’t square with a $412 billion unfunded pension liability. This is what happens when you use your expected return as your discount rate.

Keeping score on the nerdiest rivalry in the world:
Financial economists 1
Actuaries -1000.

If Hartford does file for bankruptcy, it may be able to cut pension benefits or, more probably, cut retirees’ health benefits (it is not clear the guarantee applies to health benefits). But first they'll cut services to Hartford's residents and not pay their creditors.

What comes after growth?
If a rising tide lifts all boats, should we rue the tide if it lifts some boats more than others? That is the question of our time.

Matt Klein wonders, based on a conversation with Jason Furman, if growth-promoting policies are overrated and we should worry about redistribution instead.

I am not sure if overrated is the right word. When an economy is fully matured, there is just less policy-makers can do to boost growth. Growth at this stage comes from gains in productivity, which is largely out of the government’s control. Furman argues redistribution can be effective, while growth policies aren’t, so we may as well focus on inequality.

I am not sure that implies our main economic objective should be redistribution instead of growth. The problem is there is not any compelling evidence, either way, that inequality helps or harms growth. I tend to be risk averse when it comes to structural changes.

In other news

According to the OECD, the UK is in all sorts of trouble.

The IMF is sounding a little less Keynesian these days. They are getting worried low interest rate policies are distorting financial markets and creating new risks. Sounds like IMF economists have been spending some time at the BIS.

All the more reason, when pondering your choice for Fed chair, remember inflation is hard to change and can be unpredictable. One of the Fed’s most powerful tools is setting expectations. The most important quality we want in a Fed chair is credibility. I am skeptical that means we should pick someone who makes gut decisions based on his or her feel for the markets.

The Economist has a good story on Puerto Rico's power grid and why it, like Puerto Rico's economy, is so hard to fix.

One last thing to think about. Do horror movies have distinct risk factors?

Until next time, Pension Geeks!

Allison