Known Unknowns


Welcome to Known Unknowns, a newsletter from an economist whose dissertation was kind of wrong, but she still believes in economics.

Why Don’t Private Investors Care about Profit?

We consume many services from companies who don’t earn (and may never earn) a positive profit. That means someone is subsidizing our Lyft rides – and that someone is you.

Another week, another unicorn down. WeWork had to abort its IPO. It all raises a few questions: What is going wrong in private markets? How did they get their valuations so wrong? When we look back, it will seem crazy that so much money was invested in companies that had no plans to ever earn a positive profit and were led by such erratic CEOs. Public markets are much less forgiving of such things. In theory, private funds should be, too, but they aren’t because they have no incentive to.

Private markets have become disconnected from investing in profitable companies because their LPs don’t really care. If you are a public pension fund, a private equity/VC fund is an attractive investment. It takes its money for several years, meanwhile giving you a return assumption that sounds high, like 16% each and every year, with no thought of risk. Public pension funds need to claim that their investments are making above-market returns to justify their crazy discount rates (which also don’t account for risk). Otherwise, they have to accept their liabilities are bigger than they thought and increase taxes. Private equity offers a great solution: credible high returns, and no one needs to know any better for years.

Of course, if these unicorns don’t have the exit we are counting on, and the private market valuations don’t pan out, pension funds will face bigger shortfalls. Guess who needs to make up the difference?

Wage Risk

The New York Times peers into the financial lives of the middle class. It’s supposed to be disturbing, but I was pleasantly surprised how many middle-class families are able to meet their expenses and still have money to save. It is true that a middle-class family with young children can’t afford everything they want, like yoga, or weekend trips, because child care has become more expensive. But was there ever a time the middle class didn’t face budget constraints and put off retirement savings until their children were older? It seems it was always that way. But now the middle class has higher living standards.

The story claims that American families also face more income variability. Now, few people are more invested in that narrative than I am. My dissertation claimed income variability had increased since the 1980s. But, 10 years later, economists got access to bigger, better data, and it turns out income has not become more variable year to year. It was tough to accept, but that’s what the data says. Most households face less risk – not only from their individual salaries but also from having two incomes and perhaps more economic concentration at the national level (less concentration locally).

Now it is true, families face more income tail risk – the odds of a bad, persistent negative wage shock during a recession has increased. But year-to-year, income shocks have actually gotten smaller or stayed the same. Maybe that’s why so many families in the story are in good financial shape.

The difference here is not academic. If we want to reduce economic risk we need to understand the nature of the problem.

A Defense of Economics

The economics profession has faced lots of criticism lately, some of fair, some of it confused, and some unhinged. Economists do have a lot of influence on policy, so they also – rightly – face more scrutiny. And I like to think all this criticism is intended to hold us to the highest standards.

So, should we also hold our critics to high standards? Or any standard? I think so, we live in times where trade and currency wars and rent-control are becoming mainstream policy positions in both parties. Talk of how will we pay for this policy and does it best serve those who need it is shouted down.

In a time of economic populism, the choice among mainstream journalists to shame experts and blame them for the world’s problems is a curious one. So, all we can do is take the criticisms that are valid and push back on the ones that aren’t.

I mostly enjoyed Binyamin Appelbaum’s book on how economists destroyed the world (if only we had some much power). Actually, if economists get the blame for the state of the world, we should also get credit – for less poverty, stable inflation, rising living standards, and less risk. Bill Easterly has written the defense of neoliberalism we all need.

Many of Appelbaum’s stories were interesting and well researched. Now, I know it is considered gauche to point out errors in a book. Publishers can’t afford fact checkers and some errors are inevitable. I wouldn’t want someone to do it to me. But then, I didn’t try to impugn the credibility of an entire profession.

Pushback on some of his assertions is appropriate. Here is a small sampling. Life expectancy has not fallen for the bottom 20% in the post-war era (one study says so, but all the others I’ve seen found the opposite). Long Term Capital Management did not cause a financial crisis; the only financial crisis that occurred in 1998 was in Russia, which caused LTCM’s collapse – not the other way around. And the efficient market hypothesis does not predict stable stock prices. I am tempted to offer workshops for journalists on what the EMH really says, but I am certain no one would come because it is such a useful strawman. I am also baffled that someone would write any entire book lamenting economists’ indifference to inequality (evidenced by their skepticism of the minimum wage) and not even mention the earned income tax credit.

I get these things happen, but if you’re going to take down the economics profession – you really should bring it. I am almost more disturbed that these claims were swallowed approvingly by reviewers. People were more distressed about a fake Twitter thread that claimed railway gauges trace back to the width of Roman horses.

Economics is always a work in progress. The economy changes and so does our understanding. Economists seek to make sense of different policy alternatives and separate out winners and losers. Our most radical view is no policy is a free lunch. If someone tells you anything different, they are selling you something.

Often, it is more art than science. Economics also often comes down to values. That is why so many economists disagree. Were economists’ values corrupted when they assumed rising living standards for most of the world’s population was more important than equality of outcome? Perhaps, that comes down to your personal values. Furthermore, economists have debated these values for generations. But it would be a mistake to argue about our values without data or trying to make sense of trade-offs and unintended consequences. Economics offers a logical structure to make sense of things. I think we need that more than ever.

In many ways, the economics profession is a model of how civilized people can disagree. There is actually some political diversity in economics. The fact it is singled out for group think or even accused of being bought by special interests (apparently evidenced by the dearth of Marxists in mainstream departments) says something not great about the times we live in.

Low Fees

While I am defending the efficient markets hypothesis, let’s talk about low fees. Low fee investing maybe one of the biggest improvements in consumer welfare in the last 20 years. Households are saving a fortune – and it all started with the efficient markets hypothesis, which long argued there was no reason to pay for active management.

But can we have too much of a good thing? Low-to-no fee funds and no-fee trading are becoming more popular. Though, as we know from finance – there is never a free lunch. You’ll pay for it elsewhere.

In Other News

Tall people don’t have better personalities, after all.
Low interest rates have economic costs.

Quick programing note, I will be away the week after next—so the next newsletter will be 3 weeks from now. Until then, Pension Geeks!