Lotteries: The Price of Hope or a Tax on the Poor

The State Lotteries at the Turn of the Century: Report to the National Gambling Impact Study Commission presents data on the heaviest players.  It highlights the following divergences between the distribution of the heavy players and their proportions of the population:

Characteristics of the top 20% of lottery purchasers, 1999
Demographic Group	Percentage of Heaviest Players	Percentage of US adults
Male	61.40%	48.50%
Black	25.40%	12.20%
High School Dropouts	20.30%	12.30%
Household income under 10,000	9.70%	5.00%
Median Age	47.5	43

 

Typically the focus of this presentation is on the low income line and the argument follows: lotteries are a regressive tax on the poor, albeit a voluntary one, which transfers money from the users of the lottery (implying foolish) to the wealthier (in forms of education subsides and other public programs).  People argue that on this basis that they should be banned.  This crossed me the wrong way in that I don’t like the government telling adults what they should or should not be able to do.  (of course the question of what an adult is, is in and of itself a challenge)  But what if it is not foolishness but rather the hopeless buying hope. 

What I mean is that I often hear people say, ‘I would never buy a lottery ticket, it has negative net present value.  How could someone be so stupid?’  We’ll its not just about the present value, it is also about the distribution.  In a portfolio you would take on assets even if they have negative expected value if they have really good correlation characteristics as it would improve the portfolio.  In non-finance term these groups are buying lottery ticket not because they think they are a good value but because they give them hope; hope is worth something. 

Now if you think I’m being paid by the New York State lottery – I’m not – let me clarify.  Let’s say I’m a high school drop out (just didn’t have the inherent mental capacity) who works a job that pays 10 dollar an hour, I work 50 hours a week and 48 weeks a year (so I work pretty hard); let say I’m paying total of 20% of income in taxes, leaving me with 1600 a month in income; I live pretty light (600 rent, 200 insurance, 300 auto, 200 food, 200 other/emergencies); meaning I could save up to 100 dollar a month.  Now if I save that money and invest it by the time I’m 65 (assuming this fellow is 25, and a real rate of return, after tax, of 3%) he will have just under 100K (in today’s dollars).  Not exactly a tremendous sum, meaning that he has no hope of financial security (or the high life) even though he’s making good decisions given his constraints.  So if he spends 52 dollars a week on lottery tickets he improves his chances from just about 0% to just about 0% (but he can identify the source of that improvement and believe in it) [note: the value of his portfolio at age 65 drops by about 4,000 dollars].  If he’s rational he doesn’t expect to hit it big but he now feels like (in large part because he can identify the source of the trivial probability) he has a chance.  (I’m not suggesting this is the best mean to give yourself hope but it is a means). 

So look at the table up top again.  Are these groups associated with foolishness or hopelessness (or something else, it is quite possibly driven by other factors)?  It is some combination of the two on average but at an individual level its likely one or the other (if instead of spending 1 dollar a week he drops half the paycheck on the table; it is foolishness).  So another argument, besides the libertarian argument against banning lottery sales, the fact that banning them would remove a source of hope for the hopeless.

Thanksgiving Diversification

Short Thanksgiving Day Post:  First, I love Thanksgiving.  I really enjoy getting together with extended family.  With that in mind I have one statement: if options are a good things then we must be worse off by being constrained by taking holidays instead of receiving our holidays as more flexible vacations days.  This would mean no thanksgiving travel because even if all families decided to retain thanksgiving 100% would not choose the last Thursday in November.  Ok, so am I arguing we should abolish holidays and replace them with a greater allotment of vacation days.  Not entirely, two thoughts comes to mind: (1) in a very competitive world it may be looked down upon to take vacation but not to stay with your family during Christmas thus due to cultural reasons vacations and holidays are not identical and (2) the problem of coordinating could be a challenge, the traditional holidays do it for us.  Net net it is not clear to me if flexible vacation would be better but the transition, if we moved away from holidays, would not be received warmly.  I’m already being called soul-less at the thanksgiving table.

Ben’s Helicopter: Look up for Falling Money

Economists would love to perform studies in the same way that physicists do but when studying human action and the allocation of resources it is hard to replicate the environment.  This means it is rare that you have the opportunity to test out new theories particularly system wide theories such as approaches toward monetary policy.  This being said the fact that you have not done something before should not stop you from doing it.  It should weigh into your confidence about that course of action and thus into the calculation, but if you determine it is the best course of action then go for it. 

Chairman Bernanke has spent a lot of his time studying monetary policy; the United States and the World is much better off because he happens to be in the right place at the right time.  He is using his knowledge and influence to institute innovative programs in response to the present crisis.  He’s been way ahead of the ball on it too.  During his first rotation on the Federal Reserve Board the discount window which had been a last resort liquidity before death mechanism was converted into a penalty window in an attempt to better facility crisis lending.  It never took off because a stigma - that a bank that used it was on death’s door – was attached but at the begging of this crisis over a year ago the first thing the Fed did was to remind and encourage banks to use the discount window.  The banks did not use the window which pushed the Fed to created auction programs, essentially the discount window except they would push the money out, in order to fix the money markets.  This helped prevent a credit freeze for the time being.  Then as banks became increasing undercapitalized and thus unwilling/unable to lend, other markets started to freeze up such as the commercial paper market and the consumer credit market.  This prompted essentially a direct lending program most recently to consumers via the Term Asset-Backed Securities Loan Facility - TALF.  [Let's be honest, Ben, a non recourse loan with a haircut doesn't take up any risk capital on the banks balance sheet, you are even provisioning what appears to be a loan loss reserve that is being allocated from the treasury, so even though you are not directly lending to consumers, you really are]. 

Why is this all happening?  I’ll try to break it into two parts.  First the Federal Reserve has the lender of last resort role in the United States and it has been fulfilling this role by providing liquidity to the banks.  The purpose of this is to prevent well capitalized banks from collapsing because of a nonsensical (from the top level) bank run.  Second the Fed is trying to prevent deflation which fits into to its goal of maintaining stable prices.  Are we experiencing deflation?  The headline and core inflation stats are negative but expectations about inflation haven’t gone down but if we continue to see credit contracting it would be reasonable to expect deflation.  Ben gave an excellent speech on this topic just over 6 years ago.  He pointed out that the constraint of zero interest rates is not really a constraint because the real rate (nominal, what you see on the bank window, minus the inflation rate) is more meaningful from an economic perspective, meaning if you have tools to push inflation up you can get the real rate below zero.  One means to push up inflation is to print money or if you are in polite company to enter a quantitatively easing monetary regime. 

As a side comment why would downward prices – deflation – be a bad thing?  One it can push real interest rates up to a level where investment in cash is better than investing in productive machinery which is bad for the real economy.  Two it weakens the financial system because the real values of debts increase.  Think about it this way, if you borrow $100,000 dollar at a 10% interest rate and you make 50,000 dollars a year; you will pay 20% of your salary to service the debt.  If massive deflation hits (50%) and all prices (your salary is a price) drops to 25,000; you are paying 40% of your salary.  It quite likely that you default as would many others.  This would then impair the banking system and credit would contract, deflation would continue and real rates would be too high preventing real economic investment. 

So what does it mean to print money?  The image of the treasury presses is not wrong but a little bit early 20th century.  So I’ll do my best trying to describe my understanding of this.  Let’s start with the idea

MV = PQ or Money * Velocity = Price Level * Quantity

If P is dropping (deflation) it must come from a rise in Q, the quantity of goods, a rise in Money or Velocity (the speed at which the money is going around).  Let’s ignore Q as it is very usually for us to be able to just quickly increase the amount of stuff we make and focus on MV.  M and V are tricky to nail down but one way to think of them is as the aggregate balance sheet capacity of the banking system (more M then V but, stay with me).  As you’ve learned from the premier on balance sheet crisis you know that the financial system balance sheet capacity has contracted in a meaningful way.  To layer on one more layer of complexity, not only is it just the size of the balance sheet that matter but when thinking about the money in the system it also matters what the money is willing to do (is it willing to buy risk – sort V-ish).  Not only is the size of the banking system’s balance sheet contracting but they are shunning risk, meaning credit is cut off and ‘money’ is vanishing.  How is this counteracted?  We’ll the popular joke is to drop money from helicopters; this in theory would work but its precision lacks something to be desired.  A fiscal deficient could fill the hole for demand (push up V) when their existent the paradox of thrift (but this is outside of the fed’s hands).  The Fed can buy risky assets and flood the banking system with cash in order to get them to start feeling comfortable again in an attempt to increase M and stimulate V.  The flooding with cash hasn’t worked so far so we’ve moved onto buying assets.  Now so far, in my view, it is not exactly printing money because the purchases are funded through reserves or treasury issuances but the transforming a dollar of ‘money’ into a dollar that can be leveraged on a bank’s balance sheet (this assumes available capital) and that will pursue risk assets; at least in my view increased the very fuzzy money supply concept and should thus counteract the credit contraction deflationary forces we are experiencing.

As a student of history I often shutter when people say that something is historic; but I’d be willing to venture that this might be even though it unlikely to make the history books.

A Picture of the Financial Market Deleveraging

If you’ve read the primer on the financial (balance sheet) crisis this image may make help you see how it has progressed.  As a warning this picture is only the announced numbers (so hides private losses, ch11 related losses, FDIC implicit capital injection, and future unrealized losses on loans,…) but it is helpful to visualize the process.  You can see that losses started the process, banks capitulated and raised capital (1^st and 2^nd qtr 08), then as losses continue their ability to raise capital is hurt (3^rd qtr 08), then the process broke down and the government injected capital (4^th qtr 08).  The dotted line shows the amount of assets that firms would have had to sell to return to their old leverage ratio (given the capital deficiency).  One problem being who could buys 3 trillion dollars worth of assets? 

So you may be looking at this and thinking that we have a recapitalized banking system – or at least are close – and thus improvement is on its way.  Given the recent performance in the more seasoned mortgage markets and the continued forced selling seen in the market, your optimism is unwarranted.  First off, the IMF believes that losses from US securities and loans will hit 1.4 trillion.  If you believe only 70% of that is going to hit the US banking system we still have over 200 blns more to go and thus still need 200 blns more of capital.  And even if you think that enough loses are outside of the public banking sector such that it has been recapitalized to its old level there are two problems (1) the banking system probably want to be at a lower leverage ratio because they are not comfortable with the risk they were taking before and (2) even if the capital losses didn’t come in the banking system if they came off of leveraged entities – like a hedge fund – balances sheets they likely need to find a new home within the financial system (unless we are going to have a massive credit contraction).  Both of these are reasons that suggest the banking system needs more capital before they will start lending again. 

On top of this, why try to hit the nail on the head in terms of recapitalizing the banks?  If we undershoot were in for a credit contracting recession which could risks a deflationary depression (read total disaster) where as if we overshoot we endup with a less than ideal return on our ‘investment.’  In my view the real return comes from not exposing ourselves to the risk of a depression like dynamic.  More and more I’m thinking that drowning the banks in capital (and cash – we’ve done this) is the right path.

Auto Bailout: Folly Squared

When policy is being created what is being thought about is how it will impact the real economy or at least that is what one would hope.  Also it is easily seen that the financial crisis which began in the Summer of 2007 has had a large impact on the real economy (which has then feed back into the financial economy).  The tragedy of this statement these real economy opportunity loses are not recoverable.  Think of the excess unemployment; every day that someone is sitting at home without a job is a day of lost labor; we don’t get that day back (and I doubt they are enjoying their time off). 

It seems in the case of the automakers policy is being crafted with the thought of politics rather than the real economy.  It is hard to know who is at fault for blocking a plan for the auto but I suspect the fault is on both sides, although likely not evenly split.  [Note: I was impressed that the President Elect Obama consulted lawyers about a pre-packaged Ch11; this would be a great idea but more on this below.  I don't think it will be done that way but it would be a wise and bold choice.]

Let’s lay out the reasonably plausible options for the auto.  First, they are bailed out by congress (of course the money is really coming from the American people) with large amount of subsidies and little or no concession but done right away.  The bad part of this plan is they are likely to continue to be uncompetitive and the problem reemerges down the road but it would help the real economy because they would go back to making stuff instead of cutting corners in order to stave off their demise.  Second, they are bailed out by the congress with some concession but done in a month or so.  The bad part is that the concession are likely to be minor and thus not enough to get them back on a competitive track and the real economy would have taken a real hit while they didn’t make autos while trying to retain cash and wait for a bail out (This seems to be the path we are on and the worst path of all).  A third choice would be a traditional ch11.  This process would help the auto maker restructure and return to long term profitability because they will be able to restructure contract on economics terms but it would also give a real whack the real economy at a time that it can ill afford to take it.  The forth option is a prepackaged ch11 where the auto would quickly emerge from ch11 with tough concession made possibly with the help of a federal negotiator.  The DIP (debtor in possession) financing, given that credit markets are not working, could be provided by the government in order to help operations during the restructuring.  Lastly some of the TARP, the treasury financial system rescue plan, could be used to provide financing for an auto loans ABS (asset backed security) purchase program.  I think this plan would give us the best shoot of providing the needed transformation in the auto industry while giving the real economy a boost. 

Look at this chart of auto securitization and auto sales to see how the credit crunch has lead to problems with auto sales.  First posted at the Council on Foreign Relation’s Center for Geoeconomic Studies. 

It seems like the path we are on of that of wait, talk and then aid.  Meaning the auto makers try to scrap by (thus less real economy activity) while they wait for the bailout.  This is a shame it likely the worst option.

Market Implication: Really?

One of my favorite activities is to look at markets and back out what they are predicting.  This is more of an art than a science because it can require a fair amount of assumptions and what I’ll call dirty methodologies in order to get at implied reality such as an implied growth rates or implied break even default rates.  But I believe it is a good practice, what it does is it allows a user to convert market prices into these numbers that have real economic meaning.  For example if I tell you that the price of a stock is 50, you cannot tell me if it is expensive of cheap (even if I tell you about the growth prospects and industry rank), but if I tell you what their implied earnings growth rate is 25% and they are a 150 billion dollar company you can guess that they are overvalued (doesn’t mean you’d make money but is suggestive).  Conversely if I told you low quality investment grade bond yields were at 10%, you couldn’t tell me if that was a good investment or not, but if I told that the spreads were 8% and the implied default rate was 16%, you would have something more tangible to think about.

So with this background in mind I ask the question: what are markets pricing?  The answer: total disaster.  The following chart shows that the low grade investment (BAA) corporate debt market is pricing in default rates that exceed the default rated during the depths of the great depression. 

Similar stories are being told by the ABX (home mortgages), CMBX (commercial mortgages), and LCDX (leverage loan markets) markets.  And the story has deteriorated rapidly (one reason why the banks have been failing so hard) over the past week.  It is worthwhile to note that this doesn’t mean that the trade (long a basket of risk assets) is one sided; there are reasons that it could get worse even if the real economy outcome is better than implied. 

So what’s the story: are we in for defaults that beat out the great depression?  I hope not, I don’t think so, but I’ve been wrong before.  So how do I explain what the markets are saying, they are broken.  The great soothsayer of the marketplace is leaving me (and you) high and dry to figure things out on my own.  There are a number of reasons for this such as the lack of balance sheet capacity, the flight to quality, the waiting syndrome, and so on but I not going to address these here.  What I would like to ask is how does one know if the market is working or not?  Using the gauge of ‘I don’t like’ or ‘I don’t agree’ with its predictions is a bad way to determine the markets degree of function.  I’ve come up with a methodology to determine, net of volatility, how well markets are functioning.  I’m going to keep to myself the details, as it really is a work in progress, but here’s the picture (higher numbers represent higher levels of dysfunction).  Maybe the flight to safety isn’t crazy after all, it’s really ugly out there. 

Educational Achievement: We need less of it!?

A common topic among the do-gooders (and I mean that in the best sense) of the world when discussing how to improve the lot of the poor is how to increase educational achievement.  At first glance this seems like a good idea.  It is plausible in that improving human capital (the skills people have) should increase their income because they would be more productive.  This is fine but think about this for a moment.  What did you learn during your years of education that you now use at work (excluding the basics)?  For many of us the answer is not much.  Yes some of us rely on technical skill that we learned during our collegial days and some weight can be given to the classical education argument (learning how to learn) but the question of ‘Is education investment paying off?’ remains.    

If education (particularly a high school education) doesn’t impart skills where does its value come from?  We can see high school graduates are paid better than those with out a degree. Think about this: What if education is less about learning skills than signaling (credit to Michael Spence) to an employer that you have passed some threshold for intelligence and responsibility.  Think about the employment selection process.  Employers are almost always looking for good people but good people are hard to find.  It is work to rifle through resumes and interviewing people and even after that process the information one has is limited, thus they use education filters to quickly get to a sub group of people which they want to seriously look at.  This means that if you have the degree line item you will have a greater employment opportunity set because the degree tell the employer something about you. 

80% of American over the age of 25 have a high school degree, up from 24.5% in 1940; the proportion with college degrees has jumped from 4.6% to 24.4%.  If we choose to assume that education achievement is only driven by intelligence (they are very tied) then we can convert the graduation rates into implied IQ (A signal of intelligence).  Looking at the chart, it is not entirely crazy to say that what a high school degree implied in 1940 a college degree implies now. 

 

What does this mean for education policy?  We’ll for one we must accept that improving the educationally achievement across the board has both positives and negatives.  For one it (hopefully) increases the skill level but it also dilutes the signal (if everyone had a high school diploma it would not have any signal meaning). We should focus on raising the bar of each educational level so that it is not over achieved. 

At an individual level were stuck needing to get the level of education that allows you to signal the right level of ability.  Meaning I may only need a BS in terms of training but because everyone is getting their masters I now have to go back to school for two more year and spending a lot of money in order to give the right signal.  This is huge waste of productive resources if it is really not needed (and I believe it happens; I hear people often say I’m going back to get my MBA because I need the line item and to network.  So lets fix the signaling line item problem and do the networking at a ski resort). 

So, do-gooder, don’t stop trying to save the world but do not do it by diluting the meaning of education and wasting resources that could be used creating economic prosperity. 

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[SIDE NOTE: Although a common argument of increased education leads to increase wages is correct (whether its a causal relation is the tricky) I think a stronger argument for education is increased labor robustness.  Look at the relative employment stats: the more educated unemployment stats are much lower than the less educated].

[Update: This table (the unemployment column) is suggestive of the gain in employment robustness; thanks Heather.]

Price of admission: One Bank

I’m, for the most part, a big fan of Dr. Bernanke. Without his creativity and responsiveness we would be in a much worse position (sorry Ben, you’ll never get credit for this but Bastiat already told you that). That credit being given I’m going to go ahead and question part of the financial rescue.

Why are the liquidity provisions limited to, basically, banks?  What this does suggests a clear logical failure.  You are recapitalizing and providing liquidity to a banking system because it is failing to performing the inter-mediation work that you care about, but you are relying on these banks to perform the rest of the financial inter-mediation to the non bank financial system.  You may have assumed that new capital and liquidity would get the system working again and that was a reasonable guess, but that did not happen, so why are we continuing down the same path.  The system is half rescued.  What happens if you only put a fire half out? 

The panic and problem was contained within the institution that have the fed liquidity but those on the outside are dying and their death is poisoning the waters (which is feeding back into and causing problem for the banks). We need have liquidity (and capital – provide balance sheet capacity) for all financial intermediaries. 

It takes time to set up new programs and can be politically tricky so lending within the existing frameworks makes sense but you need to encourage (strongly) conversion and make it easy so that those on the outside get inside.  We are seeing this happening, but slowly, in two ways.  First firms are concerting themselves to banks, ala Goldman, or buying a bank (some insurance companies have done this of late).  But the ultimate goal of getting the financial system working is being foiled because of a slow and limited conversion (meaning other firms are still poisoning the water). 

It seems that bring in those out in the cold could help bring the downward spiral into a base.  As for now the only signs of improvement are where the liquidity has directly (from the fed/agencies) gone: the intra bank market, the CP market, and the conforming mortgage market (via the agencies).  The Bernanke Fed has been great about being proactive so far but need to do more about plugging the non-bank financial system holes because the damage that those firms (and their balance sheets – to be clear, recapitalization should be done by the treasury as investments not by the fed) are causing when they break down is preventing progress in the rest of the financial system.

We’re retaining flexibility. But it’s on fire?

Treasury Secretary Henry Paulson let it be known that he would be leaving the remaining ammo in the financial system rescue program for use by the next administration.   He also seems to suggest that the financial system has stabilized.  Which in a way it has, things are not getting worse at nearly the rate they were, but this seems to me like a fire marshal who sees the fire has stopped spreading tell the fireman to turn off the water, even though the existing fire is still burning.

I agree with Paulson that flex-ability is a good thing; simple principle is that options have value, but they often have a cost as well.  His changing up the plan from buying assets – which was a bad idea from the beginning- to having an equity injections program was a good thing.  The cost was derision of politicians and media (he’s an adult, hopefully he can handle that), an increased likelihood that the plan would be changed again for other political reasons (ala auto bailout), and confusing the market about how it plays out (increased uncertainty thus higher risk premia).  The change to equity injections was a net positive and it is reasonable to say that it, in some ways, helped stopped the deterioration (momentarily) in the financial economy but as credit market are still functioning poorly the knock on effects to the real economy will continue.  The only place where credit market appear to be working is where the government is doing the job of the banking system.  The conforming mortgage market (Freddie and Fannie), the CP market (Federal Reserve Purchase Program), existing – not new issuance - bank debt (FDIC insurance program) appear to work. 

The outside of the governments touch – investment grade bonds, high yield bond, non conforming mortgages, and so on – are not working well.  Rates are not coming down, spreads are historic, credit is contracting, and banks are hoarding cash like a fugitive (almost 400 Billion since the end of september).  One way to illustrate the strange going ons is to look at the risky asset market and compare risk that is not being touch by the federal government directly (corporate risk) to risk that is being touch by the federal government (mortgage risk – via the agencies). The ratio shows that corporate risk is being priced as more risky than mortgages risk, this may or may not be right and there are some complicating factors, but at face value the recent movement seems to make the point that banking products that are touching the federal government are working and those that are not are still burning.  (Remember the 01/02 recession was a corporate recession the the ratio didn’t jump this much).   

The more I think about it the more I think the idea of drowning the system in capital – just like a fire crew drowns a house to make sure the fire is out – is the best option we have and at this point its not clear if the banking system has enough capital to survive never mind having an excess.

[update: 10/20/2008]

If you assume that the price return of the S&P 500 is roughly the real return (meaning that inflation equals the dividend rate, not right but not crazy - since I don’t have a way to get total return easily); the last time that I could have invested in the S&P 500 and made a real return I would have been in 6th grade…this equity market (forced selling — deleveraging) drawdown now takes the silver as the second worst.

It is important to note that this chart is not suggestive of valuation (whether or not stocks are a good value) but does give insight into the riskiness of the equity asset class. 

Avoid the Golden Standard

The weekends G-20 ended with a few broad presses releases.  I read one that was released under the header ‘Declaration of the Summit on Financial Markets and the World Economy’ which came from the White House.  I suspect others were similar.  A significant focused of the statement was on improving the rules of the financial game.  A valid goal given that the quality of games has much more to do with the rules than the players. 

Some of these improvements such as increased transparency through standardization of the accounting practices are a good idea.  This would be useful because it helps people communicate and thus allow more players into the investment management (capital allocation game) making the game more robust.  But standardization of methodology, risk management, and strategy in investment management creates rigid capital markets that are likely to have dire consequences.  An example of bad standardization is the rating agencies.  The idea that they need to be held to the highest standard is missing the point.  Even if the rating agencies were extremely professional in their analysis they would still be dangerous to the system because the investment process would be extremely un-diversified.  (For finance geek, think about the fact that a crossover index exists or simple trading strategies based on predicting rating changes – which are not particularly challenging).  Another source of rules that weaken financial system diversification focus on ideal risk management methodologies.  A degree of reasonableness can be mandated such as minimum capital levels (or more conceptually maximum leverage) without encouraging correlated (un-diverse) capital market but if specific rules are handed down expect correlation to rise.  (Don’t be convinced that a golden standard exists because the process of risk management is reflexive; you need to be aware of what others are doing and if everyone is doing the same thing you’d likely want to stay away from that method (or front run it, meaning to trade in front of it)). 

Rather than have a golden rule create a competitive environment full of robust capital pools.  Meaning focus the rules of the financial system on providing information for investors and eliminate rules that push investor away from the thought process of allocating capital (such as using rating agencies or the prudent man rule). 

The principles of diversification that are commonly recognized in portfolio construction should be used when creating robust capital markets but their usefulness does not stop, in fact the principles of diversification should be used consistently throughout our daily lives when making decision in a uncertain world.