Budget Host Liberty Inn

In the early 90s while driving on I80 in eastern Iowa I spent a night in a motel near an exit. These days when driving long distances (which I do a fair amount of because I am afraid of flying) I generally make reservations for intermediate stops over the internet before starting out. However at that time I would just drive until I was ready to stop and then start looking for a place to spend the night. This usually worked out okay. In this case as I recall the motel had a sign near the exit offering some sort of cross promotion (something like 10% off your room rate if you bought a tank of gas, that sort of thing) with a nearby gas station and/or restaurant.

In later years I drove on that section of I80 a number of times and with nothing better to do started trying to pick out the location where I had once spent the night. But although I knew the approximate location (a couple of hours east of Des Moines) I was never able to confidently identify the exit. Eventually this annoyed me enough that when I got home I found the old motel receipt (I am a packrat type with a house full of useless stuff like that). This told me that the motel was the "Budget Host Liberty Inn" and that the exit was number 259. Armed with this information the next time I drove by on I80 I was of course able to locate the exit. I saw there was an Econo Lodge motel nearby but it and the site in general still didn't seem familiar. Of course driving by at 70 mph an hour doesn't give much time for a close inspection. And then I moved from Ossining to Princeton and stopped driving on that section of interstate highway. Recently while on Covid lockdown I looked on the internet for more information about the place and was able to find some.

The 35 room motel was built in 1966. At some point it became part of the Econo Lodge chain (motels move from one chain to another a fair amount). It operated as an Econo Lodge until about 2015 and then as an independent motel (named "Elegant Inn") until about 2018. It appears the building may now be in use as a warehouse for a company that sells vintage motorcycle parts. In 2015 somebody (perhaps on behalf of the owner in preparation for a sale) took some fancy 360 degree pictures of the Econo Lodge entry, front desk, breakfast area and two rooms which can be found on google maps. It all looks pretty nice but the extant reviews (from 2010-2015) are a mix of "okay for a cheap motel" and "not okay even for a cheap motel". I only found bad reviews for the "Elegant Inn".

There is an adjacent gas station/truck stop and convenience store that dates to 1964 with some alterations in the early 90s. There is also a restaurant building (built in the early 90s) on this property (which is currently distinct from the motel property). It appears the restaurant building has not been in use for at least 10 years. The changes on this property were made soon after I stayed in the motel and may partially explain why I was unable to recognize the exit. Also available pictures of the Econo Lodge incantation of the motel show some superficial alterations were made to the facade at some point (perhaps when it joined the Econo Lodge chain). Together with a garish paint job this would be enough to significantly change the motel's appearance again making it harder to recogize. And of course memory is unreliable, I have stayed in many cheap motels over the years and may over time start conflating details.

If you drive a lot you see a fair number of abandoned businesses like gas stations, motels and restaurants along interstate highways. This always seems a little sad to me. In this case the motel property (which includes 4 acres of land) sold for $695,000 in 1996 which indicates (unless the buyer grossly overpaid) that it was doing well at that time although the building was already 30 years old. At a cap rate of 10% this implies operating income of $69,500 a year or a bit over $5 per room per night (or perhaps $10 per occupied room per night). This seems pretty good but apparently it didn't last. Perhaps the building started showing its age. And the failure of the restaurant wouldn't have helped. In any case the motel sold in 2007 for $388,000 and again in 2018 for $170,000 and now is not worth operating as a motel. As noted the restaurant failed some time ago. The gas station/truck stop is still operating (albeit currently for sale) but you have to wonder about its future long term.

So what went wrong here? My guess is that for whatever reason this exit failed to amass the critical mass of businesses needed to make a location sufficiently attractive to passing drivers to survive long term. Perhaps somewhat counter-intuitively businesses along an interstate are better off clumping together (at least up to a point) than spreading themselves out evenly. This is easier to see in cases of complementary businesses like gas stations, restaurants and motels as each will draw business to the others. It is clearly better to have a gas station, restaurant and motel all at one exit than spread out one each at three adjacent exits. But even competitive businesses like gas stations are better off clumping together. This is because an exit with two or more gas stations is a more attractive place to buy gas than an exit with a single station as travelers will expect a better price. And two gas stations may draw enough traffic to support a restaurant (where a single station would not) which in turn will draw more business to the gas stations. As this process continues some exits will lose out unable to compete with nearby exits with more businesses bringing in a greater volume of traffic.

Of course this process has limits. If you get too big a gap between gas stations, restaurants or motels it becomes attractive to open a new location near the midpoint. But you don't really need gas stations (or restaurants or motels) every 5 miles along a rural interstate.

Railroader

I recently read "Railroader" a 2018 biography of Ewing Hunter Harrison III by Howard Green.  Harrison (who went by Hunter or E. Hunter) lived from 1944 to 2017.  He worked for railroads most of his adult life starting out as a laborer (carman-oiler) in 1963 and eventually becoming the chief executive officer (CEO) of four different major North American railroads.  He made major changes that were very successful (at least from a shareholder point of view) and which have reshaped the industry.  Comparable in some ways to Steve Jobs, Harrison is much less well known (as indicated by the respective sizes of their wikipedia entries linked above).

A key measure of profitability in the railroad industry is the operating ratio which is defined to be the ratio of operating expenses to revenue.  Clearly lower is better.  Harrison made his reputation by significantly lowering the operating ratio at each of the railroads (Illinois Central, Canadian National (CNI), Canadian Pacific (CP) and CSX(CSX)) where he worked at the executive level. This led more or less directly to increased profits.  In many industries such increased profits would be temporary as competition means lower production costs are eventually passed on to customers in the form of lower prices.  However there is little price competition among the major railroads (they do compete on price with the trucking industry) so this process is occurring slowly if at all.  The result is much higher stock prices and happy shareholders. Certainly I am happy that my Norfolk Southern (NSC) stock is up about 120% (as compared to about 40% for the market as a whole) since I bought it in 2015.  Harrison didn't work for NSC but shareholder pressure is forcing the other major railroads to adopt his methods.

While Harrison made his shareholders happy other stakeholders such as employees and customers were less pleased.  If you browse the forums where railroad people hang out you will find a lot of animosity towards Harrison.  This is natural as some of the shareholder gains came at the expense of employees.  Many workers at all levels lost their jobs either because Harrison determined that they weren't really needed or because they were unwilling or unable to adapt to the new order.  No one likes to lose their job and there is a natural wish to believe (however delusionally) that the company will come to regret eliminating it.

Some customers too were unhappy with the changes.  In some cases because they were made worse off even if overall the changes were beneficial.  In other cases because the changes were disruptive short term regardless of any long term benefits. Harrison's take or leave it negotiating style and in some cases the lack of reasonable alternatives didn't help. Customer dissatisfaction appears to have been particularly acute with CSX the last company Harrison managed because Harrison seems to have tried to make changes too rapidly leading to frustrating service disruptions.  Harrison's haste is somewhat understandable as he died less than a year after starting at CSX and must have suspected he didn't have much time.  However it was enough as he was succeeded by a disciple, James Foote, who has largely followed the course Harrison set.

So what was Harrison's secret.  How was he able to repeatedly achieve outstanding results.  One important factor has been alluded to above.  The railroad industry is very old and over time arrangements had evolved that balanced the interests of employees, shareholders and customers in a certain way. Harrison realized that this balance was not set in stone.  A balance more favorable to shareholders was possible.  For example just because it had become customary to allow some employees to leave early (before the end of their shift) didn't mean Harrison had to go along.  If he required employees to work their full shifts he could get by with fewer of them.  There seems to have been a fair amount of fat of this sort that Harrison could eliminate if he was willing to unilaterally alter longstanding arrangements.  Similarly in some cases Harrison could raise prices or otherwise change customer contracts to the railroad's advantage.

Another thing Harrison did was emphasize the efficient use of capital equipment.  This is important in a capital intensive industry like railroads.  Harrison realized that locomotives and rail cars were only earning money for the railroad when they were in motion.  So he tried to keep them in motion.  If he operated his locomotives more hours per day he could get by with fewer of them.  Similarly if he reduced the time rail cars sat around in yards waiting for the train that would take them on the next leg of their journey to be assembled and dispatched he (or his customers who in many cases own the cars) could get by with fewer of them and also improve service by reducing transit times.

Harrison also introduced what has become known as precision scheduled railroading (or PSR).  This involved two changes. Freight railroads had traditionally not operated on set schedules instead dispatching trains once a sufficient number of cars had been assembled.  This meant customers could never be sure exactly when their shipment would arrive.  Harrison moved towards fixed schedules in which trains left at set times.

The railroads had also used a hub and spoke system in which a rail car would start at a spoke location pass though one or more hub locations and finally end up at another spoke location.  This involved a lot of assembling and disassembling of trains as cars would be brought together for one leg of their journey and then go their separate ways on the next leg.  This work was done at hump yards so named because they were built on an incline (or hump) to allow gravity to help move the cars around.  These yards tended to be expensive bottlenecks which slowed the movement of cars through the system.  Harrison moved towards a point to point system in which trains moved cars directly from their origin to their destination.  This allowed the closure of many hump yards. The net effect of these changes is theoretically to reduce costs while improving service by making it faster and more reliable.  In practice the cost savings from PSR seem to be clear cut but the service improvements have been a bit more debatable particularly in the transition stage while kinks are being ironed out.

Over the years Harrison had a lot of detractors but for the moment at least he seems to have prevailed.  The railroads he managed have for the most part continued on the new course he set and the remaining large North American railroads are adopting his methods, the financial results he achieved are just too impressive to ignore.  During their latest quarterly report conference calls NSC talked about hiring people with PSR experience and Union Pacific (UNP) said it was going to "pause" construction of Brazos Yard, a large new hump yard it had started constructing just last year with considerable accompanying fanfare.  The other large American railroad BNSF (Burlington Northern Santa Fe) doesn't directly report to public shareholders as it is now part of Warren Buffett's Berkshire Hathaway conglomerate.  Buffett has said that he tolerates a certain amount of fat in the companies Berkshire owns so there is less pressure on BNSF to rapidly adopt Harrison's methods.  Still it seems unlikely that Buffett will accept substantial underperformance indefinitely.

Regarding the book, Howard Green is a television journalist who interviewed Harrison several times. Apparently they got along reasonably well so Harrison commissioned Green to write his biography.  It was to be unauthorized in the sense that Green was to have the final word on content and in any case Harrison (who had been seriously ill for some time but continued to work) died before the book was finished.  Still Harrison probably expected the book to be generally friendly towards its subject and it is.      

The strength of the biography is Green's access to Harrison, his family and his friends.  This led to hundreds of hours of interviews many with Harrison himself.  However Green perhaps relies too much on stories told by or about Harrison in interviews.  While these stories do give an impression of what the man was like there is often room to doubt that they are completely accurate.  In several cases Green notes that other people's accounts of the same events differed.  However in other cases Green seems to have made little effort to establish what actually happened.  One disadvantage of becoming friendly with your subject (and his family and friends) is that it may make you hesitate to ask questions that they might find disagreeable.  For example Harrison's father apparently suffered some sort of injury while serving in the armed forces during WWII. The book is extremely vague about exactly this was.  I expect the relevant military records still exist but perhaps Green was reluctant to ask Harrison to request them.  Similarly Harrison was seriously ill while working at CSX and ended up dying just a few days after finally going on medical leave.  But again the book is vague about exactly what was wrong.  It appears Harrison was not very forthcoming and Green was unwilling to press him. CSX was also kept in the dark and as a result changed its bylaws to require future CEO's to be regularly examined by a company doctor.  

Harrison retired somewhat unwillingly from CNI at age 65.  He didn't enjoy not working and eventually teamed up with a couple of hedge funds to get himself installed as CEO first at CP and then still looking for new worlds to conquer at CSX.  Naturally the incumbent CEOs (and his previous employers) were not too enthusiastic about this so a certain amount of maneuvering involving proxy fights and lawsuits was involved. This was covered in a bit more detail I would have preferred as I was more interested in what he did as CEO.  

I thought the book was a little weak in analyzing the relative contribution of the changes Harrison made to the improved financial performance.  For example the book discusses numerous changes Harrison made to improve the operating ratio by cutting costs.  But of course the operating ratio can also be improved by increasing revenue through higher prices or volume.  The book says little about this.  Perhaps this is because the contribution of revenue increases was insignificant but if so it would nice if this was explicitly stated.  

It is also unclear to me to what extent the benefits of Harrison's changes extend beyond railroad shareholders to society at large. Harrison claimed his changes would improve service and allow the railroads to take market share from the trucking industry.  Was he correct?  The book isn't much help in answering this question, perhaps interviews with a few large rail customers or trucking competitors might have shed some light.  Regarding future competition between trains and trucks, trains are more energy efficient and will have a competitive advantage if oil prices increase significantly.  On the other hand self driving technology would help trucks more than trains as driver costs are more important for trucks.   

In summary I thought the book was okay.  It was reasonably entertaining and I learned some things from it. However when I saw the book in my local library I checked it out because I already knew a little about Harrison and the changes he has brought to the railroad industry and was interested in learning more.  If you have no such desire you probably won't find this book to be of much interest.

The Undoing Project

I recently read "The Undoing Project" a 2017 book by Michael Lewis.  It primarily tells the story of two Israelis, Daniel Kahneman and Amos Tversky, who worked together for many years studying how people make decisions especially bad decisions.  Kahneman received the 2002 Nobel economics prize for this work (shared with Vernon Smith).  Tversky would probably have shared in the prize as well if he had not died in 1996 (at the relatively young age of 59) making him ineligible.

I was disappointed in this book.  It is quite long (352 pages plus notes) and unlike most of Lewis's work I didn't find it to be particularly entertaining.  It contains a lot of biographical material about Kahneman and Tversky which (while intermittently interesting) isn't especially relevant to their professional work.  It is repetitive in places (for example colleagues and students describing how brilliant they were).  It abruptly introduces other characters and then drops them without really integrating them into the narrative.  It contains chapter notes at the end of the book but no index.  It suggests that their work was very important but doesn't really explain why.

Nor did I think it was especially instructive.  It isn't technical enough to be a good introduction to Kahneman's and Tversky's professional work.  I have previously reviewed books by Ariely, "Predictably Irrational" and Thaler, "The Winner's Curse" which discuss related work on decision making.  While I didn't recommend them either they would provide a better introduction to the field.

In short I would skip this book.  It isn't a good introduction to this subject area and I didn't find it compelling as entertainment.

Boomerang

I recently read Boomerang, a 2011 book by Michael Lewis based on magazine articles he wrote in 2009, 2010 and 2011. These articles looked at Iceland, Ireland, Greece, Germany and the United States in the aftermath of the financial crisis. I generally like Lewis as a writer and I found the book entertaining and a useful reminder that the excesses that led to the financial crisis were not confined to the United States.

In Iceland the problem was the banks. They grew extremely large (compared to the economy of Iceland) by making lots of bad loans around the world. The rapid growth should have been a red flag as credit worthy borrowers are a scarce resource that other banks will compete strongly for. This makes it hard for a bank to grow rapidly while maintaining high loan standards. Obviously there is less competition for bad credits so it is easier for a bank to grow rapidly if it makes a lot of low quality loans. But this generally doesn't work out too well in the long run.

In Ireland the problem was an amazing property and construction boom which Irish banks fueled with easy credit. When the bubble inevitably popped the banks became insolvent and would have failed had not the Irish government made a dubious and extremely costly decision to guarantee all their debt. In the US there is a lot of loose talk about taxpayer dollars bailing out the banks but in fact the government profited overall by supporting the banks (since as it turned out they were fundamentally sound). This was not the case in Ireland.

In Greece the problem (as least as related by Lewis) is that the Greek people individually and collectively are not credit worthy. So it was a big mistake to admit Greece to the Euro as this gave the false impression that Greece was credit worthy. So a lot of bad loans were made to Greece.

The German problem was a little different. Germany was saving more money than could be productively invested in Germany. So the German banks looked to invest abroad. Foreign investing can work out but you have to be careful you don't get stuck with a bunch of garbage the locals have sensibly passed on. The German banks failed to be adequately cautious thereby acquiring a lot of bad loans and a worldwide reputation for stupidity.

I thought the final chapter on the United States was the weakest in the book. Lewis discusses the financial problems of some state and local governments but in a big country like the United States there will always be some problems. Lewis doesn't really make the case that these problems threaten the country as a whole.

So in summary I can recommend the book as a good example of its genre.

Inequality

The Nov/Dec 2014 issue of the MIT alumni magazine, Technology Review, had a long cover story on inequality, "Technology and Inequality", by editor David Rotman. While it isn't particularly surprisingly that MIT thinks more spending on education is the solution to all problems I nonetheless found it irritating in this instance. Misdiagnosing a real problem is harmful not just because it encourages spending on solutions that will not work but also because it discourages investigating solutions that might work.

The problem with the MIT article (and many similar ones) is that it correctly notes that people who have completed more levels of education tend to earn more money in their subsequent careers and then jumps to the almost certainly false conclusion that the additional years of schooling are why they are more valuable employees. It seems far more likely that some people have more natural academic ability than others and that the traits that make them good students also make them good employees. So the educational system is just identifying students who will make especially good employees. For the most part students who do poorly in school do so because they lack natural academic ability not because their schools are especially bad. There is confusion on this point because average academic ability varies widely between schools so some schools have lots of high ability students who do well and other schools have lots of low ability students who do poorly. It is natural to think that schools where most of the students are doing well must be far superior to schools where most of the students are doing poorly. But in the United States this is not the case, schools (within the range commonly found) make little difference. Move a poor student to a "good" school and they are likely to continue to do poorly, move a good student to a "poor" school and they are likely to continue to do well. Furthermore what differences do exist are predominantly due to peer effects, it is better to be surrounded by good students than by poor students. And of course it is not possible for everybody to have mostly high ability classmates.

One of the traits which helps you do well in schools is of course intelligence or IQ which the article doesn't mention at all. I do not find it surprising people with IQs of 115 do better in school and in their work careers than people with IQs of 85. But schools (in the US) have little effect on IQ and more spending on education cannot be expected to significantly reduce IQ differences and hence income inequality stemming from them.

Nor do I find it surprising that IQ is becoming more important in the job market. In 1920 there were over 25 million horses and mules in the US, by 1960 this number had fallen to slightly more than 3 million (see here). Pure muscle power used to be worth a lot in the economy, now not so much. There is a real issue here but more education isn't the solution.

Irrational Exuberance

I recently read "Irrational Exuberance" by Robert  J. Shiller.  This was the 2005 second edition which added some material about housing prices to the 2000 first edition which was about the stock market.  Schiller's thesis in both cases was that prices were high by historical standards making expected future investment returns poor.  Unfortunately although Schiller proved to be correct I didn't find this book very interesting. 

One problem is that the book is dated.  Arguments about whether we are in a stock market or housing bubble are less interesting ten or fifteen years later when we know the answer.  There wasn't a lot in this book that was new to me.  Another problem is that Shiller sometimes makes his arguments in a somewhat simpleminded way.  For example he cites (p. 47-49) the rise of 401(k) plans as a factor increasing demand for stocks.  But of course traditional defined benefit pension plans also invested in stocks.  So it is not clear that shifting to defined contribution plans makes much difference. As another example Shiller claims (p. 177) that "... the efficient markets theory asserts that all financial prices accurately reflect all public information at all times."  But this is the most simplistic form of the theory, a more sophisticated version allows for some imperfections that can only grow to the point where they can be profitably exploited by the smartest best capitalized investors.  This deals with Shiller's later objection (p. 179) that without some profitable trades the smart money would not stick around to keep prices in line.

Shiller spends considerable time dealing with the objection that we can't be in a bubble because bubbles are impossible.  Apparently this isn't really a strawman as it seems there are reputable economists who believe something like this.  Still I find it hard to take this objection seriously and am not that interested in lengthy refutations.  In general I thought the book was too long, that the main ideas could have been presented more concisely.  I also found some of the advice unconvincing.  Schiller is big on hedging as a form of insurance.  But insurance generally costs money and may not be worth it.

In summary although Shiller is correct in his major claim that asset prices can get out of line I didn't find this book very compelling and so can't recommend it.   

Property Tax

Thomas Piketty in an interview for a British think tank suggests property taxes should be assessed based on your equity in a property (value less debt) not on value:

But it is perfectly possible at the national level to transform our traditional forms of property taxation, which are typically proportional and which do not take into account financial assets and financial liabilities, because they were set up in the nineteenth century when most property was real estate property, so they do not take into account financial wealth and liabilities. This can be turned into a progressive tax on net wealth, which basically would be a way to reduce property tax –council tax in the UK – for the vast majority of the population. Typically, if you have a house that is worth £500,000, but you have a mortgage of £490,000, you are not rich – you have a net wealth of £10,000, so you should pay less than someone who has no mortgage or who paid off his or her mortgage many years ago. 

This makes little sense for US property taxes on owner occupied housing as I will explain.  Piketty is correct that someone with a mortgage on their house is less well off than someone who owns their house free and clear.  However this is already taken into account in the US tax code through the mortgage interest deduction in the federal income tax code.  Although this deduction is often cited as a loophole it has always made sense to me.  But I don't think it makes sense to provide a second reduction in your taxes for having a mortgage.  In fairness to Piketty many countries don't have a mortgage interest deduction in their income tax code in which case his equity argument above has more force.  But in those cases a simpler fix is to add a mortgage interest deduction.

I had previously though the real loophole regarding taxes and owner occupied housing was that the imputed rent on an owner occupied house is not included in income.  But while thinking about this it occurred to me that property tax is roughly equivalent to an income tax on imputed rent.  (This idea is not original to me but I had not encountered it before.)  So besides the practical problems in trying to assess and tax imputed rent as income there is a theoretical case for excluding it as well.  Of course if property taxes are a surrogate for income tax on imputed rental income they should ignore mortgage debt as this doesn't affect the imputed rental income you are receiving by living in your house.

A complication in thinking about tax breaks on owner occupied housing is that any benefits tend to be reflected in selling prices and hence make less difference to new buyers than might be expected.

Utility Functions and the CAPM

A basic concept in classical economics is that given certain plausible assumptions it is possible to define utility functions which measure how desirable economic actors find possible states of the world.  Rational actors will then try to maximize the expected value of their utility function.  For example most people will have an utility function which gives an additional two million dollars less than twice the value of an additional one million dollars.  Hence they will prefer a sure million dollars to a 50% chance of two million dollars as this will maximize the expected value of their utility function.

The Capital Asset Pricing Model (CAPM) uses considerations of this sort to predict that risky assets will sell at a discount to their expected future value (as computed in dollars) and that the amount of the discount will increase as the amount of future uncertainty increases.  As without such discounts investors would prefer to buy only the safest assets.  It follows that risky investments will have greater expected return.  Note risk here is referring to non-diversifiable risk.  Risk particular to individual assets can be essentially eliminated by buying a diversified portfolio of such assets.  However some risks (such that the economy as a whole will do badly) are not particular to individual assets and cannot be eliminated by diversification. 

In the case of stocks it is reasonable to divide the risk (uncertainty in future returns) into two parts.  That due to idiosyncratic factors particular to individual companies and that due to uncertainly about the general future trend of stock prices (as stocks tend to move up and down together).  Stocks vary in how sensitive they are to general market movements.  Some might tend to move up and down twice as much as the market, others only half as much as the market.  The Greek letter beta is conventionally used to denote how sensitive the price of a particular individual stock is to a general change in the level of stock prices normalized so that a stock with a beta of x will tend to move up or down by x% when the general market moves up or down by 1%.  High beta stocks will have more non-diversifiable risk and are predicted by the CAPM to have greater expected returns.

The CAPM is quite elegant mathematically.  However that does not mean it is correct. Eric Falkenstein has extensively criticized it in books and his now dead blog, Falkenblog, which I mentioned earlier this month. Falkenstein's criticism (I don't know to what extent it is original, for the most part it is new to me) comes in two parts.

He claims that empirically high beta stocks have historically performed worse than low beta stocks which is a bit strange if their expected returns were actually higher.  A big part of this seems to be due to the highest beta stocks performing badly with returns otherwise pretty flat with respect to beta.

On the theoretical side he points out the usual utility function framework is inadequate as it neglects the fact that people care about how they are doing relative to others.  So they are going to prefer seeing their stocks go up 20% when the market is up 10% to seeing their stocks go up 20% when the market is up 30% although their personal return is the same in both cases.  To the extent that people care more about relative returns than absolute returns (or as Falkenstein puts it are driven more by envy than by greed) the predictions of the CAPM will be flawed.  For the so called risk free rate of return (often taken to be the interest rate paid on government bonds) is not actually risk free if people care (as they often will)about missing out on a big move upward by the stock market.  The risk free investment for such people will be an index fund which guarantees them the average market return.  Which means in effect that all risk is diversifiable and that there is no reason to anticipate greater expected returns when voluntarily assuming risk by deviating from the market average portfolio. 

High Pay

Piketty's book is mostly about increasing inequality in the distribution of capital (and hence in income from capital).  However income from labor is also becoming less equal.  One aspect of this is the emergence of a group of extremely high earners.  Piketty's explanation for this is as follows.  This group largely consists of highly paid top corporate executives.  They are in positions where they can strongly influence their own pay.  This gives them some ability to overpay themselves and the reduction in top marginal income tax rates gives them more incentive to do so.  The natural result is very high rates of pay, well above economic value. 

I agree that top corporate executives in general are currently substantially overpaid.  Piketty's  account certainly seems plausible and is probably part of the explanation.  However it is not the entire story as there are lots of high earners who aren't negotiating their pay with themselves.  Krugman brings this up in his review:

 ... Also, I don’t think Capital in the Twenty-First Century adequately answers the most telling criticism of the executive power hypothesis: the concentration of very high incomes in finance, where performance actually can, after a fashion, be evaluated. I didn’t mention hedge fund managers idly: such people are paid based on their ability to attract clients and achieve investment returns. ...

However I think Krugman is also confused in that it isn't actually any easier to evaluate the performance of hedge fund managers than the performance of corporate executives.  In both cases you can look at how well they have appeared to do in the past but this won't predict their future performance very well.  This is because how well they do is highly dependent on luck and other factors outside their control.  But people tend not to adequately allow for this.

So I think another part of the explanation for unjustified high pay is that employers have a natural tendency to overestimate their ability to predict future performance.  So they are willing to pay more to attract their preferred candidates than is justified by actual differences in expected performance.  As a result it is quite plausible that top corporate executives would be overpaid even if their pay was negotiated with truly independent boards of directors.  Just as hedge fund managers as a group are obviously overpaid even though their clients could readily obtain better expected performance (after fees) in low cost index funds.

Capital in the Twenty-First Century

I recently read "Capital in the Twenty-First Century" by Thomas Piketty (translated by Arthur Goldhammer).  This long (685 pages) 2013 book by a French economics professor has become popular in liberal circles.  However in my opinion it isn't very good.

The book can be summarized as follows.   Around 1900 wealth was large (in terms of years of annual income) and concentrated (unequally distributed) in France and similar nations.  By 1950 wealth was smaller and more evenly distributed but then became to grow larger and more concentrated again.  The author projects further increases in the years ahead, takes for granted that something needs to be done about this and proposes a worldwide tax on capital.

The historical part which traces the distribution of wealth from 1800 or so to the present is of some interest but could have been presented much more concisely.  Piketty concedes that economists in 1900 or 1950 would have been unwise to expect to be able to accurately predict the future distribution of wealth but then undaunted makes his own predictions.  I see little reason to give them much credence.

Piketty's main policy recommendation is a worldwide graduated tax on wealth.  His arguments for this aren't likely to convince anyone not already favorably disposed.  He professes to be concerned about wealth becoming concentrated in a few large inherited fortunes but much less drastic steps would prevent this.  For example requiring large estates be split at least 10 ways (that is no single heir could inherit more than 10%).  This would fairly quickly disperse large fortunes.  As Piketty acknowledges simply abolishing primogeniture has had such an effect.  

In contrast it appears likely that Piketty's wealth tax would not simply cause wealth to be spread more widely but instead would cause wealth to be diverted into consumption which would over time substantially reduce the amount of wealth.  It is unclear why Piketty thinks this is a good idea.  Piketty's predictions rely on the claim that there are few diminishing returns to wealth, that it is possible to productively employ ever increasing amounts of wealth.  So what is the benefit of a poorer society with less wealth available to increase labor productivity?   

Piketty attributes the problems of current (and former) actually existing wealth taxes to difficulties arising from trying to impose such a tax in a single country.  Hence his proposal for a worldwide tax.  But the difficulties could also be attributed to the compromises required to get a wealth tax enacted and these would only increase if you had to get the tax enacted worldwide.

The book seems unfocused and much too long.  Which makes it harder to identify the key points.  Among other things Piketty rambles on about the novels of Austen and Balzac at considerable length.   Which he cites as sources for the claim that around 1800 it was difficult to live a decent life without access to inherited wealth.  Whatever the truth of this it has little relevance to today's conditions where anyone in the top 10% of labor income is doing fine.

Piketty makes some curious claims, for example on page 432 that:

... In the long run, unequal wealth within nations is surely more worrisome than unequal wealth between nations.

This seems debatable to say the least.  But perhaps Piketty is more bothered by the few people who are much richer than he is than by the billions who are much poorer. 

In summary I found this book hard to get through and I don't recommend it.  If you are interested reading a few reviews seems like a less painful way to pick up the main ideas.

The Winner's Curse

I also recently read "The Winner's Curse", a 1992 book by Richard Thaler.  Like Ariely's "Predictably Irrational" it discusses situations in which people don't behave as some economic theory predicts they should.  My evaluation is similar, the book while not totally devoid of interest is not worth recommending.

This book largely consists of revised versions of a series of articles Thaler (often with coauthors) published in the Journal of Economic Perspectives between 1987 and 1991 on the general theme of economic anomalies, situations where people behave contrary to theory.  These articles summarized academic research on each topic.  I found this preferable to Ariely's book which in my view unduly emphasized his own research.  However the articles are now over 20 years old and so potentially dated.  And they are written in a style which I didn't find particularly engaging. 

But my main objection is the same as to Ariely's book, it is not clear how significant these anomalies are.  I think most people understand that economic models are approximations which are not exactly correct.  So finding a few cases where their predictions are off doesn't by itself mean too much.  As Thaler concedes near the end of this book, what is really needed are models (or theories) that predict better. 

So in summary I don't think this book offers a lot to the lay reader. There were a few points of interest but in general it isn't going to be of much help in understanding current economic issues or in making better personal finance decisions.

Predictably Irrational

I recently read "Predictably Irrational", a 2008 book by Dan Ariely, then a professor of behavioral economics at MIT.  Based largely on his own experimental work it discusses situations in which people often behave in ways which are at least arguably irrational.  Unfortunately I didn't think the book was very good.

My main problem with the book is that it is weak on the big picture.  By way of analogy human vision is generally pretty good but not perfect as the existence of optical illusions shows.  But a book just describing various optical illusions would not be a particularly good way of giving an overview of human vision.  Similarly it is hard to know what to conclude from a book describing a few experimental situations (often quite artificial) in which people behave irrationally.  I didn't get much more from this book than the observation that people sometimes behave irrationally which I already knew.   

One reason for the book's problems with the big picture is as mentioned above it is largely based on Ariely's own experimental work.  I believe a book like this should present a general overview of the field suitable for the lay reader.  This would include summarizing the most important and well established experimental results.  Just describing your own work (in what I sometimes thought was excessive detail) is not as useful.  Among other things it is difficult to be objective about your work, its importance and weaknesses.  Also I suspect there is a publication bias at work in this whole field.  I doubt it is as easy to publish experimental results concerning situations in which people do behave more or less rationally.  Which could give an unbalanced view of how pervasive irrational behavior actually is.

The book does present an useful general principle, namely that people like to evaluate things relative to other things rather than on an absolute basis.  So  B may appear more attractive when presented with a clearly inferior alternative C than when considered in isolation.  So experiments can be devised in which people prefer A to B when given 2 choices but prefer B when given 3 choices with C an inferior version of B added.  The addition of C makes B appear more attractive although this violates models which assume A and B have a definite absolute value.  Similarly people tend to evaluate their circumstances relative to their recent past (or compared to people they consider their peers).  So happiness is not as related to income as much as you might expect.  A rich person whose life is getting worse will tend be unhappy while a poor person whose life is getting better will tend to be happy even though objectively the rich person is still much better off.       

There are a few more worthwhile observations in the book but not in my view enough considering its length.  And I didn't think the book was particularly well written.  So while I don't think the book is totally worthless I would not recommend it.

End this Depression Now

I recently read "End this Depression Now" a 2012 book by Paul Krugman about our current economic problems and what to do about them.  I thought it was fairly good although I do not share Krugman's liberal politics.  Krugman's books are more balanced and less polemical than his NYT newspaper columns making them more palatable to me.  Despite the title most of the book is devoted to discussing our current problems and how we got into them.  Less space is devoted to Krugman's ideas for fixing things.  Perhaps because, despite Krugman's protestations to the contrary, he realizes they are nonstarters politically.

Krugman's diagnosis is that our current sluggish economy reflects an overall lack of demand.  There are idle resources but businesses are unwilling to hire people and increase production because they fear (with good reason) that they will be unable to sell the resulting goods and services.  I find this plausible.  A competing explanation cites structural problems, that the economy is set up to produce the wrong things and that time is needed retrain workers and refit factories.  I don't  find this convincing.  If overall demand was adequate but not matched to supply you would expect to see shortages developing and prices rising for those goods and services in strong demand as well as idle capacity in areas of weak demand.  But for the most part this isn't happening.  Now structural problems could become a problem as the economy improves.  I am not convinced that estimates of current capacity generated by naive extrapolation of pre-crisis GNP trends are realistic.  But I don't think structural problems are currently a binding constraint.

I find Krugman's explanations for the origin of the lack of demand and ideas for fixing things less convincing.  He appears to believe that the economy has multiple equilibrium conditions and that although the economy is currently in a unfavorable equilibrium condition (into which it was pushed by the financial crisis) there is also present a preferable full capacity equilibrium.  So all that is needed is temporary government actions to push the economy into the more favorable equilibrium where it will remain by itself without needing continuing support.  For my part I doubt this more favorable equilibrium actually exists (under current conditions) making policy attempts to push the economy into it futile and potentially dangerous. 

One point of disagreement is whether the lack of demand is a chronic condition.  Certainly there was a temporary aspect, the financial crisis panicked people into trying to increase savings (or reduce debt) and due to the well known "paradox of thrift" this leads to a drop in demand.  But the acute phase of the financial crisis is long past, people are no longer panicked but demand remains depressed.  I think this reflects an underlying structural problem which needs to be addressed.  Krugman dismisses my favored explanation briefly in a paragraph on p. 83.

For example, one popular story about inequality and crisis--that the rising share of income going to the rich has undermined overall demand, because of the shrinking purchasing power of the middle class--just doesn't work when you look at the data.  "Underconsumption" stories depend on the notion that as income becomes concentrated in the hands of a few, consumer spending lags, and savings rise faster than investment opportunities.  In reality, however, consumer spending in the United States remained strong despite growing inequality, and far from rising, personal saving was on a long downward trend during the era of financial deregulation and rising inequality. 

I find this unconvincing.  Personal saving is measured on a net basis which can hide a growing imbalance as part of the population saves more and more while another part spends more than their income and goes deeper and deeper into debt.  This can maintain demand for a while but isn't sustainable indefinitely.  Eventually the indebted portion of the population reaches their borrowing limits and is forced to cutback on consumption while the savers continue to try to save leading to a drop in demand.  This looks to me a lot like conditions before and after the crisis point. 

Krugman has two main ideas for improving the economy, pushing up the inflation rate and a temporary deficit financed surge in government spending.  Both seem politically difficult at present which in my view is just as well as I find them uncongenial.

The rationale for increasing inflation is that this would allow additional cuts in the real interest rate (which is currently constrained by the inability to reduce nominal interest rates below zero, "the zero bound").  But I am unconvinced that any benefits would exceed the costs.  Krugman suggests a relatively benign sounding increase from 2% to 4% but it is unclear why this would be enough to have a significant effect.  Perhaps an increase to say 12% would be needed which sounds a lot less benign.  In any case, as Krugman acknowledges, an increase in the inflation rate also has large distributional consequences favoring debtors at the expense of  savers.  So having a lot of savings myself I am not inclined to support increased inflation.

The rational for increasing government spending is to increase overall demand encouraging businesses to expand.  I don't doubt it would have some such effects in the short run but am less convinced they would be sustainable.  As noted above while Krugman believes temporary deficits would be sufficient to push the economy into a more favorable equilibrium I am not convinced.   A political issue is what to spend the money on, there aren't that many uncontroversial and clearly temporary projects for the government to fund.  Krugman points out that crisis imposed budget problems led state and local governments to lay off many workers (deepening the crisis) and argues that this could have been prevented by increased federal aid to local governments.  But while this might have been a good idea several years ago it is entirely unclear that federal aid to hire all those workers back is a good idea now. There are other problems, some of the increased demand will be reflected in increased imports.  This could significantly reduced any benefits to the US economy.  US policy cannot really be evaluated in terms of purely domestic effects. 

Krugman also discusses Europe's troubles.  He attributes many of them to the formation of Euro zone with which I agree, the Euro was clearly a mistake.  But it is unclear how to fix things, as Krugman states unraveling the Euro would be very costly but there are also serious problems with keeping it as it forces an inappropriate uniformity of policy throughout the Euro zone.

In summary this book is a reasonable explication of conventional liberal thought about the economy.  However it is not all that original, I didn't find it to offer a lot of fresh ideas which I hadn't encountered before.  Another issue is the political discussion (which speculates about the outcome of the 2012 elections) is a bit dated.  Nevertheless it is reasonable introduction to the issues from a liberal point of view.

Housing markets

One of the Congressmen I find most irritating, Barney Frank, was in the news yesterday continuing to spout nonsense about the housing market:

“We’ve already abolished Fannie and Freddie,” he said, referring to the government takeover. “Yes, we waited too long to fix it. But the money is not being lost by anything they are doing now.”

This is simply wrong. As the article acknowledges the government is propping up the housing market by providing subsidized mortgages. But subsidized is just another way of saying money losing. Perhaps under the circumstances there is something to be said for this policy (although I oppose it). But pretending it is not costing the government money is dishonest. And they haven't "fixed" anything.

Also it is easy to underestimate the perverse effects of government subsidies. I might currently be in the market for a house but I am reluctant to enter a market in which I would be competing with people playing with government money, no money down government backed loans that they can easily walk away from if prices move against them.

Labor markets

Matthew Yglesias writing about how more education can reduce the wage gap between skilled and unskilled workers by increasing the supply of skilled workers and decreasing the supply of unskilled workers:

There are a lot of things going on here, but one point to keep in mind is that progress in educational attainment is generally beneficial not just beneficial to the people who get the extra education. Insofar as more Finnish people acquire skills and learn to be cell phone company executives or furniture designers or Finnair pilots that’s (a) more income to be spent on goods and services produced by lower-skilled people and (b) fewer lower-skilled people to compete for those jobs. Consequently, the Finnish people who don’t upgrade their skills also benefit from the fact that other Finnish people have been upgrading. Consequently, the great expansion in educational opportunities in the 1870-1970 era helped produce prosperity even for people like Connie Freeman’s dad who didn’t necessarily personally acquire a great deal of education.


This makes a certain amount of sense. But of course when it comes to the effects of immigration on wages Yglesias no longer believes in the negative effects of increased supply predicted by simple models (or perceived by those directly affected).

Libertarians

People sometimes mistake me for a libertarian. This is not the case. Like libertarians I value individual freedom. So in cases where increasing individual freedom does not impose unreasonable costs I will tend to agree with the libertarian position. However I am more likely than libertarians to see trade offs between individual freedom and other values. Both because I give greater weight to other values (such as order) and because I have a different (and in my view more realistic) picture of how the world works. So I don't oppose all restrictions on the market. As I indicated here I don't believe people have some sort of natural right to prey upon the stupid and I support reasonable measures to prevent them from doing so.

These thoughts were prompted in part by this post by Tyler Cowen in which he compares restrictions on high interest lending to restrictions on gay sex. In my view this is an example of the folly to which excessive devotion to libertarian principles can lead. There are in fact good reasons for regulating business transactions more heavily than the same actions in a non-commercial setting. And in fact we ban commercial gay sex (prostitution) entirely.

So I don't think loose usury limits are a major imposition on my freedom. And if they prevent some bad credit risks from getting loans? Well if I recall correctly Adam Smith thought this was a feature not a bug and I am not convinced he was wrong.

Progressive consumption taxes

According to Matthew Yglesias:

In terms of reform it, the frustrating thing is that everyone agrees that it would be better to have a progressive consumption tax than a progressive income tax. And yet, nobody does this and there’s no sign of a political move to do it. So if there were to be a major political push toward reforming the tax code, why not reform it all the way?

This sounds good (and would benefit misers like me greatly) but there is a problem. There is a quite plausible case that the root cause of our current difficulties is that people are trying to save too much. This can cause cuts in production (and layoffs) because people do not want to currently consume all that the economy is capable of producing. Or it can cause asset price bubbles and bad loans as the amount of savings exceeds the amount of worthwhile investment opportunities. If so a progressive consumption tax would just make things worse.

Stock market returns

Lately Felix Salmon has been arguing against investing in stocks. Some of his arguments make sense, others not so much. Here for example Salmon claims in part:

A lot of people like investing in stocks because the stock market has, in the US, and over the past couple of generations, managed to outperform GDP growth. But that’s not sustainable over the long term. ...

This is one of those assertions which is superficially plausible but falls apart when you start to think about it. Consider for example a steady state economy where GDP is not growing. Does this mean stocks would have to return nothing? I don't see why. Stocks could pay say a 3% annual dividend while not increasing in value. Thus returning 3% a year. Which is more than zero.

Value creation

In my mortgage math post, I claimed that:

... The main incentive for making financial products complicated is to make them hard to value and thus easier to sell for more than they are worth. ...

A commenter responded in part:

Maybe I've just bought into the hype, but I was under the impression that, at least in some cases, the complex, derivative whole can be more than the sum of its simple, nonderivative parts, because different investors, due to their different circumstances, differ in their valuation of the derivative pieces.

I am not claiming that complexity never adds value (or that it is theoretically impossible or anything like that) just that in practice the apparent value added often turns out to have been illusory. And that this was the case for the mortgage backed securities that recently proved so problematic.

Now obviously these products were being created because they could be sold for more than their cost. Cost being the amount required to purchase the underlying mortgages plus the fees and overhead required to create and sell the derivative securities. So investors in these securities did think value was being created. But they were mistaken. The buyers were relying on the credit ratings of the securities and these ratings were optimistic. This is not too surprising. The people creating these securities could test a million different ways of reassigning cash flows to create derivative securities, examine the resulting ratings (they had access to the rating company software) and pick the assignment that gave the highest combined value to the derivative securities created. Now if the ratings had been perfect this would not have been a problem but of course the ratings were far from perfect and this procedure found the cases where the ratings were most inflated (whether from model flaws or actual bugs in the software). The security buyers didn't adequately discount for this effect and thus overpaid. I believe any actual value created was generally less than the extra overhead costs so that these securities had little real reason to exist and will largely disappear now that buyers are more wary.

Another related problem with these products is that they turned out to have no effective defense against fraud in and/or misrepresentation of the underlying mortgages. The mortgage brokers who arranged the mortgages had no incentive to see that the buyer's income and credit rating and the appraised value and sales price of the property were accurately reported since the more inflated these values were the more they could resell the mortgage for. And the resale price directly impacted the broker's income since they could give a mortgage for $200000, resell it for $220000 (if the buyer's monthly payment would actually have supported the larger mortgage in the current mortgage market) and pocket the $20000 difference. Again the rating agencies and buyers relying on the ratings didn't adequately allow for this effect which got steadily worse as underwriting standards completely collapsed during the housing bubble. Of course this could have been a problem with simple mortgage pools as well but I believe the greater distance between the ultimate buyer and the underlying mortgages made things worse.

Mortgage math

Matthew Yglesias discusses a simplified model of mortgage based structured financial products (CDOs and CDOs2) posted by Alex Tabarrok taken from a book by Robert Pozen. The model shows how structured finance can transform a collection of moderately risky mortgages into securities some of which are intended to be quite safe and others of which are intended to be quite risky by assigning defaults to the risky securities first. Not surprisingly if defaults turn out to be higher than expected some of the "safe" securities can prove risky.

Yglesias says "Importantly, this is not a scam. The math really checks out. ...". The math may check out but I think it is largely besides the point and these products were essentially scams. The main incentive for making financial products complicated is to make them hard to value and thus easier to sell for more than they are worth. Here the optimistic model assumptions which led to these securities being overvalued were not some unfortunate accident but a necessary part of the scheme. There is in fact no compelling reason to reassign the risk of defaults in this way. So if the complicated structured finance securities were valued correctly they would not be worth more than simple pools of their component mortgages meaning there would be no incentive to create them.