Economic Pet Peeves

My biggest pet peeve in economics is The Wealth of Nations by Adam Smith and specifically the “Invisible Hand” theory. I live by The Wealth of Nations but economists are driving me nuts.

To start with The Wealth of Nations which I am betting it is by far the most quoted book/literature in economics and is not even read by the vast majority of economists. By read I mean cover to cover not I skimmed it or I just read one of the five “books”. I have been reading the book for years now and it has taken me years due to the vast amount of pages, the depth of the concepts, and the lack of my personal free time. I have been told by PhD students, Professors, students, and economists that The Wealth of Nations is a good book which I agree with but then they miss quote portions of it just to prove a point. You can’t just take a sentence out of the book with no context and then think somehow this proves your point. I view it as the bible of economics and that being said it has been miss quoted just as much as the Bible. If you haven’t read the book, please don’t quote it and then think you have made a point. The book is written in Old English (published in 1776) which again adds to the complexity of understanding the material.

For the modern economist who thinks that the economy is like a house cat you must not understand Adam Smith or you don’t believe in the foundation that Adam Smith has created. If you don’t believe in Adam Smith’s principles please state that before you speak and announce that you are an economist as if it validates you. If I know you don’t agree with Adam Smith than at least I can understand that you have a different train of thought which I can respect. Now back to the house cat; modern economists think that the economy is like a feral cat that has been domesticated by their fancy econometrics. The Invisible Hand theory states that the economy allocates assets (being money, labor, or anything of value) the most efficient way possible. Now you have the modern economist who steps in and decides that having lower GDP is bad, poverty is a problem we must solve, and the list goes on with issues that economists feel they can solve with econometrics. The economists use econometrics to look for patterns in market data and then figure out how to adjust a variable to coerce people and the economy to adjust in a way that will “fix” their cause. The problem I have is that the economy is a wild beast that can’t and shouldn’t be tamed. Somehow the economists think they are God and think they know better than the Invisible Hand which is the economy. No human can ever out do the markets and no human should try to interfere with the markets to push their cause.

An example of the feral cat is the long list of financial crisis we continue to have and will continue to have. The economists on their ivory towers dictate governmental policy to help push their causes and agendas. Then when the cat attacks them they act surprised and can’t understand why the cat that they thought they tamed attacked. After these crisis (typically financial) the economists all get together and brainstorm why it happened. They then write books on these crisis and give ways on how next time they will tame the economy using new and better methods. Why can’t economists realize that the economy has allocated assets due to the efficient equilibrium? Every time you push it in the direction you want it fights back and makes a market correction. The Invisible Hand principle that the modern economists say they believe is being contradicted every time they try to manipulate the economy. The modern economist is ignorant if he claims to believe in the Invisible Hand and then manipulates the markets in an attempt to please the public.

In conclusion, if you are going to preach economics and use The Wealth of Nations make sure you understand what you are talking about before you preach it. If you ask me a question and I don’t know, I will either tell you I don’t know or I will voice it as it is my opinion. Just be honest!

Market Interpretation: June 2013

    Over the past six months the market has been rising and I have read a lot of article on why people think this is happening. Some analyst think this is an over reaction to good news and that the market is going to take a big hit soon as a corrective measure. As a note, today the market is down about 0.80%. This view of how the market is over valued is completely wrong for many reason.

    Analyst are looking at market GDP as an indicator of the stock market which is very flawed. This flaw is due to the Keynesian thought process which is wrong in more ways than I would like to talk about in this post. The reason the market took a hit today is because the market didn't add as many jobs in the private sector as the analyst predicted (http://www.latimes.com/business/money/la-fi-mo-adp-jobs-economy-20130605,0,2964130.story). This argument of unemployment is why some analyst have been predicting that markets have over reacted to good news and that the markets will correct downward. The problem is these analyst haven't been looking at corporations at a micro level and then figuring out how this effects the market and the economy.

    The real reason that the market has had an upward trend is due to increased productivity. Increased productivity leads to an increase in GDP and many other measures but it is important to note that productivity is far more important than GDP. Since the credit crisis many people were laid off meaning that unemployment has gone up. These companies first took a hit since people didn't have money to spend. As the market started to recover and many Americans started to increase spending regardless of employment due to the stimulus and social programs. These companies started to streamline their processes and got more efficient since they had fewer employees and an increase in output. Basically these companies have learned to run their business with less employees which has led to an increase in productivity. Productivity meaning that the ratio of employees to units produced as decreased.

    This increase in productivity has led to the need for less employees which means unemployment rates will remain high. The unemployment rates will change once the demand for goods and services grows enough to employee these people or until companies get lazy again and become more inefficient. The bottom line is that companies are reducing costs in comparison with revenue which is leading to higher returns on their stock. Since many companies are experiencing this trend it is making the market or at least the indexes such as the S&P 500 increase as a whole. The market will fluctuate over time but the long-run (the next 1-2 years) will have good returns unless more manipulation on behalf of the government we currently have forces companies to make inefficient decisions.

    As a side note many people are predicting another market crisis in the next 5 to 10 years which I would agree with as long as the government and Keynesian ideas continue to dominate. This upcoming crash will be due to poor policy and over regulation which has been the causes of most if not all of our financial crisis.

The Psychology Behind Student Debt

            Student debt is a growing concern among Americans as we have now pasted a trillion dollars nation-wide. Student debt isn’t always needed and higher education is not always worth the cost but I will cover higher education issues in another post. The issue at hand is how to make smart decisions on how to repay the loans. The one decision that I would like to cover is investing.

            I have heard from many people including financial planners who recommend making investments as a way to save for one’s retirement. I agree that retirement is an important goal to look towards but there is a psychological pitfall by investing while having student debt. Many people feel that investing now will make you millions of dollars and that is far more than your student loans. This is wrong.

            Students should be looking at the returns not the total “expected" amount. A Federal Stafford loan has an interest rate of 6.8% and a Federal Graduate Plus loan has a rate of 7.9%. There are also Federal Perkin loans which have a 5% interest rate and private loans which can have lower rates as long as you have good credit. Private loans offer little or no repayment options. Most students will have a rate between 6.8% - 7.9%. Now it is crucial to understand that debt (loans) are the same as an inverse investment since you will have cash outflows instead of expected cash inflows. For comparison, a 10 year bond (the same maturity as a Federal student loan) today is yielding 2.14% (risk-free rate). The average stock return is about 8% over the long-run.

            Now you can clearly see that borrowing money at any of the rates above and receiving returns at the risk-free rate yields a negative return (2.14 – 6.8 = -4.66%). Now there is the option of investing in stocks with the assumption that you will get 8%. The 8% however is risky and the additional 5.86% is compensation for taking the risk. The 8% return is an assumption that an individual holds the market portfolio over a very long period. Holding a well-diversified market portfolio is also costly in many ways which reduces the 8% return.

            A student is best off reducing their monthly expenses by paying off the debt as soon as possible. If a student has excess money it should go towards paying down the highest interest rate loan or by paying down the smallest loan and using the snow ball approach that Dave Ramsey recommends. By investing in risk-free assets you are reducing your wealth and by investing in risky assets you are exposing yourself to financial hardships and uncertain returns.

            The psychological pitfall is to assume that retirement is your end goal and offers a higher return than the cost of your college debt. The end goal for everyone should be to maximize wealth which needs to be done with the consideration of risk and return. Paying off your student loans first and then making investments once the debt is gone is the best way to maximize wealth with low risk. If you end up landing a job after college and the company matches up to a certain amount for a retirement account you should in this case make an investment since the risk/return is far better than the cost of the debt. I would however not invest any more than what they will match. The take home lesson here is to consider your debt interest rates against your investment interest rates and make sure that you maximize your returns as best as possible.