Summing it up...

The Republicans: Give me $1,000 or I'll burn our own house down. Why won't you negotiate?! Why won't you offer $500?!

The traditional media: Both sides are equally at fault (always, the facts are irrelevant); the Democrats should "negotiate".

Personal finance education can be good, but is typically poor

Eminent Chicago behavioural economist Richard Thaler wrote Saturday on the poor effectiveness of typical personal finance education, "It would be premature to conclude that all efforts at improving financial literacy are futile. But it is a fair conclusion that simply doing more of the training commonly used now will not produce significant results. So what else might we try?"

I have long written that the vast majority of personal finance education is very poor, and I've been teaching it at the University of Arizona continuously since 2005. The great Harvard financial distress expert Elizabeth Warren has written the same thing. Below is a quote from her seminal personal finance book, "All Your Worth". I believe "All Your Worth" gave birth to good modern American personal finance, and I've assigned it cover-to-cover since it first came out in 2005. But, sadly, I'm one of the only personal finance instructors in the country to use that book, or even the core Balanced Money Plan in it. Here's the quote:

The Two Income Trap did more than raise some public policy issues; it touched a raw nerve. We would be going about our business, and then, out of the blue, someone – a neighbor, a caller to a radio program, a mom dropping off her son at preschool – would pause and say quietly, “You’re not just talking about money, you know. You’re describing my entire life.” And then the voice would drop to an urgent whisper, “No one knows how much I worry about money. What should I do?”

Of course, we gave the best answer we could. But how much could we really say in the grocery store checkout line or in the 90 seconds allowed to a radio caller? Over time, those conversations began to haunt us. Whenever we had a quiet moment, we would think about the people who had asked us for help. Sure, America needs policy changes, and in time maybe we’ll get some laws that make more sense. But in the meantime, what should people do?

At first we thought the answer would be really easy – just find a couple of good books we could recommend. So we started looking for a great book that would help ordinary people get control of their money.

And we looked.

And looked.

Everywhere we went we found pretty much the same thing. Plenty of books on the difference between bull and bear markets, and lots of tips on how to find a great deal in potato futures. In other words, we found oodles of advice for people who are financially secure and just want to make a little more money. But what about people who aren’t so secure? What about the people who stopped us in the grocery store, the mothers at the preschool, and the guys at Home Depot? Where was the advice for them?

It didn’t exist, so we developed All Your Worth. (pages 6-7)

In 2009, I was asked to do a chapter review for the Springer book, "Consumer Knowledge and Financial Decisions" (2012). In it, I wrote about the terrible state of personal finance education, and what would constitute good effective personal finance education. I agree with all the suggestions Professor Thaler offered in his op-ed, and long incorporated them into my courses, as did Professor Warren in her book. To show you that I've thought this for a long time, I'm going to print an excerpt from that chapter review verbatim, as it was in 2009, with no modification, even though for a post like this, rather than a specific reply to a chapter, I'd like to modify and improve it, and I'd like to add what I've learned in the last four years. But, I'll have more posts on this. For now, as I wrote it in 2009:

4) Personal Finance is taught very poorly today – Now we get to the biggest issue: For the vast majority of personal finance textbooks, popular books, courses, and materials I have seen (and that's a lot), even if you learned it 100%, it would improve your personal financial success very little, and it would decrease your odds of personal financial distress, or ruin, very little.

It's just full of trivia, vagueness, things of little value to personal financial success, and avoiding personal financial distress or ruin, and vague, poor, or even dangerous advice. I think this is partly due to the fact that good personal finance has changed greatly over the last generation or two but what is taught has changed little.

America is far riskier and more dangerous financially than in the past: 

-- Regulation a generation ago prevented very dangerous tricks and traps. 

--Excessive prestige/positional arms races were prevented by bank regulation leading to strict lending limits for homes, cars, etc.  

--The social safety net was stronger, and employment was much more secure.  

--There was usually a second earner in reserve in case the husband lost his job. A stay at home wife could also care for the ill, with no family income loss.  

--Medical insurance was far cheaper, and far more secure. In addition, the co-pays and deductibles were far lower.  

--Most people had guaranteed pensions, not voluntary, you invest, 401Ks, or nothing.

 and more 

As a result, advice like, just clip coupons and eat less steak, worked in the past because it was not possible to grossly overspend on large fixed expenses, and financial life was much more secure. You could teach trivia and little things then, and it didn't matter nearly as much as it does today.

This is also, by and large, the opinion of Harvard bankruptcy and personal finance expert Elizabeth Warren. Professor Warren writes in her 2005 book "All Your Worth" (which I think is by far the best personal finance book available today, and which I assign to my students cover-to-cover):

The Two Income Trap did more than raise some public policy issues; it touched a raw nerve. We would be going about our business, and then, out of the blue, someone – a neighbor, a caller to a radio program, a mom dropping off her son at preschool – would pause and say quietly, “You’re not just talking about money, you know. You’re describing my entire life.” And then the voice would drop to an urgent whisper, “No one knows how much I worry about money. What should I do?”

Of course, we gave the best answer we could. But how much could we really say in the grocery store checkout line or in the 90 seconds allowed to a radio caller? Over time, those conversations began to haunt us. Whenever we had a quiet moment, we would think about the people who had asked us for help. Sure, America needs policy changes, and in time maybe we’ll get some laws that make more sense. But in the meantime, what should people do?

At first we thought the answer would be really easy – just find a couple of good books we could recommend. So we started looking for a great book that would help ordinary people get control of their money.

And we looked.

And looked.

Everywhere we went we found pretty much the same thing. Plenty of books on the difference between bull and bear markets, and lots of tips on how to find a great deal in potato futures. In other words, we found oodles of advice for people who are financially secure and just want to make a little more money. But what about people who aren’t so secure? What about the people who stopped us in the grocery store, the mothers at the preschool, and the guys at Home Depot? Where was the advice for them?

It didn’t exist, so we developed All Your Worth. (pages 6-7)

To illustrate why I think personal finance education is so poor today, I'm going to list what I think are the most important things that should be taught in personal finance. Then, I will show how poorly the widely used Jump Start survey/exam tests for those things.

Most Important

i. Budgeting – Fixed costs less than 50% of after tax pay, savings at least 20% (Harvard professor Elizabeth Warren's Balanced Money Plan in her book, "All Your Worth")

ii. Counting the dollars is far more important than counting the pennies – For the vast majority of people clipping coupons and cutting back on the lattes won't come close to making up for overspending on home and vehicles. The big expenses have got to be taken care of first and foremost. This is the largest problem in personal finance today. Family fixed expenses have gone from an average of 54% of after tax income in 1972 (with a potential second earner housewife typically in reserve) to 75% even with two earners (Warren, 2007). This leaves only 25% that can be cut back quickly to weather a job loss or other crisis without resorting to destroying savings and then possible a debt spiral (my play on the accounting term death spiral). With fixed expenses (including basic food, all fixed expenses) instead at 50% or less, a family could probably just cut back on discretionary expenses and get by on the other spouses income and unemployment without touching savings. The destruction of savings and a debt spiral is unlikely.

iii. Understanding and Handling Well Positional/Context/Prestige externalities

iv. Investing – Well diversified stock portfolio like Wilshire 5000 for money you won't need for at least 10 years, and won't need a lot for at least 20, TIPS, dangers of non-government backed bonds, inflation danger of long term bonds even if they are government backed, paying off mortgage faster a great safe investment, no home equity loans, making sure you have enough safe liquid money.

v. Real Estate – How much to spend on a home, thinking of it as an expense, not an investment, avoiding bubbles, avoiding mortgage and other traps, when to buy, when to rent, the breakeven period for home buying and selling costs, when to wait longer and keep renting for a larger down payment, better credit, and therefore a much lower mortgage rate, all of the costs of a home, not just the mortgage payment, a small apartment will allow more wealth creation than a large house if the savings from rent being less than the mortgage payment, from not having a downpayment, from not paying for maintenance, etc. is put into savings like a Wilshire 5000 type fund and TIPS, the average home price appreciation is less than inflation when including maintenance, insurance, etc., and so on.

vi. The exponential growth of compound return, and the power of saving – The curve is ski sloped shaped, not a straight line, so great wealth can be amassed over the long run with just steady moderate saving. How this power can work against you when taking out debt.

vii. The biggest and most dangerous tricks and traps: Private student loans, home equity loans, extreme sub-prime mortgages, the most exorbitant and dangerous for profit schools, fringe economy businesses/services/scams, etc.

viii. Diversification – Not just in stocks, also as a general concept, diversifying with a paid for home, with not having most or all savings in a small business 401K, which unfortunately have little government protection, with having no debt, with flexibility and good relationships with family and friends, etc.

ix. Education and careers – The value of a college degree, the value of training, that it's not just about money, with good personal financial practice you can be financially secure and much happier in a lower paying career that you enjoy more, than you would be in a higher paying career that you enjoy less, or in a career whose hours allowed little of a family or personal life, the volatility of career pay today so be careful about raising your expenses automatically in proportion to pay increases, researching the careers you're interested in.

x. Bankruptcy – It's something that's important to know and consider in today's far less secure world. It can prevent a lifetime of constant financial distress and oppression, and having poverty and suffering linger unnecessarily for many years or decades, the purpose of bankruptcy, why the founding fathers made sure to put it right in the constitution.

xi. Handling crises well and understanding that in today's far less secure America, they are not that unlikely to occur in your lifetime – Knowing how to handle crises well can prevent destroying all savings, and after that a debt spiral. Don't wait until you exhaust your savings and have resorted to debt if you're unemployed, etc., instead act very early and proactively in the crisis, slash expenses, move in with your parents, etc., very quickly, do not cash out home equity and retirement accounts if it looks like medical bills, or any crisis, will lead to bankruptcy anyway, instead declare bankruptcy before cashing out those things as you can keep most or all of them in bankruptcy.

xii. Insurance – Health, term life, liability, disability if reasonable (which is often), the concept of insurance; it's a negative average return, so only for catastrophic, or very difficult, losses.

xiii. The fact that good personal finance has changed greatly over the last generation or two so be careful of the older advice – America is far riskier and more dangerous financially than in the past when regulation prevented very dangerous tricks and traps, excessive prestige/positional arms races were prevented by bank regulation leading to strict lending limits for homes, cars, etc., the social safety net was much stronger, employment was much more secure, and there was usually a second earner in reserve in case the husband lost his job, a stay at home wife could also care for the ill with no family income loss, medical insurance was far cheaper and far more secure, in addition the co-pays and deductibles were far lower, most people had guaranteed pensions, not voluntary, you invest, 401Ks, or nothing, and so on. As a result, advice like, just clip coupons and eat less steak, worked in the past because it was not possible to grossly overspend on large fixed expenses, and financial life was much more secure.

Next Most Important

i. The importance of good relationships and handling money issues with loved ones well – Good cooperation and coordination is valuable for the personal financial success of couples. Divorce can be devastating to one's personal finances (of course sometimes people are just not compatible, or a spouse is abusive). It's far more expensive for two people to live separately than together. In addition, diversification is decreased greatly when we live singly, and when we don't have close friends and loved ones who can help us weather crises; being able to move back in with parents, and have it be mutually enjoyable, can be extremely valuable for weathering unemployment and other crisis without destroying all savings and/or beginning a debt spiral.

ii. The importance of good nutrition, fitness, and other health and safety practices to personal financial success – Illness, which includes accidents, is the number one cause of bankruptcy. Better health means better and more secure employment. Smoking can cost as much, or more, than transportation in cigarette purchase costs alone. Poor driving can lead to thousands of dollars per year in ticket and excess insurance costs, and it can lead to an accident whose medical bills and lost work can easily bankrupt you even with health insurance; it can cause you to miss so much work that you lose your job, and it can leave you with a permanent disability.

iii. The how much to work after childbirth decision – Do you, or do you not, really make much or any more money working after childbirth when considering everything, daycare costs, extra transportation, eating out more, taxes, etc. At the same time, there is a danger for a woman staying out of the workforce for many years; her earning power stagnates, or declines, when it might have increased greatly over five, ten, or more years. If a divorce occurs, she may be in trouble financially with little earning power.

iv. Great enjoyment of life with little or no money – Sports, bridge, chess, and other games, many hobbies, nature, reading, music, learning an instrument/creating music, with a $300 electronic keyboard you can play almost any instrument, and the keyboard will have a built-in recording studio; it should also last for decades, social connectedness and romance, family memberships at tennis/recreation clubs can be inexpensive, and more.

v. How to be a smart shopper in general, especially for the big items – The importance of smart comparison shopping; it's especially worth your time for the large items, home, mortgage, vehicles, childcare, insurance, the great saving power of buying used, especially with cars (and how to buy and maintain used cars well), and furniture, but also many other things, especially in the eBay, craigslist era.

Please stay tuned for more posts on this, but let me just note for now, how I, and Elizabeth Warren, advocate for simple rules of thumb, like Thaler suggests, and understanding just basic intuitions, nothing complex, long, or hard to understand and maintain in you memory, things like Professor Warren's foundational, no more than 50% of income spent on "Must-Haves" (basically fixed and necessary costs) and the short memorable intuition why (good intuition, itself, tends to be very memorable, much more so than rote), and the memorable intuition why diversification makes sense in stocks, and in general.

Positional Externalities, Culture, and Regulation vs. Taxes

The normal thinking is that pollution taxes are much more efficient than regulations. So, if you want to lower carbon – because you don't think the probability of frying your grandkids' planet has to be 100% before you take preventative action – then you put in a gas tax, rather than increase mileage standards a lot.

This way, if someone really wants to drive a ginormous truck, they can still do it, just pay a lot more to cover the cost of their increased polluting, endangering other drivers, sending money to terrorist supporting regimes, wearing the roads, using parking space, blocking other people's view,…

But as usual, this kind of analysis doesn't take into account the pink elephant of economics, positional externalities. If you just raise the gas tax, a lot of people will still buy these ginormous trucks. Then others will feel bad about buying regular size and compact trucks; they will feel a lot of pressure to just spend the money, borrow more, buy the cheap health insurance, etc., so they can buy a bigger truck, and not be the one with the tiny one (yes, we're still talking about trucks, but it's the same idea).

On the other hand, if you have a regulation that says no truck can get less than 30 mpg, unless there's a valid work reason, then no one can get a ginormous pollution machine; there's not this pressure. And also it can change public attitudes and culture when no one is driving around in these monsters. I'm old enough to remember in around 1980, when mileage standards suddenly skyrocketed and cars and engines suddenly became way smaller. It really changed the car culture. Prestige now came much more from luxury amenities and crushed velvet.

Of course, you could increase the gas tax enough to pay for not only the pollution externalities you incur on others, but also the positional externalites, the collision danger externalities, the sending money to terrorist sponsoring regimes externalities, etc. But you still don't change the culture as strongly as with a blanket regulation.

Look at World War II, where the war effort really helped give birth to the great middle class, until the recent generation of far right dominance killed it. You had a lot of rationing on things like meat, rather than just a tax. So everyone was contributing in this way. It was a community effort. Not the middle class and poor were able to eat very little meat, but the rich went right on eating steak just like they used to, war or no war, and just easily paid the tax.

And look at regulations against racism. Sure, you could have a tax on business to somehow cover the cost of racism they incur on others and society, but it would be hard to decide on what such a tax should be. And, it wouldn't do nearly as much to change the culture of racism.

I should add, though, that it's probably best to have a combination of taxes and regulation. Sometimes the polluting, or other externalities, are so varied and/or fungible, that it's most efficient to just get at the root with a root tax, and perhaps some regulation in addition, to get the best of both approaches.

The Intuition for Wallace Neutrality, Part II: Why it doesn't Work in the Real World

My first post explaining the elusive intuition behind Wallace Neutrality was well received. In particular, I was happy to see it discussed in a post on the blog of the think tank Bruegel. Bruegel is a very large and impressive organization. It was the #1 think tank in Western Europe, and the #1 international economic policy think tank in the World according to a 2012 University of Pennsylvania report. It's a project of 17 EU countries, chaired, until recently, by Mario Monti, and now by Jean-Claude Trichet.

I mention their excellent post now, in part, because reading it a second time after being away from this material for a while finally really crystalized in my mind a key intuition for why Wallace neutrality won't work in the real world – and why quantitative easing can.

The Bruegel authors wrote at the time, "Richard Serlin will have a detailed post in the next few days detailing the problems when thinking Wallace neutrality actually occurs with QE in the real world. Stay tuned." Embarrassingly, a few days became a year! But I just could never really crystalize it, and nail it down the way I wanted to. Then, after putting it down for a year and picking it up again, it all came together. So, without further ado...

Why Wallace neutrality doesn't work in the real world, and thus quantitative easing can

The intuition came when I was reading, and reflecting on, Bruegel's paraphrasing of something I had written:

Richard Serlin (HT Mark Thoma) gives the bottom line intuition of Wallace neutrality. Consider that the government buys 100 million ounces of gold in a QE. The assumption is, of perfect foresight, perfect everything investors, that over the next several years, unemployment will go down and the Fed will reverse course, and then sell all of those 100 million ounces back again. Thus, the supply of gold in 10 years will be exactly the same as if the QE had never occurred. The gold just temporarily sits in government vaults (or with government ownership papers), rather than private ones, then goes back to the private vaults – No difference at all in 10 years. So, in 10 years the supply of gold is exactly the same, so the price of gold in 10 years will be exactly the same. If the price of gold in 10 years will be exactly the same, then its price today will be exactly the same, since with prefect foresight, perfect analysis, etc. investors, the today price is just the discounted 10 years from now price.

I had gone down various roads in thinking about why the neutrality that worked in Wallace's model would not work in the real world, and I just wasn't able to really nail down any of them the way I wanted to, at least not the ones I wanted to. But thinking about this again, the idea came to me. The intuition is this:

Suppose the Fed does buy up 100 million ounces of gold in a quantitative easing. And the people who are savvy, well informed, expert, and rational know that in some years the economy will turn around, and the Fed will just sell back all of those 100 million ounces. So, in 10 years, the supply of gold will be the same as it would have been if the quantitative easing had never occurred. The ownership papers will shift from private parties to the federal government in the interim, but will be back again to private parties like they never left in 10 years. So, no fundamental change to the asset's value in 10 years.

And if no fundamental change to the asset's value in 10 years, then no fundamental change to the asset's value today, as the value today, for a financial asset with no dividends, coupons, etc., is just the discounted present value of the asset's value 10 years from now.

Now, as should be obvious – especially with gold – not all investors are savvy, well informed, expert, and rational – let alone sane! So, when the price of gold starts to go up, some of them will not sell at that higher price, even though fundamentally the price should not go higher; nothing has changed about the long run, or 10 year, price of gold.

In the Wallace model, and commonly in financial economics models, no problem, arbitrage opportunity! Suppose there are investors who are less than perfectly expert, knowledgeable, and rational – or way less – and they don't sell when the government buys up the price a little. Who cares. It just takes one expert knowledgeable investor to recognize that there's an arbitrage opportunity when the price of gold goes up merely because the government is buying it in a QE, and he'll milk it ceaselessly until the price is all the way back down again and the arbitrage disappears.

What's the arbitrage? Well, we're pretending we live in the world of Wallace's model (and many models like it). Markets are 100% complete and frictionless. If the price of gold goes up by even one cent, when there's no change in its fundamental value, that is when there's no change in its payoffs in the various states ten years from now, then an investor can, first, synthetically construct and buy from the primitive and/or other assets in the market a combination that has the same exact payoff as gold in any possible state of the world ten years from now.

At the same time as the investor purchases this synthetic gold, he sells, or sells short, the natural gold.

Because we're assuming that the markets at the start of this QE are efficient, an ounce of the synthetic gold portfolio sells for the same as an ounce of the natural gold. But once the natural gold goes up by even one cent, arbitrage! That single expert informed investor sells (or sells short) the natural gold and buys the synthetic gold. And he does this for as many ounces, without limit, as it takes to bring back down the price of gold to where it was, undoing the government's QE 100%, no matter how large it was, no matter how many trillions the government spent.

Now, for this to work as advertised, first you need 100% complete markets, so you must have a primitive asset (or be able to synthetically construct one) for every possible state at every possible time in the world.

[using Chandler Bing voice] Have you seeeen our world? The number of states just one minute from now is basically infinite. Even the number of significant finitized states over the next day, let alone a path of years, is so large, it's for all intents and purposes infinite. Thus, try to construct a synthetic asset that pays off the same as gold, now and over time, and you're not going to come very close. And if you try buying it to sell gold, or vice versa, to get an "arbitrage", you're going to expose yourself to a lot of risk.

And this is a key. I think a lot of misunderstanding comes from loose use of the word "arbitrage". The textbook definition of arbitrage is a set of transactions that has zero risk, zero. It's 100% risk free. It's not low risk, as often things that are called arbitrage are. It's not 99% risk-free. It's riskless, zero. That's what makes it so powerful in models, at least one of the things.

Another one of the things that makes it so powerful in models is that it requires none of your own money. If there's an expert and informed enough investor anywhere, even just a single one, who sees it, it doesn't matter if he doesn't have two nickels to rub together, he can do it. He can borrow the money to buy the assets necessary, and at the market interest rate. Or, he can just sign the necessary contracts, for whatever amounts, no matter how big. His credit and credibility are always considered good enough.

So, if markets are incomplete, and your synthetic gold, or gold substitute, is significantly different from gold in its future payoffs, then your "arbitrage" is not an arbitrage. It's not risk free, and you – even with perfect expertise, perfect public information, perfect forsight, and perfect rationality – are going to, at most, put limited money into it. You certainly won't limitlessly put money into it for as long as it still exists, without a second thought, like you would with a real arbitrage.

Second, of course, people do have serious liquidity and credit constraints that prevent them from limitlessly jumping on an "arbitrage".

Third, in the Wallace model world, it's frictionless. There are no transactions and time costs and problems that could eat up a complicated, or ultra-complicated, arbitrage.

So, in the real world, unlike Wallace's, what you have when the government does a QE and starts pushing up the price of gold is not an arbitrage, but a good deal. You have an opportunity for an above average risk-adjusted return, an abnormal profit, if you will. And that's if you're one of the people expert and knowledgeable enough to see it, and to the extent that you have the money or credit to take advantage of it.

Well, let me say something that's fundamental here, but so often grossly not understood or appreciated:

A good deal is not an arbitrage.

It typically has nowhere near the power to move prices to their fundamental values.

Now, what you will often hear is that the market is efficient, or highly efficient. Suppose that the price of gold, or of IBM stock, is fundamentally worth some amount, and its price strays from there. It goes up by a few dollars due to the government doing a large, or vast, QE and buying it up. Well, so what if it's not a true arbitrage opportunity, it's still a good deal (to sell it, or sell it short); it's still an above average risk-adjusted return. It may be true that most investors have little finance expertise, little finance public knowledge, and little time and willingness to study and analyze individual financial assets even if they did have the expertise. But there are still a lot of big money investors and institutions that do have the expertise and knowledge, and the willingness to spend the time to use it to analyze. And those savvy investors will jump in and sell (or sell short) and sell until the price goes back down again, and it's no longer a good deal, just an average risk-adjusted deal.

Well, what are the problems with that? The usual one you hear is that savvy investors are only a small minority of all investors, and this is especially true of highly expert investors who are highly informed about a given individual asset, or even asset class. And they only have so much money. Eventually, if the government keeps buying in a QE it could exhaust their funds, their ability to counter, by, for example, selling gold they own, or selling gold they don't own short.

Even rich people and institutions only have so much money and liquidity, or credit. You can't outlast the Fed, if the Fed is truly determined. Your pockets may be very deep, but the Fed's pockets are infinite.

So, you usually hear that.

But there's another reason why the savvy marginal investor is limited in his ability and willingness to push prices back to their fundamentals that I never hear. It's a powerful and important reason: The more a savvy investor jumps on a mispriced individual asset, the more his portfolio gets undiversified, and that can quickly become dangerous and not worth it.

Gold may sell for $1,700/ounce and you think its fundamental price is $1,650, but it gets very risky, very fast, to put 10%, 20%, 30% of your wealth in gold, and the price is still only up to $1,651. What do you say then? It's still only $1,651, and it's fundamental value is $1,700, I'll put more in? What if you put 80% of your money into gold, and the price is still only up to $1,652? Put in 100%? What if the price is even then still only up to $1,653? What do you do next? Say, hey, it's still only $1,653, and it's fundamental value is $1,700, so I'll start borrowing money to buy gold?

Obviously not. Gold is a good price at $1,650, an above average risk-adjusted return, when put in a portfolio in the appropriate diversified proportion, which in the CAPM would be the market weight. But as you add more than that weight, your portfolio becomes unbalanced, and any additional gold becomes worth less to you, and very quickly.

Let me be very clear on this powerful idea. It got me a letter published in The Economists' Voice, an outstanding economics and policy journal, whose chief editor is Joseph Stiglitz. The key quote from that letter is here:

...One reason which was missing, at least explicitly, and which I have not seen yet in the literature, at least explicitly, is that a smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the wealth invested in the market—they may not be able to come close to pushing prices to the efficient level.

So, taking the gold example, suppose the government goes in and starts buying up gold big time and pushing its price up. As you can imagine, lots of gold owners are of the Fox News, and, shall we say, not so expert, variety, and aren't even going to think of selling their precious gold if it goes up by 10, 20, 30%. In fact, that will probably make them want to buy more! But, a lot of savvy expert investors will sell what they have, and even sell some short, but they will start taking on a lot of unbalanced risk as they start doing this in earnest, and the government can outlast them and keep the price up.

And likewise with any asset, or asset class, that the Fed decides to attack in earnest with a QE.

The bottom line is that unlike in Wallace's model, an arbitrage will not be created, only a good deal, something very different. And while the government can't overwhelm even a single savvy investor, without even two nickels to rub together, with an arbitrage, the government can overwhelm all of the savvy marginal investors when there's just a good deal created.

I don't think this (multipart) reason is the only reason why Wallace neutrality won't hold, and QE can work, in the real world, but it's a big whopping one. So I think at some point, at least, QE would have a large effect, albeit the QE might have to be much larger than anything ever attempted.

One last note: Individual assets that the fed may buy in a QE may sometimes have pretty close substitutes, but with the unlimited buying power of the Fed, they can buy up large percentages of not just the individual assets, but of the close substitutes to the individual assets too! So, in another words, they can buy up and move the demand curve for whole classes of assets, close substitutes and all.

The Intuition Behind Simsek's, "Speculation and Risk Sharing with New Financial Assets"

Mark Thoma guides us to an article about a very interesting new finance paper by MIT economist Alp Simsek, “Speculation and Risk Sharing with New Financial Assets” .

If I might take a stab at the intuition:

Suppose you have a world with just two underlying assets, A and B, which are highly negatively correlated.

And there's only one security people can buy. It's 1/2 A and 1/2 B. So everyone has just this security in their portfolios.

Now suppose the financial system becomes more sophisticated, so people can now choose from three securities: Just A, Just B, and 1/2 A and 1/2 B.

If there are sharp disagreements in beliefs about the assets A and B, everyone might go from a portfolio of just 1/2 A and 1/2 B, to a portfolio of either only A, or of only B. So, the average risk of people's portfolios would go up greatly; total risk in the economy would go up greatly; diversification would go down greatly.

Essentially, the more you give people options and ease to gamble based on strong and differing beliefs, the more they will drop some of their diversification and go in and gamble against the people with sharply differing beliefs, like in a winner-take-all-tournament. As Simsek says in the article, “as you increase assets [what I call securities above], this speculative part [of risk] always goes up.”

In Praise of the 15-Year Fixed Mortgage -- as Opposed to the 30

Recently there's been talk in praise of the 30-year fixed mortgage.

I teach one of the largest personal finance courses in the country at the University of Arizona and am president and founder of National Personal Finance Education, one the largest licensed providers of a personal finance course required for people in bankruptcy.

I've thought about this a lot.

My opinion on this is that usually 30 years is too long, at least for most college graduates with a decent income. And if it's a Wal-Mart worker couple, they should be very careful about buying any home they can just barely afford with a 30 year mortgage. The focus should really be about trying to upgrade their skills and education, and especially the education of their children, so as not to be a Wal-Mart couple.

Anyone who's followed my blog knows I have a lot of sympathy for the working poor. I'm a strong advocate of not only free universal high quality pre-school, but also free universal high quality bachelor's degree, or worthwhile vocational training. I favor free universal healthcare, like Medicare for all, and a stronger safety net. But a Wal-Mart couple doesn't help themselves by creating severe financial stress to just barely be able to afford a home with a 30-year mortgage. It doesn't take anything that rare or unlikely going wrong to lead to a traumatic foreclosure. Living even in a modest house can be much more expensive than living in an apartment in a comparable neighborhood; consider the mortgage, the downpayment, maintenance, property taxes, insurance, increased furniture and utilities costs, an attitude that you should spend more with a house, and more. It would be better for the kids to live in a more affordable but decent apartment complex, and have some financial security, accumulate a cushion of thousands of dollars in the bank, and to help yourselves and your kids you focus on education, education, education.

So while I think for the working poor a 30-year mortgage may be necessary -- if it is prudent and affordable to buy the home -- usually the 15-year fixed is best for the solidly middle class and college educated (and even then it's often best to make additional payments to end it even sooner). The interest rate is lower, usually by a lot; the payments aren't that much higher (due to the lower interest rate and the surprising exponential nature of compound interest over long periods of time – Try comparing the monthly payments and see.), and it's so valuable with the country so financially insecure for families to get to no mortgage as quickly as possible. Elizabeth Warren in her seminal personal finance book, "All Your Worth", rightly stresses the great importance of getting your "Must-Haves" (basically fixed expenses) low in today's dangerous America, and having no mortgage is a great way to lower your Must-Haves. Get some solar panels (in the right area with the right tax spiffs), and now you have little or no utility bill too.

Life, especially today, gets a lot riskier as you get older. At 25 you might have super health and resilience and no dependents, and be able to live happily and healthily on nothing, eating macaroni and cheese, sleeping on a futon, and driving a beater. That becomes way harder when you're 45, with kids. And if you lose your job at 45, it will be a lot harder to find one close to as good, or good enough, with age discrimination, declining health and energy, and perhaps antiquated, or rapidly antiquating, skills. 45 is a really good time to have no mortgage payment, as opposed to not until 60.

In addition, as usual, positional/context/prestige externalities are profound and huge. When a family thinks 15-year mortgage, they are likely to buy a smaller home, not get so much wood, granite, and stainless steel, buy less large and expensive vehicles, etc. But because they get used to that level -- and don't start getting used to a higher level of position, prestige, etc., the decreased utility is not that much, and the increased security of having no mortgage right when the kids are setting off for college can be huge. And how important it is for kids to be able to go to college without having to flip burgers 20-40+ hours per week, a great advantage for graduating, GPA, and learning. And in any case, the buying a smaller home, cars, etc., can mean that total payments aren't even higher.

Interestingly, given the ginormous importance of positional externalities, if the government nudged forward 15 year mortgages, you might see people commonly owning their own homes twice as quickly with little loss of utility, as you wouldn't lose position, prestige, or context of quality if everyone else was also doing 15-year mortgages and so they also had commensurately less to buy a home with.

Of course, we'd also have to control home equity predators from undoing this.

Is maximal profit at any cost really what shareholders want?

Rajiv Sethi has a great post on the recent reprehensible behavior of Goldman Sachs.

What I'll add is this: There's the horrible argument that Goldman Sachs should do these horrible things because they should do whatever maximizes the profits of their shareholders – Sell crack, poison the streams children drink from, whatever, it must be good because invisible hand! But, of course, any trained and decent economist knows about all of the ways the pure free market and invisible hand can go horribly wrong, especially if you care about optimizing total societal utils, which I consider ridiculously more important than Pareto optimality. These ways include externalities, asymmetric, and just poor, information, monopoly power, relatively high transactions/negotiations costs, giant economies of scale, zero marginal cost idea/information goods,...

But here's something you rarely hear: Are you really optimizing shareholder utility, or doing what shareholders really want, if you do anything that maximizes profits? And the answer is often, of course not. Would the average shareholder of Goldman Sachs vote for these (and many more and far worse) horrible actions in exchange for what's sometimes just a relatively small increase in return (to their portfolio as a whole), if they had to spend the time to vote and were completely informed of what was going on, and the implications?

Many shareholders hold extremely diversified portfolios. So they can vote that none of the companies in Goldman Sach's industry do these horrible things, and thus the decrease in profits is much less than if Goldman Sachs is the only one acting ethically. And, even if it would hurt Goldman Sach's industry, it might (and very likely would) help other industries in a well diversified investor's portfolio.

And on top of that, any decrease in return would apply to everyone, and this is huge due to ginormous positional externalities. You basically don't lose prestige, position, context, due to falling behind others in wealth and consumption. Everyone's return is lowered the same amount.

Of course, the vast majority of shareholders hold only a micron of each company, and so it's not worth their time to vote, and if you own through a mutual fund, the mutual fund votes for you anyway. I've owned a piece of pretty much every company on every major exchange for years, at least through mutual funds and ETFs, but I've never voted. So, who controls tends to be rich individual major shareholders (often very greedy), pension funds, mutual funds, and other institutions and companies, and/or the managers themselves.

With regard to institutions, like pension funds and mutual funds, their managers basically consider it their fiduciary duty to vote however maximizes the dollar returns of shareholders, regardless of ethical/social issues. I was in an MBA program in the 90's and a finance Ph.D. program in the 2000's; the constant message was, a mangers duty is to do whatever maximizes shareholder wealth, or return. And I've seen a lot more evidence of this through the years in experience and study. It's a very, invisible hand, greed is good, message. The culture is very important and different from a generation or two ago. Because the policeman can't be everywhere, and the law can't cover every kind of situation and gaming that can come up, culture and norms are very important.

So, with regard to the shareholder voting of mutual funds, this quote from a 2006 Wall Street Journal article is consistent with my experience and study:

On proposals related to social issues, fund companies commonly vote against them or abstain, basing their decision on whether the measures would financially benefit shareholders.

Now, interestingly, you have the word, "commonly", as if sometimes the mutual funds do vote for social proposals. And you can see in that article that there are significant percentages of times when they do. And also here, with regard to global warming proposals. But I suspect that most of the voting for social proposals is for profit reasons, to protect the name of the corporation and its brands, something Apple may be making a mistake in not worrying about more (but remember, the managers may be long gone, with their huge bonuses, before the long term price is really paid). Of course, the argument that corporations will always be forced to act ethically to protect their reputation is very wrong. Amongst other problems, often the vast majority of the public won't know what's going on, and often the profits will outweigh the bad publicity, such as it gets known.

But the bottom line is that, the shareholders only care about money at any cost, greed is good, invisible hand, message is wrong, and the change in our corporate culture towards this has been extremely harmful. Maximal profit at any cost is not always what the average shareholder wants, even weighted by shares owned. The average shareholder, even weighted by shares owned, is often very willing to have a slightly lower return on his total portfolio to have his companies not doing horrible things.