Republicans exploiting serious flaws of the press in ever more dangerous ways

With regard to Paul Krugman's September 12th colunm, Blizzard of Lies:

All of this frighteningly shows what an enormous problem the press is.

There are two big problems:

1) So many people in the press think it's their job to be equally "nice" to both sides, regardless of what the truth is. The goal should be as well as possible to convey important truths in a non-misleading way (It's not enough that what's written is literally true, if you know it will mislead a large percentage of your readers about something important, and you are very capable of writing it in a way that won't mislead), and an accurate way. Until there's a change in press culture and morays greatly towards this, there will be serious problems, and the country will be at great risk of making disastrous decisions like we did in the 2000 and 2004 presidential elections.

2) There are enormous positive externalities to serious quality news reporting. Thus, we can greatly increase welfare and efficiency by subsidizing it, for example with a well constructed program like the investment tax credit for serious investigative reporting. Without subsidizing it, corporate organizations will have an extremely strong incentive to only do what maximizes profit which is a great deal of fluff and sensational reporting and relatively little serious and expensive investigation and analysis. Just look at what's happening at the Los Angeles Times right now. The world is a lot more complicated than it was in 1810, the primitive time Republicans want to take us back to (you know, the good old days, when people fended for themselves, average life expectancy was under 40, and those who were old were by far the largest group in poverty). A big problem with the press today is that they have to report on complicated economics and science when they majored in journalism -- and on very short deadlines. They really need large staffs of in-house experts in economics and science who can work closely with them on their articles, but profit-wise this is a money loser, and won't happen if we leave it to the pure free market. The enormous positive externalities from these things have to be subsidized or we're at much greater risk of more George W. Bushes. The costs of not addressing these externalities are absolutely enormous.

Why does the equity premium puzzle literature seem to not consider this explanation?

Second in a series: My last post is the first.

My current goal is to do very little short-term-deadline related work so I can focus flexibly on long term (maybe very long term), high return learning, research, and business projects. I have a December 15th deadline to finish up some major work for the upcoming University of Arizona Personal Finance website, but after that it's just moderate teaching. I'm not taking on anything new with restrictive short term deadlines, maybe not for many years. I'm fortunate that I have the option to do this as an adjunct professor, and, to be honest, having done well in business and investing. Most professors don't have nearly so much flexibility to optimize, but I won't go off on the good and bad of academia now.

A big thing I want to work on is why I can't find in the literature my supply (of equity) related explanation for the equity premium puzzle. I've already looked over this literature pretty well, including Brad Delong and Konstantin Magin's recent survey article, but I will eventually be combing this literature with a fine tooth comb, and if I can't find anyone else offering an explanation like this, I will be developing it, and persistently asking why it's not offered until I get a reasonable answer.

In the meantime, though, I'll add this:

The vast majority of the literature seems to assume that the return of equity equals the return of a risk free fixed asset plus a risk premium. But I think this is a specification error. It's should really include a corporate efficiency or flexibility premium, which I haven't seen:

RE = RF + RiskPrem + EfficPrem

not

RE = RF + RiskPrem

And, as I explained in my last post, the efficiency comes from the fact that with stock the firm has greater flexibility to take large projects which may make little or no money for years, which may even lose money for years, but which overall will be very high return due to long run profits. There are many areas where short run constraints (often undue ones) greatly decrease optimization. This is true of business. It's true of politics, and it's also true of academia (unfortunately, very true.).

Warren Buffet, arguably the most successful investor in history, constantly attributes his success to unusual efforts and willingness to avoid short term constraints, so that he can choose the projects, within companies he controls, and in buying stock, that offer the highest NPV (Yes, my own personal situation was an inspiration for this explanation of the equity premium puzzle.) For example, in discussing his use of insurance company funds rather than debt to finance projects, he writes in his Berkshire Hathaway statement of business principles, "...they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt — an ability to have more assets working for us — but saddle us with none of its drawbacks."

All of the explanations for the equity premium puzzle I have seen in the literature are based on the demand side; trying to find utility functions for a representative investor, and ex-ante probability distributions for returns, that would explain investors demanding such high average returns for stocks relative to bonds, rather than bidding those returns down. But I suggest a supply side explanation (not to be confused with the academically discredited "supply side economics'"). The long run supply curve for corporate stock may simply be extremely long and flat, and consistently about 5 ½ percentage points in return higher than the premium bonds supply curve, even at stock quantities as high as the entire national savings rate.

Why would this be? As I've said, I posit that stock might simply allow a firm to create more wealth with an investment dollar than bonds. And this is because of the flexibility of stock. Firms are able to invest in high return long run projects when they raise money with stock that they sometimes cannot when money is raised from bonds due to the short run constraints of having to make interest payments and satisfy bond covenants. If my supply side hypothesis is true, or true to a large enough extent, then we could expect to continue to see stock returns outperform bond returns by large margins over the long run.

A big problem with the literature is that authors typically assume that the entire economy can be represented by just one representative agent. Then, they posit a utility function for that agent and calibrate it's parameters to empirical data. They are then "puzzled" that with the risk aversion parameters they find, or with any ones that look reasonable, the representative investor doesn't bid stock returns much lower, because they appear to have much too high an expected return relative to their risk.

I say the solution to this puzzle may be that there is not just one representative investor, but clienteles. Some people are just much more risk averse than average, and they will settle for a far lower expected return even to avoid moderate risk. Others have liquidity issues. They need a short term positive return guarantee badly, because, say, they are saving for their children's college education coming up in a few years, or they just need to know that they will have the cash necessary to pay monthly expenses.

Even if this clientele is very small (in investing dollars) relative to the much less risk averse clientele that doesn't mean that the much less risk averse clientele will bid down the equity return from its lofty level, because it depends on the supply of equity too. It's not just the demand for equity. If the demand is huge but the supply can keep up, even at high equity costs in terms of average return, then the average return will not fall.

And the supply curve could be that lofty, and persistently high and flat, or even increasing, due to the presence of a great deal of constant returns to scale, increasing returns to scale, and generally promising long term projects of the type that can't be carried out nearly as well with the short term constraints that come with fixed instrument financing. Please see the graph below:

Click graph to see a clearer full size version

An explanation for the Equity Premium Puzzle that I haven't seen in the literature

With regard to Brad DeLong's September 6th post, "The U.S. Equity Premium: Past, Present, and Future":

I have an explanation for the equity premium puzzle that I haven't seen in the literature, but it seems to me to be a potentially very strong one. It's related to the supply of equity, rather than as with all of the other major explanations I have seen, the demand for equity.

It's simply because of the great decrease in restrictions on a firm's profit maximizing activity when financing with equity rather than fixed methods (bonds, bank loans, etc.), especially when it comes to high NPV projects that have payoffs far in the future, firms can create more wealth when they finance with equity, so they will therefore be willing to pay a higher expected return. Thus, graphically the supply curve for equity is simply higher than the supply curve for fixed instruments.

If the supply curve for equity is very long and flat, or even increasing, as we would expect if there were a great deal of constant and increasing returns to scale opportunities, and if it were consistently enough higher than the supply curve for fixed instruments, then this could for the most part or completely explain the puzzle of why equity returns have been so much higher than fixed instrument returns, even when adjusting for risk.

Moreover, if the equity supply curve is long and flat (or increasing) enough, then we could expect equity returns to be as good in the future as they have been over the long run in the past, or even better.

For more details, please see my working paper, "Estimate of Risk of Privatized Social Security Should be based on Far More Information than Just Historical Stock and Bond Returns", pages 3-5.

New York Times report turns out to have been incorrect. Sarah Pallin was not a member of the Alaska Independence Party.

I apologize for using the mistaken New York Times article in my last post. Here is a corrected New York Times article.

Secession? Could you imagine what they'd say if this were the Democratic Nominee!

From today's New York Times, "she [Palin] was a member for two years in the 1990s of the Alaska Independence Party, which has at times sought a vote on whether the state should secede"

Could you imagine what the Republican machine would say if the Democratic vice presidential candidate were a member for two years of a Party which has at times sought a vote on whether a state should secede!

They call you unpatriotic if you don't wear a flag lapel pin everyday, even though the trust fund babies like Bush who the party loves rarely if ever do anything hard for their country, and even though the vast majority of hard working Americans who are willing to do hard things for their country don't wear a flag pin everyday.

Yet not a peep out of them when their vice presidential candidate was for two years a member of a Party which at times sought a vote on whether a state should secede. If this were a Democratic candidate for the vice-presidency, with a 72 year old running mate who's had Melanoma, they would be screaming about treason and how the country is at risk.

Add: Just look at what is says on the Alaska Independence Party website:

The Alaskan Independence Party's goal is the vote we were entitled to in 1958, one choice from among the following four alternatives:

1) Remain a Territory.
2) Become a separate and Independent Nation.
3) Accept Commonwealth status.
4) Become a State.

The call for this vote is in furtherance of the dream of the Alaskan Independence Party's founding father, Joe Vogler, which was for Alaskans to achieve independence under a minimal government...

The Republican machine would be going insane if this were the Democratic candidate for the vice-presidency, with a 72 year old running mate who's had Melanoma. The propaganda mills would be running 24/7. They'd be calling the candidate a traitor, and I wouldn't be surprised if they would pressure the state's U.S. attorneys to go after him or her. It's breathtaking the hypocrisy.

More on tax cuts (pun intended)

Economist Jason Furman (real economist, not self-proclaimed, he has a Ph.D. in economics from Harvard and served as Special Assistant to the President for Economic Policy in the Clinton Administration.) notes that the Congressional Budget Office, the Joint Committee on Taxation (JCT), and academic researchers have found that tax cuts that are financed by borrowing, hurt the economy over the long run; please see here for more.

So in other words, tax cuts that are financed by just increasing the deficit mean more national borrowing, which lowers net national savings, and thus investment. And as any family knows, the less you save and invest, the poorer you are over the long run. Thus, the serious unbiased studies that have been done show that a dollar in tax cuts ends up costing more than a dollar over the long run, not less, if it's financed by government borrowing.

What if it's financed by cutting government programs? Well, as I wrote in my last post, many of those government programs have extremely high social returns, like alternative energy, infrastructure, education, basic scientific and medical research, etc., and are things that the free market will grossly underprovide (provide at a level far less than that which yields maximum growth and welfare) due to market imperfections that are well established and proven in economics (real, scientific academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts.

Tax cuts, on the other hand, it has been found, tend to eventually be spent, by and large, on short term consumption items of little or no productive or investment value. If you cut your spending on productive infrastructure, alternative energy, education, etc. to give big tax cuts to Paris Hilton and friends so they can buy more million dollar Ferraris, and have more nights in $50,000 hotel rooms, you end up far poorer as a nation over the long run, not richer. These things have little or no productive or investment value. They're consumption, not investment. A dollar in tax cuts ends up costing you far more than a dollar over the long run, not less, as the Republican machine would like us to believe.

What if you cut wasteful government spending? Well, that should be cut no matter what, with or without tax cuts, but history has shown that cutting of waste actually decreases -- and greatly -- when we have Republican administrations and these giant tax cuts tilted massively towards the rich. There are several reasons for this. First, Republicans dislike and disrespect government, so they put little or no effort into learning how to run it well. Second, cronyism is ingrained in the party (update: please see here.), and third, there is a culture of corruption, and this is largely necessary if Republicans are to maintain power. With positions that are so harmful to the vast majority of Americans, they need to please rich corporate and individual donors in order to raise the money necessary for large scale advertising and propaganda to mislead and distract.

So the tax cuts end up being financed by government borrowing and cutting of government programs that have high or extremely high returns. You don't get richer by "saving" money by cutting your investment in your education, your mutual fund, and your government bonds, so you can spend it on a five star vacation or a new SUV.

Finally, what about Republican claims that tax cuts will make people work more hours because it increases their pay per hour? First, people today, by and large, work so hard, and spend so little time with their families by historical standards and compared to people in other countries, that it's not at all clear that this is desirable, and it's not even physically possible to work many more hours at this point. In addition, there is a point where production is decreased from more hours, because eventually it really hurts the quality of work. People become tired and burnt out. Competence and creativity are hurt. But aside from any of this, it has been shown in economics that in fact there is little long term relationship between tax rates and work hours. For most of the 20th century real wages per hour went up greatly at the same time that hours worked dropped. There's little long term effect, and what effect there is can easily go in the other direction. Cutting taxes can decrease work hours. A key reason is the long ago established and accepted in economics, income and substitution effects, which you can find in any university microeconomics text.

The idea is this: If you raise someone's wage from $8/hour to $12, they may go from 40 hours/week to 45, because they get $4 more for giving up an hour; that's the substitution effect. But if you raise their wage from $8/hour to $1 million/hour, they will probably work like 40 hours per year! And then spend the rest of the year enjoying all of that money. That's the income effect. When you raise someone's wage per hour, they don't have to work as many hours to live in a way that they consider well. Empirically, it appears that with taxes at about their current level, the income effect becomes greater at about the middle class level, and then we get what's called a backward bend to the labor supply curve. Cornell economist Robert Frank has a nice brief New York Times Economics Scene article explaining all of this, "In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up".

A dollar spent on tax cuts costs more than a dollar over the long run, a lot more.

With regard to Mark Thoma's August 27th post, "The Whole Analysis Sounds Pretty Fishy":

So the the right wing propaganda tank, Tax Foundation, claims that tax cuts recover up to 40% of their costs through so-called dynamic effects, while Bush's own Treasury Department estimated less than 10%.

Even if it actually were 40%, are tax cuts a good idea, especially tax cuts going predominantly to the rich and extremely rich? They're still costing the government 60% that can't go to many extremely high social return projects that the free market won't undertake due to market imperfections that are well established and proven in economics (real, scientific, academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts.

Suppose we consider continuing Republican policies and spending another 1 trillion on tax cuts for the rich. Even if 40% were recovered (and in the long run, as opposed to just looking at short run effects, the dynamic effects go in the opposite direction -- a dollar in tax cuts ends up costing a lot more than a dollar in government revenue if that means a dollar, or even 60 cents, less in investment in high return government projects.).

The vast majority of the tax cuts, it has been shown, will eventually be spent on consumption items of little long run investment value -- leaving little to show or to grow. If instead, even just 60% of that 1 trillion were spent by the government on extremely high social return investments like infrastructure, education, basic scientific and medical research, alternative energy, etc., then 10 or 20 years from now that 600 billion could result in many trillions, or even tens of trillions more in national wealth, as opposed to having the whole 1 trillion spent on rapidly depreciating Ferraris and yachts, and ultra luxury vacations and other things for the rich that have little or no productive value.

In the long run, a dollar spent on tax cuts for the rich, instead of badly needed social investment puts us one more step closer to losing our status as the most wealthy and modern nation, and over the long run, like any other decision to increase frivolous consumption at the expense of high return investment, it costs us a lot more than a dollar, not less.