Nostradoofus

The news story du jour is to muse about why small businesses are not hiring.  Talk of tax credits, in my view, totally misses the point.

Nostradoofus essentially answered this question some time ago:  the problem is not cost, but red tape, both government and private.

The non-salary costs of hiring employees (chiefly health insurance, worker’s comp, liability insurance, legal work and tax filings) have grown far more complex and unpredictable in the past 15 years, yet are almost entirely outside the control of both employer and employee.

The problem is not so much the expense, but the trend toward ever greater UNCERTAINTY and COMPLEXITY of employing workers — the thousand small details that constantly change and that are outside the employer’s control.

This problem falls disproportionately on small business, which lacks the scale to employ specialized human resources staff to handle the complexity and unpredictable change.  Small business also lacks the financial depth to handle unpredictable changes in cost.

Repeat:  the costs themselves are not the problem.  Health insurance and pensions, for example, are both good and necessary. The problem is the UNCERTAINTY of those costs, and the COMPLEXITY of compliance.

This trend also helps explain offshoring.

To bring the problem into better focus, consider the fact that most small businesses have 0 or 1 employees.  As a result, to move the unemployment needle significantly would require that we convince a lot of solo businesspeople to hire their first employee.  This, in turn, would require convincing each of those prospective employers to do all of the following.

• File weekly, monthly and quarterly employment tax reports with at least 3 different taxing agencies.
• Expose themselves to huge penalties if they file anything incorrectly.
• Educate themselves about insurance (liability, worker’s comp, medical) and pensions.
• Shop for insurance at least once a year.
• Take on “single unknowns” like unpredictable growth in health insurance costs.
• Take on the “double unknown” of unpredictable liability exposure to employees.

Balanced against this commitment of hundreds of hours a year and a totally unpredictable financial commitment, the prospective employer has a simple alternative:  bid the work out on Elance.com.  If the employer can engage someone outside the US, they eliminate all tax filings, insurance and pensions, and almost all legal liability.  They just send cash by PayPal when the job is done.

From the perspective of the harried, overworked solo businessperson, this simplification is much more compelling than any mere cost advantage from offshoring.  Other things equal (cost and quality), offshoring is by far the better deal for the small business, because it is so much simpler.

The only policy solution here is for the US to get serious about streamlining its sclerotic employment system.  For example, one of the best arguments for nationalized health care and pensions is that they are simple and modular.  You just pay into them and get the services.  This allows both worker and employer to focus their attention on other things.

Independent modules, by their nature, offer lower performance than purpose-optimized solutions.  Viewed in isolation, modules are suboptimal.  But what they lack in efficiency, they more than make up for in simplicity and maintainability.  This is as true with government and bureaucracy as it is with software development.

It would be irrational to argue that optimization is always more important than simplicity, just as it would be irrational to argue we should write all software in assembly language, just because it will run faster.

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One of the main reasons Clinton was able to balance the budget in the 1990s was that Treasury Secretaries Robert Rubin and Larry Summers restructured U.S. sovereign debt to shorter maturities. Did this unintentionally create the conditions for artificially low interest rates, serial bubbles and sovereign debt spiral?  Read on…

Readers are probably aware that the single most important factor in Clinton’s budget surplus was the Treasury’s move to shorter-dated bonds. Short durations almost always have lower interest rates (except when they don’t — more on that in a moment). Governments have traditionally borrowed almost entirely in long-term bonds, such as 10-year and 30-year Treasuries. In the 1990s, the U.S. moved to shorter durations, resulting in instantly lower debt service costs, and a balanced budget.

The risk, which I’ve not seen mentioned anywhere, is that the federal government then becomes remarkably similar in capital structure to an investment bank, depending upon constant refinancing of huge short-term debts just to remain solvent — exactly the capital structure that killed both Bear Stearns and Lehman Brothers. With the U.S. government, it seemingly plays out in two ways.

1. Massively politicizes the Fed.  The Chairman of the Federal Reserve (who is unelected) now directly controls the size of the U.S. budget deficit simply by changing short-term interest rates, which changes the cost of the next rollover. Or, viewed from the other side, there is unprecedented pressure on the Fed to hold rates artificially low, to manage the deficit. (Maybe the serial bubbles and artificially low rates since 1996 result largely from this new pressure.)  This pressure did not exist before, because long-dated bond rates are determined by market prices, not by the Fed.

2. Massively exposes the US to a sovereign bond panic.  Suppose everyone decided for a couple of years that US T-bonds were toxic (perhaps due to war, terrorist attack, or some other unanticipated event).  If the government were mainly financed with 30-year bonds, then no big deal, they can just wait it out. But if the bonds are largely 1-year maturity, there is no way to roll over the bonds, and financial catastrophe ensues.

This is a particularly huge black swan — the move to short-dated bonds created a short-term illusion of stability, while massively increasing long-term exposure to a sovereign wipeout.

It is also very hard to get out of this situation, because the deficits are too large to roll back into more expensive 30-year bonds — just as a homeowner with an option-ARM mortgage is dreadfully exposed to interest rate swings, but cannot afford to refi back into a 30-year fixed.

The biggest danger seems to be that no one even recognizes the risk. According to Nassim Taleb, this blindness is a key feature of a black swan: unappreciated risk of a rare event with a catastrophic outcome.

Because the situation is apparently inescapable due to fiscal pressure, one might argue the United States is already in a sovereign debt spiral, one that will become visible only when short-term Treasury auctions start to fail.

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To clarify the net neutrality debate, imagine if Google made a hostile bid for Comcast.

This would place net neutrality opponents in an untenable position.  They essentially say it should be acceptable for a cable company to play favorites in internet service delivery;  but if that’s true, then there is nothing anti-competitive in Google owning a cable company.

Net neutrality opponents can’t have it both ways.  Either biased delivery is anti-competitive, or it isn’t.  If it is, then net neutrality wins. If not, then Google should be allowed to buy Comcast and throttle everyone else’s services.  Which would make no sense.

This is just a specific case of the more general fact that network-effect natural monopolies (railroads, cable companies, phone companies, Microsoft) defy normal microeconomics, because they have increasing returns to scale.  As a result, they tend to require regulation to ensure efficient market function.  In general, this regulation takes the form of forbidding bias in the freight delivered over the network.  So the railroad must carry anyone’s rail car, the phone network must carry any long-distance carrier’s call, Microsoft’s applications division should have been forced to split off from the OS division, and fiber networks should be forced to carry anyone’s traffic.

This applies only to network-effect natural monopolies, and not to other, weaker forms of market power.

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Say 3 companies simultaneously identify a big network-effect opportunity, and none has a particular tactical advantage. If rational and omniscient, each should invest up to its expected present value, or one third of the industry’s estimated PV. The net present value for the entire industry will then be zero, because all the money was spent up front in the battle for the winner-take-all #1 position.

Now move back to the real world, with uncertain, subjective estimates of market size and odds of success. Humans are known to be at their least rational in estimating NPV in low-odds, high-payoff situations (that’s why Lotto tickets sell). So presumably there is a bias for all three entrants to overestimate both the market size and their own odds of victory.

Thus all three are more likely to overinvest than to underinvest, so the industry NPV is negative.

Critically, the above experiment presumed no tactical advantage, and unlimited capital. This shows the incredible importance of tiny tactical advantages in early-stage network effect markets. In addition to being first mover, choosing the deepest-pocketed, fastest-moving VC is tactically useful in signaling to other hopefuls, as early as possible, that the game is over.

Why have US real salaries been stagnant for over a decade?  As mentioned in the previous post, part of it is undoubtedly competition from a globalized labor force.  But offshoring is not easy.  This begs the question:  aside from cost, is there some other appeal in outsourcing, despite the quality and management challenges that come with it?

In answer, consider this partial list of things you can eliminate by offshoring:

• Medical insurance
• Worker’s comp insurance
• Worker litigation risk
• Weekly, monthly, quarterly and annual tax filings
• Pension management

This is an interesting list, because it corresponds closely to the areas where US business costs and complexity have exploded in the past 20 years.  It suggests that stagnant wages and offshore competition may both result from rising costs that neither employer nor employee can control.

As partial support for this position, note that health care costs per worker have risen more in the past decade than wages rose during the Clinton years. Stated differently, if health care costs were capped, worker income might have increased significantly.  And this is just one of the unbounded, uncontrolled costs mentioned above.

It’s not just the money, but also the manager’s time and attention.  Complexity has a cost.  Eliminating the five things above, in favor of simply wiring funds, is tremendously simpler.

The US might enjoy surprising gains by applying drastic simplification and cost control to the above list.

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As you read this, recall that I generally buy the general laissez-faire, free-trade commerce argument.  Generally, but not religiously.  And, as always, the most interesting posts explore not the rules, but the exceptions.

Economists and investors have argued for a decade that moving US manufacturing capacity to China is not a problem — actually a good thing — because all the profit remains here.  The argument is reasonable, and runs something like this.

iPods are designed in the US, but made in China.  Some of the price of an iPod goes to China, but none of that is profit, because Chinese manufacturers are intensely competitive producers with consequently low return on capital.  Apple keeps nearly all the gross profit in wholesaling an iPod, while the unfortunate Guangdong manufacturer passes almost all its revenue through to its employees and capital expenditures.  Apple’s profit then funds more R&D and design work by highly paid employees in the US.

This all makes sense.  I buy it.  And it works well in other high-wage, non-mercantile countries, such as Denmark.

But the argument makes simplifying assumptions, rarely mentioned by proponents:  neutral trade balance, and stable corporate earnings as a percentage of revenue.  These assumptions have been generally false in the U.S. for over a decade.

Because they are false, the loop is broken.  The consumer spends $100 to buy an iPod from the Apple website;  about $30 of that ends up in China, essentially all with either employees or capital equipment lenders — no profit;  the remaining $70 remains in the US as gross profit to Apple.  But all of the growth in that profit over time goes not to consumers, but rather to AAPL management and shareholders, because wages have stalled for 15 years.  Meanwhile, because of the trade deficit, the $30 that went offshore doesn’t come back as revenue, but rather as loans, and thus cannot be sustained indefinitely.

Compounded over time, this situation should produce exactly what we see:  collapsing wealth and stagnant income in the middle class.

But note the problem is not directly with the free trade, nor with the export of manufacturing.  Those are benign, IF (and only if) the trade balance is neutral and at least some of the growth in corporate earnings flows through to US workers.

Both of these problems result partly from distortions in the dollar/yuan exchange rate.  We know the dollar is artificially high, based on purchasing power parities.  This, in turn, is caused partly by our reserve currency status, and partly from intervention by mercantilist central banks (China, Japan, Korea, Taiwan).  It directly exacerbates both the lopsided trade balance and the lack of US worker competitiveness.

So, while I don’t love the idea of a dollar collapse, it may be a tactical necessity until we can solve longer-term problems with competitiveness: poor K-12 education, wasted resources (prisons, military, health care), serial overindebtedness, and more.

The longer-term problem with worker competitiveness is extremely serious.  No American of any political stripe seems to be asking an obvious question: what if US wages are stagnant because US workers have grown less competitive for some other reason, and not just the cheapness of offshore labor?  Not saying it’s true, just that it’s a question worth asking.  The next post has some thoughts on US labor competitiveness.

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A geographically distant reader asked me today:

Maybe you can explain why, despite high unemployment and cratering real estate, the stock market has skyrocketed this year.  Our church’s weekly contributions are suddenly off 25%, so I’m concerned something broader is going on.  Thoughts?

His message comes at an interesting time, as local businesses tell me the same.  The owner of the local dry cleaner, who has predicted economic trends for the past 25 years by watching foot traffic out his window, tells me things have fallen off another cliff since September.

Corporate earnings from summer 2007 to spring 2008 suffered a 92% decline — the most abrupt in U.S. corporate history — yet share prices act as if all is well.  Why?

There are really just two possible explanations.  Either the market is pricing in a nominal recovery (meaning either a real recovery or massive inflation), or we are in another asset bubble.

I suspect the latter, because the market’s P/E ratio — a basic yardstick priciness — is at an all-time high, by far, while there is no evidence of price inflation, and little evidence of recovery.

The following indicators are at, or near, the worst on record, and still worsening:

• Consumer spending.
• Personal bankruptcy.
• U-6 unemployment.
• Mortgage delinquency and default.
• Consumer credit growth.

Those are off the top of my head.  The list is endless.

We may see some form of “recovery” in the next few months, such as stabilization at the new, lower levels.  This does not justify the dizzying heights of current share prices.

A hypothesis widely circulated among other finance and economics blogs, which makes sense to me, is that capital simply has nowhere else to go but the capital markets.  Consumer cannot borrow more — they are struggling to pay off the debt they have.  Business investment is way down, worldwide, because there is overcapacity in almost every capital asset.

Instead, capital flows to where there appears to be a high short-term return:  equities and commodities.  In sufficient quantity, and coupled with the momentum-driven strategies that dominate high-frequency trading, this causes equity prices and underlying value to decouple.  This decoupling is known commonly as a “bubble.”  Perhaps you’ve heard of it.

For the past 10 years, the common factor of all asset bubbles has been excessively loose credit, both artificially low interest rates and artificially easy lending practices.

This appears to be happening again with finance sector rescue programs from the Fed and Treasury — i-banks and lenders simply convert to bank holding companies, whence they can borrow at zero, on easy terms, and put the money anywhere they want.  There are few rational places to put it, so there is incentive to put it in irrational places.  So the S&P goes to 140 times trailing earnings.

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Just before the Iraq invasion in 2003, I commented to a friend that we should instead just buy Siberia.

Huh?  Bear with me.

At the time, oil prices were relatively low, so Russia was in difficult straits. They were short on cash, and faced a growing geopolitical threat from China, whose population outnumbers Russia by 9 to 1 across a very long, very thinly defended border.  Meanwhile, the US was still flush with credit (if not cash), able to buy what it wanted.

At that time, the entire GDP of Russia was only about $800 billion.  My proposal was that we offer them that much in cash — an entire year’s income for their entire country — in return for the coldest, least desirable, least habitable, least populated, least defensible part of eastern Russia.  And all its oil and gas rights, of course.  We would agree to defend it with only conventional forces, no missiles, no nukes, etc.

This would solve our oil problem.  Russia could hand its China problem to America. And we could stay thousands of miles away from the Middle East.

No, Russia would never have agreed to it.  The point of proposing this idea, then as now, was to put the cost of the Iraq war in perspective.  The estimated total cost of our Iraq adventure (excluding human cost) is now around $5 trillion, or 6 times the entire GDP of Russian in 2003.  Good investment?

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The Wall Street Journal reported today that the IRS is seeing massive fraud in the homebuyer tax credit.

The article mentions something I hadn’t noticed:  the tax credit is refundable, which means that if you don’t owe any tax, then the government actually pays you.  This one fact brings the whole picture into focus, and reveals what a bad idea the credit and other incentives are, even without borrower fraud.

Let’s say you are a renter with a short planning horizon, no understanding of finance, and no moral compass, other than a desire to avoid jail time. Carpe diem, dude!  One day, the government offers you a rich tax credit for buying a house. The FHA is falling over itself to offer you a subsidized loan.  A friendly homebuilder points out that, if you buy enough house, your interest deduction will exceed your income tax obligation.  This lets you stop all your salary withholding right now(!), and you’ll still actually collect $8,000 in April.  Maybe the builder even happens to know someone — unaffiliated, naturally — who will lend you the down payment.

Carpe Diem Dude’s perspective:  you pay nothing down, and immediately get a new house, a 25% raise in take-home pay (which mostly goes to the mortgage payment), plus an $8,000 check next April.  If you wipe out and default, well hey, that’s a long time from now — months, maybe — and it was never your money anyway.  Besides, you keep the $8,000.  Why not?

Friendly Homebuilder’s perspective:  you get a desperately needed home sale, which saves your job.  It costs you and your company nothing, assuming that you jacked up the purchase price by enough to pay your cousin Icepick to loan the down payment to Carpe Diem Dude (oops, did I say that, or just think that?).  If the buyer defaults, hey, it’s the FHA’s money, no harm no foul.

FHA’s perspective:  you are a government-backed agency receiving constant pressure to write new loans. Your Congressional taskmasters say publicly that writing bad loans is the policy, so keep up the good work.  And hey, if it all comes apart, you were just following orders.

This is an incredibly great deal!  If only I didn’t already have a house.  Is there an age requirement?  Maybe my elementary school-age kids can each buy a house…

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Private college appears to deliver negative lifetime return on investment to most attendees.  Provisos are itemized below, so please resist your instinct to recoil, and read the whole thing.

The Census Bureau reported in 2002 that the median college grad’s income was $45,400, compared to $25,900 for the median high school grad.

The College Board reported in 2006 that private college consumed an average of 5.3 years of the student’s time.  Public college took 6.4 years.

I made these rough assumptions:  40-year working life;  discount rate of 8%;  fully loaded tax rate of 30%, including all mandatory payments to all levels of government.

Based on those sources and assumptions, the after-tax present value benefit of a private college degree is about $65,000. That’s total, not per year.

Unfortunately, college costs much more than that — the College Board says the average is $53,000 $69,000 in tuition and fees alone, including all financial aid, before food and rent.  Add in living expenses, and you’re far beyond $65,000.

So it appears the return on investment is very likely negative for most families, and even more negative if we consider the cost of the subsidies.

What this argument isn’t

This is not an argument for more aid, nor less aid.  ROI (return on investment) appears negative regardless of whether tuition is paid by the parent, student loans, scholarships, or the government.  The problem is not financing or subsidy levels, but the fundamental cost/benefit equation.

This is not bashing private colleges.  I have degrees from three, and I’m glad.

Caveats

NPV is a dubious instrument, highly sensitive to tiny estimation errors in the discount rate.  You can prove anything by turning that dial.  But note that the discount rate would have to be below 6% to justify anything like the median cost of private college today.  It doesn’t add up.

College offers the option value of attending graduate school, which is not reflected in this calculation.

College may have indirect benefits not captured by NPV.

College may have positive externalities for society as a whole, not measured here.

The latest census data on income is several years old, which could invalidate the result.  But I believe it still holds true, because incomes are purportedly nearly stagnant.

Conclusion

There are plenty of ways you could pick this apart, but it’s rearranging deck chairs on an investment Titanic: the answer is so far below zero that you have to make flattering assumptions for private college to look sensible.

Pretty sobering, because it was almost certainly not the case a generation ago.

Public college ROI might be better or worse:  tuition is lower, but since it is internally subsidized, we do not know if the actual cost is lower (though I suspect it is). We do know that students spend much longer attaining a degree there, causing more foregone income.  Could go either way.

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