Grow Our Way Out? Sure, but How?

Henry Aaron is a pretty smart guy--anybody who gets a Ph.D. in economics (or any other field, for that matter) from Harvard has to be pretty sharp.  Now, it's true, Aaron did his research training when the old version of Keynesianism reigned freely, before it was discredited by stagflation.  But he's had 35 years to adjust his conceptual framework.  And, you don't get to write for the Brookings Institution if you're a goofball.

Right?

Here's Aaron's recent post at Brookings.  It's not that long and it doesn't involve math, so don't be intimidated.

The essence of his argument is that as long as Congress doesn't screw things up, we won't have any debt problem.  By screwing things up, Aaron means forestalling the expiration of tax cuts and slowing federal spending.  


Aaron makes some cogent points, like his assessment of the depth of the most recent recession, and when he describes how badly we need tax reform.  Of course he makes some other points that betray his yearning to play Robin Hood because...well, dadgummit...I'm not sure why he wants to play Robin Hood.  It must just be one of those things that feels right to people who don't value analysis.

Let's look at Aaron's central thesis.  As I've argued before, we still stand a chance of growing our way out of the mess we're in.  On this point, Aaron and I agree.  But that's where our agreement stops.  Aaron's entire 'analytical' basis for claiming that we just need to keep spending and let taxes go up is a CBO projection: "According to projections of the Congressional Budget Office, the currently-large U.S. budget deficits will shrink to manageable levels once the United States returns to full employment."

Where to begin?

CBO projections are notoriously volatile; how could they not be?  Besides, even though there are plenty of dunces in Washington, there are a lot of really smart people also--if this whole thing were really as simple as prudently responding to the CBO's projections, there wouldn't be any problem.

But Aaron's main problem is that his argument begs the question whether and how the U.S. returns to full employment.  His confidence in our return to full employment also assumes a satisfactory standard of living when we get there.   There is some historical precedent for this belief.  See the chart below.

Beginning in roughly 1930, and really taking off in 1942, the Federal Government ran up huge annual budget deficits which accumulated into a massive debt of  >120% of GDP in 1946.  But then, from 1946 into the 1970s, the economy grew us out of this tight spot.  The extent to which technological innovation and manufacturing raised the American standard of living over the three decades after WWII was spectacular.

I think there are at least four main reasons why Aaron's assumption that history will / should will repeat are wrong:

1.  Manufacturing capacity / capability is totally different.  At the peak of our indebtedness immediately following WWII, the U.S. was without an economic equal, and not by a little bit.  I mean by light years.  Britain, France, Germany, Russia, Japan, and Italy (China had been devastated by Japan's brutal occupation, too, but they were not a major economic power in the 40s) each had their manufacturing capacity decimated by the war.  In contrast, American manufacturing plants were totally intact and were in fairly short order able to convert their production lines from military goods to industrial and consumer products (really helpful if you're trying to rebuild a planet).
2. Not only were American plants not bombed out, but the largest increase in debt between 1942 and 1946 supported fixed capital investment.  In other words, we had even more manufacturing capacity in order to build stuff after the war than we did before the war.  As we learned (painfully) with President Obama's 2009 'stimulus' initiative, not all government spending is equally effective.   
3. Even more significantly, a much higher percentage of those countries' young men--the principal laborers--had been killed or disabled by the war.  Germany's military deaths as a percent of its January 1, 1939 population were 8%.  Russia's military deaths (hardly the whole story) were 6% of the population.  Japan's military deaths were 3%, but total deaths in Japan were about 4%.  The U.S.?  Military deaths were just 3/10ths of 1% of the population. 
4. Lastly, to the point about this being the wrong time to constrain government spending, consider the level of federal debt in December 1941: it was barely 50% of our economic output.  The increase in deficit spending for social and stimulus programs of the early depression years was significant in percentage terms (public debt rose from ~ 20% of GDP to ~ 40%, during the first half of the 1930s), but it paled in comparison to the massive leveraging to finance the war.  All of that is to demonstrate that deficit spending won't have the same impact now as it did back then, because we're already swimming in debt.  Even if we knew how to pursue the most effective stimulus spending right now, we're inescapably racing against the ticking debt bomb. 

Needless to say, things are very different now than they were then.  Emerging Asian economies are already growing much more quickly than ours is.  Our superior standing in education is slipping globally.  We export massive amounts of intellectual capital every semester in the form of newly-minted graduates in technical fields.  Our corporate tax code is uncompetitive.  Far from aiding production as they did near the beginning and middle of the post-war period, the Baby Boomers are now retiring.  A flood of new regulations stifles capital investment. And the wonderful recent run of productivity gains cannot continue at this pace indefinitely.

The question Aaron should be asking, but isn't, is: why on earth should we expect the path out to be the same as before?  Instead, Dr. Aaron remains in denial about the structural basis of our current unemployment problem.

America is not great economic powerhouse simply because we proclaim it to be such.  What's made the American economy great are specific disciplines and values, things like education, hard work, reward for risking and innovating, the rule of law, and competition.

Grow our way out?  Sure, but only by competing like we never have before.

Investment Advice (In Case I Get Hit by a Bus)

A couple of years ago, I decided to write a letter to my kids in case I should step off the wrong curb, on the wrong day, in front of the wrong city bus.  It's basically a list of life principles I hope they adopt, written from the perspective of a Dad who would have shared the advice with them had he been around when they wanted to hear it and were old enough to really get it.   

I'm enjoying this little blogging project.  I don't do with with the sense that I'm really any good at it.  Blogging about important current topics is sort of my lame-o public service effort and, selfishly, it helps me learn.  Analyze before advocating; don't trust something just because it's been published; go back to the primary sources; critical thinking can't be outsourced (even if you don't feel like you do it well now, it's not that hard to learn); truth is almost always better than politeness; under no circumstances is it excusable to root for the Yankees, and all that stuff.

Needless to say, I'm not a professional blogger.  I'm not a real economist either: teaching night school at a local college is an avocation, sort of like leading backpacking trips.  Actually, now that I think about it, with what I get paid to teach, it's similar to the backpacking guide thing in at least one other way.

What I am, professionally, is an investor.  It's good work.  I love my business partners and what we do for the people who've hired us to manage their money.  I also love sharing with people the truths (and 'not-truths') about investing I've learned over the years.  One of my all time favorite movie scenes is in the Wizard of Oz: Toto pulls back the curtain to reveal that the Great and Terrible Oz is just a little old guy with a really slick machine.  

Back to the bus thing...

This is sort of an open letter to anyone who's curious about how the business and discipline of investing really work, written from the perspective of a guy who loves sharing what he can with people he cares about, and who otherwise might not get to share it with them before he meets his maker.

Or, if that sounds a little too gloomy to you, think of it as my Jerry Maguire memo.

1. Buy low, sell high.  No, I'm not being cute.  This principal is so basic, yet so easily forgotten, even by professionals.  How to apply it appropriately and consistently is a longer and much more detailed discussion.  But, if all you do when you invest is repeat 'buy low, sell high' to yourself, you'll do better than a lot of people.
2. When it comes to wealth accumulation, there is no substitute for living below your means and investing what you don't spend.  Every single investment strategy there has ever been pales in comparison to the shear power of saving money.
3. If you should accumulate much, be generous and ready to share it.
4. Invest with the realization that you do so to meet some specific, tangible need(s) in the future.
5. If you're seriously considering buying an annuity, may I suggest a .38 snub nose instead? It's much quicker, and far cheaper in the long run.  OK, OK, that was over the top.  I'm just kidding.  Annuities are loaded with fees, very lucrative to the selling broker, and because people in the insurance industry are allowed to call them 'guaranteed' (Hint: make sure you understand the basis of the guarantee), they've been flying off the rack lately.  Truthfully, you can construct (or have constructed for you) effectively the same portfolio as the one underlying an annuity, and incur a WAY lower expense in doing so.
6. There are really only 2 varieties of investment assets: financial assets and real assets.  Financial assets can be further divided into equity and debt (e.g., stocks and bonds).  You value financial assets by discounting their future cash flows.  Real assets are things like gold, vacant land, timber, and other commodities.  Real assets are valued only by supply and demand because they don't have a series of future cash flows associated with them.  Derivatives (e.g., options and futures) are just contracts to buy or sell (simplification, but roughly true) one of the two types of investment assets.
7. If your advisor wants you to buy gold, ask him "What is the fair value for one ounce?" and see what he says in light of #6.  (Hint: the demand variables are: industrial demand, consumer demand, hedging demand, and apocalyptic retail investor demand.  If you really want to have fun, ask your advisor to break the current price per ounce of gold down into those four categories.)
8. If you can read only one book about investing, it should be The Intelligent Investor, by Benjamin Graham.  If you want to read more, read Berkshire Hathaway's shareholder letters, What has Worked in Investing by Tweedy Browne, Creating Shareholder Value by Alfred Rappaport, and Financial Statement Analysis by Leopold Bernstein.
9. If you need someone to sketch out a strategic financial blueprint for you, hire a financial planner.  If you need help with tax preparation and planning, hire a CPA.  If you need someone to lend you money, hire a banker.  If you need someone to manage money for you, hire an investment manager.  Many advisors have added investment management to their product offering simply because they think it'll be a profitable revenue stream.  Investing (like the other professions mentioned above) is a distinct skill-set.  Hire an expert for the specific need you have.
10. In contrast to conventional wisdom, there is actually a ton of money to be made trading--but not by you.  Unless you're a professional trader yourself, you'll get your eyes gouged out (trader lingo for "not be quite as profitable as you'd hoped"--these dudes are not baby bunnies) by some really smart guys who know both sides of a market better than Kim Kardashian knows mascara.  
11. Stocks are not companies.  Great companies can have over-priced stocks and mediocre companies can have attractively-priced stocks. 
12. Mutual funds are diversified investment portfolios.  If you own several mutual funds in your portfolio, you're probably over-diversified, in which case you'll end up with performance that is much like that of the theoretical 'market portfolio'.  If you truly just want to track the market portfolio, you can do so with a really cheap fund from Vanguard, and bypass the needless activity of some clown who thinks he's earning his keep by switching your 3.5%  mid-cap international equity allocation from one fund to another. 
13. Profits go up either because sales also go up, or because companies become better (more efficient) operators.  When you invest, be certain you (or your manager) know(s) which of those is likely to happen and exactly how it's likely to come about.
14. When interest rates go up (oh, and, they will be going up), bond prices have to adjust down.  It's a common conceptual error, but rising interest rates simply are not a good deal for traditional bonds. 
15. Risk does not equal standard deviation.  Risk is the probability that your financial assets won't meet the financial needs identified in #4.
16. The brokerage industry is populated by "relationship managers."  Most of them really have no clue how to invest your money well.  But on average, they're extremely personable, and because most of you don't really want to do the work it takes to evaluate them thoroughly, you'll probably hire them primarily because they make you feel ______ (wealthy, successful, smart, important, etc.), or because they give you boxes of golf balls.  If your relationship manager sounds like he knows what he's talking about, 80% of the time it's only because he's done a great job of memorizing the quarterly talking points put out by the boys at the home office in ______ (New York, Boston, Chicago, etc.)  Sorry to be so blunt, but it's the truth.  
17. Sustainable, growing dividends will remain an important, positive return signal, almost regardless of tax laws.
18. With respect to the concept of 'market efficiency', it's not so much a stock market as it is a central repository of individual stock markets.  Some of those markets are very efficient and some are very inefficient.  
19. Your true cost for investment management is your "all-in"cost.  Calculate the all-in cost by adding the fee you pay to your advisor + the commission charged by the custodian + any internal management fees assessed by the mutual funds / separate account managers.  Make your advisor add them up for you and justify them.  Layers of investment fees are lethal to long-term performance.
20. "My Dad told me never to sell ______ (Ford, McDonald's, Boeing, etc.)" is not an investment strategy.  What if your dad had told you to never sell GM?  Do yourself a favor: take out an old picture of Dad teaching you to ride a bike and appreciate him for what he actually was to you.   Then, figure out for yourself whether you should still own the thing Dad told you never to sell.
21. When investing in bonds, ask "How do I know I'll get my money back?"  When investing in stocks ask "What will make this investment appreciate?"
22. Done well, investment management is a professional service, not a means of financial product distribution.  The brokerage business grew to be very profitable when firms figured out how to achieve scale.  The way they did that was to hire a few smart guys (see #16) to construct 'model portfolios', which could then be sold through an army of relationship managers (also #16).  It's a great deal for building a profitable brokerage firm, but it's a lousy deal for investors, each of whom have unique needs and circumstances. 
23. Portfolio structure is just as important as portfolio return (see #4).
24. If during a discussion about your portfolio's poor performance, your advisor uses the prepositional phrase "in it for the long-term" twice, it's a sure sign that he understands neither the factors driving asset prices, nor why you're invested.  If he uses that same phrase three or more times, reach across his desk, grab his crib sheet (see #16), stuff the whole thing in your mouth, chew it thoroughly, and spend the rest of your meeting pelting him in the forehead with spitballs while repeating alternately "Uh-huh" and "Sure, Skippy" whenever he stops for a breath. 
25. On the other hand, during a discussion about your portfolio's poor performance, your investment manager might look you in the eye and say something like: "We blew it.  We identified a gap in our analytical process (then describes the gap) that led to this poor performance and we've taken steps (then details the corrective measures) to mitigate the risk of this happening again.  I'm sorry this happened.  We hold your trust in high regard and hope you'll let us have a shot at earning it back."  If you do hear something like that, give him the chance he asks for, and be prepared to give him at least one more chance after that.  You're in good hands.
26. Purchasing an asset because its price has recently been going up is not investing; it's momentum trading (see #10).  Purchasing an asset just because its price has recently been going down is not value investing (see #11 and #13). 
27. Investing in publicly traded capital assets like stocks and bonds is not gambling.  Investing involves analytical work.  When someone suggests that it's gambling you can be sure that either 1) he doesn't get how markets price information, 2) he doesn't understand the price-value dichotomy (see #11), or 3) he doesn't understand either of these. 
28. With respect to #24 & #25, "poor performance" never means simply that the price of a security went down.  If you can't handle that possibility, buy CDs. 
29. Free cash flow generation is the single best indicator of management capability.
30. Registered representatives (a.k.a., 'brokers') are held to a suitability standard, registered investment advisors are held to a fiduciary standard.  Caveat emptor.