Macroeconomics and Moral Judgment (part 3)

July 6, 2013

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Suppose we believe that in the United States today, reducing debt would be good for households, good for government, and good for the economy. It would make us all more secure by reducing the risk of future defaults and financial crises. Let’s use that as a starting point for economic reform, and see where it takes us.

Logically, there are two ways for a debtor to reduce debt: reducing spending or generating income. Before the Great Recession, the federal deficit ballooned both because of spending increases and tax cuts, and it can be reduced through either spending cuts or tax increases, or both. The wealthier portion of the population pays more of the income taxes, while the poorer portion of the population depends more heavily on government programs. Framing the issue solely as the need to cut spending places the burden of debt reduction especially on the poor. During the 2012 election campaign, the “Nuns on the Bus” and other progressive religious groups questioned the morality of throwing people off food stamps while advocating additional tax cuts for the wealthy.

Similarly, there are two ways of getting rid of subprime mortgage loans. One is to discourage people with low incomes from buying homes at all. The other is to raise wages so that more potential home buyers qualify for conventional financing. Two ways of reducing college loan debt are having fewer people go to college or giving them more outright grants to do so. There are always choices.

The point here is that one way of looking at the growth of debt–government debt, mortgage debt, student loan debt, credit card debt, etc.–is to see that borrowing money has been used as a substitute for making money, and lending money has been used as a substitute for paying money. The wealthy would rather lend money to government and earn interest than pay more taxes. Corporations would rather lend money to households than pay higher wages. Any discussion of debt reduction leads naturally to a discussion of who will then pay for what. Some expenditures are so wasteful that no one should pay for them, but that still leaves the question of how to fund the expenditures necessary to sustain our economy and meet the needs of our people.

A question of distributive justice

Those who advocate austerity need to ask on whom the burden of austerity should fall. Since 1979, two-thirds of all the income gains in the United States have gone to the richest 10% of the population, compared to only one-third in the previous three decades. Income gains have been especially dramatic for the top 1%, whose share of the national income went from 10% to 23.5% between 1979 and 2007. Their real after-tax income rose by 260%. Meanwhile, real wages and benefits for nonsupervisory workers, which had risen 75% between 1947 and 1973, rose less than 4% between 1979 and 2005. Household incomes rose a little more than wages (by 21% for the households in the middle quintile), but that was because households sent more workers into the labor force and worked more hours. (Statistics are from Faux 2012 and Hacker & Pierson 2010, and are adjusted for inflation.)

Besides working harder, the other way that households could raise their standard of living despite stagnating wages was to borrow more. That borrowing was heavily promoted by the booming financial services industry, as capital not being productively invested in manufacturing flowed toward other sources of profit. Many of the richest 1% who experienced fabulous income gains made their fortunes in financial services. But Hacker & Pierson write, “The inexorable increase in household debt was not sustainable without comparable income gains–and those gains did not occur.”

Since the rich got most of the benefits of the economic boom, it seems unfair that the poor should bear more of the burden of the economic bust. But that’s the direction that debt reduction and austerity seem to be taking. Hypothetically, asking the wealthy to share more of their wealth with ordinary workers (through higher wages) and government (through higher taxes) would be a way to reduce debt while sustaining consumption, economic output and employment.

However, conservatives raise both moral and economic objections to any share-the-wealth proposal. As they see it, the wealthy are morally entitled to their incomes as long as they earned them legally. They use their wealth largely to invest in job-creating enterprises for the benefit of all. Also, higher wages would increase the cost of production, raise prices, and reduce American competitiveness in world markets. From that perspective, high pay at the top is good, but high pay for the majority is not so good. If you question the increasingly unequal distribution of income, you are labeled a socialist. You want to steal from the “makers” to give to the “takers,” as Paul Ryan has put it.

Is economic polarization good for us?

Today, the United States is more economically polarized than it has been at any time since the Gilded Age. The richest fifth of the population receives more in after-tax income then everybody else combined. Is that kind of inequality good for the economy? Here I’ll draw heavily on Joseph Stiglitz’s book, The Price of Inequality.

As economists see it, inequalities of reward are a market mechanism that can help channel resources toward the most productive uses. “Build a better mousetrap and the world will beat a path to your door.” As Stiglitz points out, that implies that the market should generate inequalities but also limit them. Skills or products that are in high demand but short supply should command a higher price, but in a free market that price differential should come down as more economic actors acquire those skills or produce those products. Extreme, persistent and growing inequality may be a sign of economic rigidities and inefficiencies. One indicator of increasing rigidity is that economic mobility–the probability of changing one’s economic position–has been declining as income inequality has been increasing.

Stiglitz reports that in recent US history, the economy has actually grown more in periods of relative equality than in periods of relative inequality. He also cites studies by the International Monetary Fund that find a positive association between greater equality and sustained economic growth. That makes it troubling that the United States now has less economic equality and economic mobility than most developed countries, especially when compared to Europe.

Gross differences in economic power can lead to the overvaluation of contributions at the top and the undervaluation of contributions at the bottom. A textbook case of the first is the successful marketing of overvalued financial products by Wall Street investment firms, especially because the executives of those firms continued to award themselves large bonuses even after their products almost brought down the banking system. The problem is not confined to exotic derivatives that only a few sophisticated investors bought. Many retail financial companies market confusing products whose profitability exceeds the value for consumers and investors. The decline of traditional guaranteed-benefit pensions has forced more workers to fund their retirement through 401(k) plans, whose returns are less predictable and more vulnerable to erosion by excessive and hidden fees. A complex economy offers many opportunities to make money by taking advantage of people rather than giving them fair value.

At the lower end of the economic pyramid, workers have trouble developing the human capital they need to compete in today’s economy. Companies often prefer to invest more in plants and equipment, which they own, than in human capital, which they employ but do not own. Why spend a lot to educate or train one’s workers, if they are free to go to work for someone else? Businesses complain that they can’t find enough skilled workers, but they would like someone else to teach the skills. Creating a healthy and well-educated workforce is not something that private capital alone does very well; it’s a job for the whole society.

Sociologist Arne Kalleberg has analyzed the increasing polarization of American work in Good Jobs, Bad Jobs. Some of the reasons for the changing organization of work are global competition, the information revolution, and the shift from manufacturing to services. US companies aren’t going to employ as many low-skill machine tenders as they used to. However, societies and their work organizations still have choices to make. As they try to improve their global competitiveness, they don’t necessarily have to take what has been called the “low road” of just cutting labor costs. They can take the “high road” of investing in quality labor to produce quality products. For example, child care workers in the United States are often low-wage workers, but they don’t have to be. Some countries have upgraded those jobs by setting higher standards of quality, raising the pay for qualified workers, and supporting them publicly with tax dollars. Is that just taking from the rich to give to the poor, or is it a legitimate way of channeling economic resources toward human capital investments that otherwise won’t occur?

What kind of economy are we trying to create? Are we trying to become more like China, boosting exports by holding down consumption for most of the people? Or are we trying to create a new economy for the twenty-first century, investing in qualified workers who produce quality goods and services and share the benefits of their own rising productivity. The second route may be harder, but isn’t it morally preferable?

Directing moral concern

Moral concern about recent economic developments leads back to the old question of what is the good society. One answer informed by economics is that it is a society that helps its citizens become economically productive and obtain a fair share of the rewards of their productivity. The United States is having trouble on both counts: Too many of our citizens are failing to acquire the skills they need to be productive, and workers who are productively employed are not seeing their wages keep pace with their rising productivity.

Who then should we blame? The obvious villains of the financial crisis, such as lenders who made loans without regard to the creditworthiness of borrowers, remain culpable. But macroeconomics encourages us to think bigger, taking into account economic conditions and policies both in the United States and abroad. Lurking behind the Great Recession is the gross economic inequality that turned so many of the wealthy into aggressive lenders and so many ordinary people into excessive borrowers.

Conservative and progressive moral perspectives

Does that mean that a moral perspective informed by macroeconomics has to be a progressive one, a vision emphasizing greater equality and social justice? I would say yes, partly, but not exclusively. Conservatives have an economic morality too, with its own strong sense of right and wrong. That’s why economic debates have such powerful moral subtexts and often become so heated and polarizing.

Conservative economic morality is a morality of work, competition, individual responsibility and property rights. People are separate, competing individuals, each person responsible to work for his or her own success. Each is entitled to keep the fruits of that success. Taking from the haves to give to the have-nots turns the moral order upside down, removing incentive by punishing success and rewarding failure. When it is morally framed in that way, the story of economics is mainly the story of how the competitive market economy produces prosperity for all if it is allowed to operate freely. The laissez-faire economy free of government interference is the basic model.

Progressive economic morality places more emphasis on cooperation, shared responsibility and social justice. Developing a productive human being requires a lot of social inputs–a lot of people working together. Those who are fortunate enough to have received many benefits–education, wealth, good parenting, and yes, good government–should be willing to give something back. The haves should help create opportunities for others to have. From this perspective, economic prosperity and democratic governance go hand in hand. The dominant model is a democratic political economy that regulates the use of private property for the public good.

If both of these have some moral and practical validity–and I think they do–then why favor one over the other? Since the “Reagan Revolution” around 1980, the conservative philosophy has dominated American economics and politics. The result has been a very distorted and unsustainable economic system, favoring the few at the expense of the many. Even the most enthusiastic supporters of capitalism should acknowledge that this is not how capitalism is supposed to work. During the Cold War, defenders of American capitalism could cite the substantial income gains being experienced by the American working class. How ironic that we “won” the Cold War and then lost our way economically! The argument for a progressive vision today is that it is sorely needed to correct the imbalance.

James S. Hacker and Paul Pierson call today’s economy a “winner-take-all” economy. That’s the title of the first chapter of their book Winner-Take-All Politics: How Washington Made the Rich Richer–and Turned Its Back on the Middle Class. The system is like the conservatives’ model economy corrupted by steroids, with muscular and well-armed financial Rambos monopolizing the wealth, disavowing any responsibility for the rest of us, and defining democratic government as the enemy. Their political minions resort to increasingly desperate measures–like making it harder to vote, eliminating all restrictions on big money in politics, and filibustering nearly every bill proposed by the Senate’s Democratic majority–to hold onto power without actually serving most of the people.

Blaming rich people indiscriminately for our problems would not be fair, since some wealthy individuals have also become concerned about the direction things have been taking. Warren Buffet has famously complained that he pays taxes at a lower rate than his secretary. We need to direct our moral concern primarily at the economic and political policies that hurt people, while recognizing that individuals differ both in their support for those policies and their ability to influence them. Influential supporters of conservative policy have had things pretty much their way for the last three decades. Now it’s time for progressives to be heard in the debate over our national choices.

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Macroeconomics and Moral Judgment (part 2)

July 6, 2013

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In my last post I argued that the study of economics should inform but not eliminate our individual moral judgments as citizens in a democracy. Economics shifts our attention from the virtues and vices of individuals to the strengths and weaknesses of fundamental economic policies. But that doesn’t mean we have to attribute economic events like the recent financial crisis just to impersonal economic forces. Policies are made by people, and some people have more influence on them than others.

To illustrate how a macroeconomic perspective can inform our moral stance, consider the distinction between personal saving and national saving.

Saving: the more the better?

Recently, I posted a series of investment guidelines called “Principles of Sound Investing.” The very first principle I discussed was “Live within your means,” dealing essentially with the virtues of saving. A household’s savings rate is a crucial determinant of its ability to sustain its income into the retirement years. This is partly just a matter of mathematics. By making assumptions about rates of return, longevity, and so forth, financial planners can calculate recommended savings rates, which usually come out in the range of 10-15%. But the issue also gets entangled with our ideas about how people should live. We tend to think of people who can save for tomorrow as frugal and responsible, while people who run up debt by spending beyond their means as self-indulgent and irresponsible.

Macroeconomics provides a different perspective on saving, one that focuses on national savings rates, not just household savings rates. From this perspective, saving is also a good thing, but only up to a point. Saving provides capital for investment in economic enterprises, which sustains economic production and supports future consumption. National production and national income depend in part on national saving. However, they also depend on national consumption, since producers can’t sustain or increase production if consumers aren’t buying. Too much consumption and too little saving can be a problem, but so can too much saving and too little consumption. That’s why the messages from advertisers seem at odds with our ethic of frugality: Go ahead, live it up; buy that sports car; you deserve it! Already in the 1950s, William H. Whyte was describing how the mass-consumption economy was undermining our traditional ethic of thrift.

Economists like Michael Pettis argue that underconsumption can be just as big an economic problem as overconsumption. He warns us against applying our individualistic conceptions of virtue to entire countries, seeing countries with a high ratio of savings-to-consumption like China and Germany as good, and those with a low ratio of savings-to-consumption like the United States and Greece as bad. In the global economy, the two kinds of countries are complementary, and together they have created the global imbalances that resulted in the financial crisis.

One country’s underconsumption enables and even forces another country’s overconsumption, through its export of goods and capital. A country whose citizens spend too little to absorb its productive capacity can rely on exports to keep the economy booming. But for that country to be a net exporter, generating trade surpluses, some other country must be a net importer, running up debt.

Underconsumption as a growth strategy

In addition to seeing underconsumption as a possible problem and exports as a solution, global macroeconomics can see underconsumption and exports as two sides of a conscious strategy for growing an economy. The idea is to hold consumption down, limit the production of consumer goods for the domestic market, and invest heavily in infrastructure and export industries. That’s been a common model for developing countries in Asia recently, as well as in countries like Brazil and the Soviet Union somewhat earlier.

The prime example of an underconsumption growth strategy today is the Chinese economy. Several key policies support that strategy. Employers raise wages at a slower rate than worker productivity. The central bank sets the value of the national currency low in relation to other currencies, reducing the buying power of Chinese consumers while making Chinese goods cheap on world markets. The central bank also sets interest rates very low, hurting ordinary depositors but helping producers borrow to expand production. The low interest rates are more helpful to producers than consumers, since China provides less financing for consumer expenditures.

This is one way to grow an economy, but it is not without costs. It limits the ability of the domestic population to benefit from the results of their own increasing productivity. In addition, it leads some other country to compensate by spending beyond its means, which it can’t do forever.

US debt in global perspective

What do the Chinese (and other net exporters) do with all the dollars they make by selling things to Americans? One thing they don’t do very much is buy our goods. If they did, the trade imbalance wouldn’t be so large. What they do a lot is lend those dollars back to us by purchasing US securities. They are net exporters of capital as well as net exporters of trade goods.

Here I’ll repeat what I said in an earlier post about international capital flows, quoting at some points from Pettis: Under some conditions, a capital or trade imbalance can be useful for the deficit country as well as the surplus country. For much of the nineteenth century, the United States depended on foreign capital–especially British and Dutch–because investment opportunities in its growing economy were actually greater than domestic savings could fund. But that didn’t hurt the country because “the wealth generated by foreign-funded investment was more than enough to repay the foreign debt and equity obligations.” Poor countries can also benefit by relying on foreign capital for a time. “For countries that lack technology, that have weak business and management institutions, or that suffer from low levels of social capital, foreign investment can bring with it the technology and management skills that allow the economy to grow faster than its foreign debt and equity obligations.”

Today, of course, the United States is no longer a poor country, nor a developing economy with more investment opportunities than we can fund ourselves. The large infusion of foreign capital into the US economy before the crash appears to have hurt the economy more in the long run than it helped it. With our manufacturing sector in decline and our net exports falling, there wasn’t much demand for new capital to expand production, at least not enough to absorb what Ben Bernanke has called a “global savings glut.” Instead, the capital went heavily to finance consumer and government spending. Economic activity was sustained, for a time, by running up government and personal debt. Foreigners bought a lot of Treasury bonds and–more relevant to the financial crisis–mortgage backed securities. The glut of capital pushed interest rates down, encouraging investors to “reach for yield” by considering untraditional but potentially high-return investments, such as the complicated pools of mortgages assembled by Wall Street firms.

So the housing bubble was driven by much more than irresponsible buyers borrowing beyond their means. A housing boom was one way to sustain a high level of economic activity in an increasingly uncompetitive US economy. It gave investors one place to invest and households one way to get ahead. We no longer seemed as capable of making products the world wanted to buy or expanding the middle class by raising wages. But we could finance an increase in home ownership anyway by making shakier loans and packaging them so they appealed to investors.

Economic imbalances

The financial crisis resulted from unsustainable imbalances in the global economy, especially the imbalance between net importers and net exporters, debtors and creditors, high-consuming and low-consuming nations. The economies involved had their own internal imbalances. China grew its export industries at the expense of domestic consumption. In the United States, the financial services industry boomed while manufacturing languished. We financed consumption more creatively than we developed the products and workforce required for success in the twenty-first century.

Economic imbalances also developed in Europe. Germany became a net exporter and creditor, while poorer countries like Greece became net importers and debtors. The use of a strong common currency, the euro, enabled the debtor countries to buy more than they should have, just as the strong dollar enabled Americans to import so much. One difference is that in Europe, the poorer countries are usually the debtors, while in the US-China relationship, it’s the richer country that is the debtor.

One lesson to learn from all this is that it takes both creditors and debtors to create a debt crisis. Those who heap moral blame on the debtors alone are not seeing the larger picture. Furthermore, the solution cannot just be that the debtors change their behavior to emulate that of the creditors. Since the roles are complementary, changes on one side require changes on the other side. The polices and practices of creditor economies depend on those of debtor economies. If Greeks and Americans suddenly adopted the frugality of Germans and Chinese, without complementary changes on the other side, the decline of consumption would produce global economic contraction and higher unemployment.

As the United States tries to solve its problems as a debtor nation, we don’t want to undermine the high output of our own economy either. Four things drive economic activity: household consumption, government spending, investment and net exports. (Since the US is a net importer, the last part of the equation drives foreign economies instead of our own.) Living beyond our means has been a way of sustaining aggregate demand for economic goods and services, both domestically and globally. Telling households and government to spend less may sound wise and responsible, but it fails to address the larger question of how to rebuild our economy on a stronger foundation. How can we grow the economy in a more sustainable way, without relying on consumers and government to spend beyond their means and run up debt? That is the subject of my next post.

Continued

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Macroeconomics and Moral Judgment

July 6, 2013

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Many of my posts over the past year have aimed at making sense out of the Great Recession that began in 2008. Several of the books I’ve discussed here have dealt with it specifically: Alan Blinder’s After the Music Stopped, Michael Grunwald’s The New New Deal, Michael Pettis’s The Great Rebalancing, and Peter Temin & David Vines’s The Leaderless Economy. I have found the latter two works especially helpful in seeing the recession from a global macroeconomic perspective. For one thing, international capital flows helped produce the housing bubbles in the United States and other countries.

In this post I want to raise the question of how an understanding of large-scale economic relationships might affect one’s moral judgment about economic behavior. Once that we have a better idea how the recession happened, are we–or should we be–more critical of the policies and practices that led up to it? Do we see moral failures where we didn’t see them before? Do we appreciate how wide and deep the responsibility lies? Or are we so overwhelmed by the economic complexity of the whole thing that we give up trying to assign any moral responsibility at all?

Finding villains

When things go wrong in society, a natural response is to find someone to blame. During the Great Depression of the 1930s, many Americans blamed Wall Street speculators for pushing up stock prices to unsustainable levels. They also vilified Herbert Hoover for policies that made the Depression worse, and they called the shantytowns that housed the homeless and unemployed “Hoovervilles”. They celebrated Franklin Roosevelt as the hero who rescued them, making his Democratic Party the dominant political party for decades afterwards.

Our Great Recession struck a much more polarized society, making it much harder to agree on villains and heroes. A popular conservative response has been to blame homeowners who borrowed more than they could repay, along with those in government who wanted to help them. When the Obama administration proposed assistance for people who were in danger of losing their homes, CNBC reporter Rick Santelli delivered an angry rant from the floor of the Chicago Mercantile Exchange, saying that the proposal would “subsidize losers’ mortgages.” This was a variation on an old theme in American conservatism: the economically successful are the virtuous ones, and it’s the losers whose irresponsible behavior is the problem. (To be fair, many conservatives also opposed helping the big banks, but in the end, the “too big to fail” argument carried the day there.)

Progressives tend to find their villains near the top of the economic pyramid. Teddy Roosevelt attacked the “malefactors of great wealth,” describing a battle “to determine who shall rule this free country—the people through their governmental agents, or a few ruthless and domineering men whose wealth makes them peculiarly formidable because they hide behind the breastworks of corporate organization.” The Occupy Wall Street movement has focused its attack on the richest 1% of the population, and especially Wall Street bankers. More specifically, many observers blame the Great Recession on:

  • Subprime lenders: In order to make more loans, lenders lowered their lending standards and made more subprime loans–loans with less favorable terms for people with shakier credit. They moved away from the traditional 30-year fixed-rate mortgage and heavily promoted more confusing arrangements like adjustable-rate mortgages with temporarily low “teaser rates.” They became less concerned about defaults because they increasingly sold off their mortgages to financial firms that packaged them for sale to other investors.
  • Investment bankers: Wall Street firms bought mortgages and repackaged them as complicated Collateralized Debt Obligations (CDOs). These pools of mortgages were divided into slices called “tranches,” with varying degrees of risk. In theory, at least some of the tranches were supposed to be extremely safe; in practice, even the safest ones were riskier than they were cracked up to be.
  • Rating agencies: Since the securities rating agencies were paid by the banks whose securities they rated, they had little incentive to be critical. Previously exclusive AAA ratings went to too many risky securities that ultimately collapsed.
  • Regulators: Both Congress and regulatory agencies such as the SEC and Federal Reserve acquiesced to financial lobbyists and resisted calls for regulatory reform to deal with the increasingly risky financial practices. In particular, they exempted derivative securities (those like CDOs that derive their value from other securities) from regulation.

Economics and moral engagement

An economic understanding of how the housing bubble grew and then burst can help focus our moral outrage on the most responsible players. On the other hand, it could also muddy the ethical waters. After all, economics in general–and macroeconomics in particular–isn’t about personal moral decisions. It’s about impersonal economic forces like supply and demand and interest rates and global capital flows. Maybe subprime lenders and investment bankers were just responding rationally to market conditions, doing what they needed to do to make a profit. One could argue that individuals are just cogs in some gigantic economic machine, and bad things like severe recessions just happen from time to time. Maybe we should react to them the same as we react to hurricanes–we don’t like them but we can’t blame anyone for them. In other words, maybe the effect of economics is to substitute analytic detachment for moral engagement.

And yet, complete moral disengagement certainly doesn’t work, even for climate events. They are coming to be seen as partly a result of human activity, for which we need to take some responsibility. And that should be even more true for the economy, which is, after all, a human creation.

A less extreme argument for moral disengagement is that someone must take responsibility for good economic policy, but ordinary citizens lack the expertise to do so. They should leave it to the experts. The job of keeping the economic machine humming along is a job for economists and others with technical skills. This is an appealing argument. Many people seem willing to put a relatively small number of people in charge of social institutions, as long as they are selected on the basis of merit. However, Chris Hayes’s book Twilight of the Elites tries to show that even a hierarchy originally based on merit has a tendency to become self-serving and detrimental to democracy. In the aftermath of the financial crisis, economists themselves got some criticism for being too cozy with powerful financial firms, having too rosy a view of the economy, and completely missing the impending disaster.

Call me a liberal, but I think that an informed and morally engaged citizenry is essential to a democratic society. The average citizen cannot be an expert on the details of every policy issue. But each citizen can try to tell the difference between policies that serve the broad public good and those that serve some narrower interest.

Macroeconomics does not have to make ordinary people disengaged, resigned or fatalistic about economic events. What it can do is inform and shape their moral judgments, so they have a clearer and more realistic idea about what is right or wrong about economic policies and practices. It can shift the focus from a few obvious players in an economic drama to the more fundamental economic choices that societies make. That’s what I’ll be trying to illustrate as I discuss the global macroeconomics of the Great Recession in the following two posts.

Continued

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Sound Investing 11: Advice

June 27, 2013

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Get good financial advice

Do you need a financial advisor?

In their book Why Smart People Make Big Money Mistakes, Gary Belsky and Thomas Gilovich talk about the “ego trap,” their term for the overconfidence people often display in financial matters. Research shows that people are very likely both to overestimate their financial knowledge and to think that they are in better financial shape than they really are. Smart people shouldn’t be embarrassed to admit that they need financial advice. Part of the price we pay for our advanced economy is that our finances have become very complicated. Financial firms offer us a bewildering variety of investment products. The federal tax code imposes a complicated set of rules for taxing different kinds of investment returns. Employers present their workers with a confusing set of savings options instead of protecting them with traditional pensions. Very few people have the time and knowledge to evaluate all the alternatives by themselves.

Unfortunately, financial mistakes can be costly, especially if the results are compounded over many years. Here are some of the most common ones:

  • underestimating future financial needs, such as by underestimating how long one may live in retirement
  • saving too low a percentage of income
  • carrying debt at exorbitant rates of interest (especially credit card debt)
  • putting too much money into one kind of investment
  • risking too much money on trying to beat the market, instead of planning for an average market return
  • investing money needed in the near future too aggressively, or investing money not needed for a long time too conservatively
  • accepting high investment fees and expenses that are not justified by superior returns
  • paying too much to buy “hot” stocks or mutual funds, while overlooking more reasonably priced alternatives
  • failing to take full advantage of tax-sheltered savings plans, especially by passing up employer matching contributions

Investors who should know better often make these mistakes unwittingly, just by not giving enough attention to each financial decision. A good financial advisor should spot such problems very quickly and recommend solutions. In addition, professional advisors have technical tools for analyzing a client’s financial data and projecting long-term consequences of present choices. For example, a “Monte Carlo” simulation can forecast future returns, taking into account not only historically average rates of return for different investments, but also reasonably likely deviations from the historical averages. This approach can estimate the probability of achieving a financial goal by means of a particular investment strategy. Advisors cannot guarantee positive financial results, but they can help improve the odds.

What kind of advisor do you need?

The financial services industry has gotten very large, and investment advice is now available from many sources, such as brokers, mutual fund companies, insurance companies, accounting firms, and banks. Any of these could be a source of good advice. In order to avoid paying too much for too little, you should consider what kind of advice you need and how you will be charged for it. Beware of “free” advice that isn’t really free, because it steers you into unnecessarily costly investment options.

Ideally, your financial advisor should be someone with your best interests at heart. The term for such a person is “fiduciary.” According to the Certified Financial Planners Board of Standards, that’s “one who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client.” The danger is that people who call themselves financial advisors will put their own financial interests ahead of yours. That’s one reason Congress passed the Investment Advisers Act of 1940, which required those giving financial advice for compensation to register as investment advisors and adhere to a fiduciary standard. The Securities and Exchange Commission, however, made an exception for those whose primary business is trading securities, but who also give some advice to their customers. In recent years, brokers and other sellers of financial products have expanded their financial advising functions and often receive compensation for them. Nevertheless, the SEC continued to maintain that they did not have to register as investment advisors nor adhere to a fiduciary standard because their advice was “incidental” to their job as brokers. So two types of advisors, those obligated to put their clients’ interests first and those without such obligation, have co-existed in the financial services industry, with the general public often unable to tell the difference. Brokers and insurance agents have been able to call themselves financial advisors, without being obligated to recommend the products that are best for their customers.

On March 30, 2007, the U.S. Court of Appeals for the D.C. Circuit struck down the SEC rule that exempted brokers providing financial advice for compensation from the 1940 law. In the aftermath of the 2008 financial crisis, the Obama administration also proposed bringing brokers under a fiduciary standard. The Wall Street Reform and Consumer Protection Act of 2010 stopped short of imposing such a standard, but it did give the SEC the explicit authority to do so. In January 2011 the SEC released the findings from its study of the issue. It concluded: “The standard of conduct for all brokers, dealers and investment advisors, when providing personalized investment advice about securities to retail customers…shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer or investment advisor providing the advice.” Whether the specific rules issued by the SEC will be strong enough to enforce that standard remains to be seen. Resistance to the fiduciary standard remains strong, especially from the insurance industry and Republican lawmakers.

[Note: A more recent post on the battle over the fiduciary rule is here.]

If you are looking for someone with a strong commitment to a fiduciary standard, you may want to limit your choice to Registered Investment Advisors. RIAs must be able to provide a copy of the disclosure Form ADV they file when registering, and you can also check their registration online at www.adviserinfo.sec.gov. You may also want to look for a Certified Financial Planner, because CFPs must meet rigorous standards of education and experience.

How will you pay?

A related decision concerns how you want to pay for advice. The options include sales commissions, asset management fees, hourly fees, flat fees for preparing financial plans, or some combination of these.

Sales representatives of financial services companies can advise you on how to invest your money without charging you a specific fee. They make their money from salaries or commissions on the products they market. The disadvantage for the consumer is that these representatives may steer customers toward the products they sell rather than informing them of the full range of investment choices. Brokers often recommend mutual funds with high commissions and fees, and insurance agents recommend costly insurance products such as annuities. Investment author Burton Malkiel says that investors often make unwise choices because “most individuals get ‘sold’ financial products. Brokers and advisors don’t make any money if they put you in a Vanguard index fund, but they do get paid for selling you a hot, actively managed fund” (Journal of Financial Planning, 4/05). These products often generate inferior returns once costs are factored in, while more cost-effective products are overlooked.

“Fee-only” advisors accept no commissions for what they sell, which leaves them free to recommend whatever products they view as best for the client. Some of them give advice for an hourly fee, or charge a flat rate to prepare a financial plan. Others are asset managers who manage your portfolio on a continuing basis. (Not all asset managers are fee-only however; some sell securities on commission too.) Asset managers charge an annual management fee, usually a percentage of your total invested assets. This appeals to people who don’t want to have to deal with a lot of everyday financial tasks and decisions. It can be very costly however, since you are paying all the time. A 1% fee on a $500,000 account is $5,000 a year, and many managers won’t accept smaller accounts.

What kind of advising you get depends a lot on what you are able to pay. Low-income households may have to settle for “free” advice, even though it may sometimes steer them toward products with poor trade-offs of costs and returns. High-income households may prefer to hire asset managers, despite their high fees. What about all the people in between? How to deliver financial planning services to middle-income households is a much-discussed issue, since they can afford to pay something, but often not enough to be desirable clients for asset managers. Occasional financial consultations for a flat rate or hourly fee may work best for such clients. Websites like flatfeeportfolios.com and myfinancialadvice.com offer inexpensive financial consultations online. No-load mutual fund companies like Vanguard offer various levels of assistance to their customers, some of which is free.

The good news from considering the principles of sound investing is that you can be a successful investor without making a large number of difficult decisions requiring frequent and costly advice. The main things you need to do–save regularly, maintain a diversified portfolio, take advantage of tax shelters, avoid unnecessary expenses, and so forth–are not fancy financial moves but just good habits. Once adopted, they can be practiced with a small amount of effort, like tending a well-planned garden. Small investors who take the right approach ought to be able to manage their investments themselves with only occasional input from a professional advisor.

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Sound Investing 10: Social Responsibility

June 26, 2013

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Consider socially responsible investing

A broader concept of sound investing

This principle is different from the others because it broadens the idea of “sound investment” to include more than the pursuit of good financial returns. Many investors wish to select investments that will not only meet their personal financial objectives, but also contribute to a better society. They would like the companies in which they are shareholders to be working toward desirable social goals, or at least trying to avoid doing harm.

Not all economists and financial planners like to distinguish between what is profitable and what is good for society, but the economic concept of “externalities” provides a rationale for making the distinction. Economic transactions can have costs and benefits for people who aren’t party to the transaction. Corporations and those who buy their specific products don’t bear the full costs of damaging the environment, or reap the full profits from developing new ideas that spread widely in society. Markets sometimes reward individuals for doing things that have negative externalities (social costs), and sometimes fail to reward individuals for doing things that have positive externalities (social benefits). In theory, socially responsible investors can help correct this by favoring “good” companies over “bad” ones.

The devil, of course, is in the details. How does one go about rating companies by social criteria? In his book With Charity for All: Why Charities Are Failing and a Better Way to Give, Ken Stern shows how hard it is to find out if a charitable organization is actually doing good work. If organizations whose mission is the betterment of society rarely publish adequate data about their effectiveness, one can hardly expect profit-making corporations to provide a fair assessment of their social costs and benefits. One approach to selecting companies is to avoid industries whose products you disapprove of, such as armaments, or fossil fuels, or beef. If your concern goes deeper, including not just the product but the specific environmental or labor practices by which it is produced, you will probably need the guidance of social investment specialists.

Social investment funds

A number of mutual funds now specialize in socially responsible investing, and their assets have been growing rapidly. Today about one out of eight investment dollars flows into this type of investment. A lot of that money comes from large institutional investors like pension funds, whose investment decisions can have a large impact on society.

Socially responsible investing takes several different forms. The most common form is screening securities so as to include in a portfolio only those that meet certain social criteria. Many social investment funds avoid investing in companies associated with tobacco, alcohol, gambling, weapons, or animal testing; and many look for good records on environmental protection, human rights, and employment policies. Secondly, funds often engage in shareholder advocacy by voting their proxies in support of responsible corporate policies, or proposing their own resolutions at shareholder meetings. Finally, a few funds invest in community development in low-income areas where capital is hard to obtain. These funds may operate community development banks, credit unions and loan funds to help finance small businesses, affordable housing and community services. Socially responsible investing may be referred to as SRI, or more recently as ESG, for environmental, social and governance.

A good source of information is the Forum for Sustainable and Responsible Investing at www.socialinvest.org. It reports the investment policies, performance and fees of many different funds.

A financial sacrifice?

Critics of social investing suggest that investors may be sacrificing superior returns by basing their investing decisions on anything but strictly financial considerations. Some investors might be willing to make such a sacrifice, but they may reasonably ask how large a sacrifice, if any, is involved.

Some of the criticism is based on the assumption that investors can get market-beating returns by investing in the highest-performing mutual funds. Investors who limit themselves to the relatively small number of SRI funds may be overlooking most of the best performers. However, this argument may exaggerate the connection between past and future performance, and as a result underestimate how difficult it is to achieve consistently above average results even with conventional funds. In theory, an investor who could always be in the most successful funds would make more money than the social investor, but in practice, most investors who chase performance fail to outperform the market in the long run, and more often underperform it once trading costs and expenses are factored in (see my discussions of expenses and opportunity). It may be more relevant to compare the social funds to the market averages than to the highest performing funds in any given year.

Advocates of index funds argue that most investors do better in the long run by accepting the average return of the market than by paying active managers high fees to try and select superior stocks. From that perspective, SRI funds are financially sound investments only if they can offer broad diversification at low cost. Many social funds are quite selective and have relatively high fees because of the research that has to go into company screening. Although it is easy to screen companies for obvious things like selling cigarettes, it is much harder to evaluate a company’s environmental and human rights record, especially if the company has many different enterprises in many different countries. On the other hand, some funds have tried to emulate index funds by developing as diversified a list of companies as they can, consistent with social screening. Funds that want to hold down their own research costs can obtain such lists from others. Overall, social investing is probably more cost-effective than it used to be, but still a bit costlier than straightforward indexing. While the least expensive index funds have expense ratios under 0.1%, expenses for social funds are usually at least 0.5%, with many over 1.0% or even 2.0%. Performance data tracked by the Forum for Sustainable and Responsible Investing shows most social funds underperforming the S & P 500 over the past ten years, many by several percentage points a year. This is due partly, although probably not entirely, to their expenses.

One of the largest and most cost-effective index funds is Vanguard’s 500 Index Fund Admiral Shares, with an expense ratio of 0.05% and average annual return of 8.52% from 2003 to 2013. Vanguard also offers the FTSE Social Index Fund. It tracks the FTSE4Good index, which screens companies according to such criteria as environmental sustainability, human rights, labor standards, and avoidance of tobacco products and nuclear weapons. With an expense ratio of 0.29% and average annual ten-year return of 6.88%, FTSE Social Index is one of the most cost-effective social funds. Still, $10,000 invested in 2003 would have grown only to $17,860 by 2013, while it would have grown to $20,732 in the 500 Index Fund.

Your bottom line

In the end, the best investment plan is the one that is most appropriate for your particular goals and circumstances. Your financial goals don’t exist in a vacuum, but they connect to your life goals and to all that you care about in your family and your community. Investment income can contribute to the quality of life, but it can also detract from that quality if it comes at the expense of a clean environment or of human rights. Your real “bottom line” is not financial profit, but value however you define it.

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