Happy 2013. Time to evaluate investment ideas, particularly in light of the new tax code. The Federal Reserve Bank has announced plans to print money until unemployment rates are reduced to less upsetting levels. They say that they can do this without creating inflation, but these are the same folks who created the 1970s inflation and who missed the problems that led up to the Collapse of 2008. The potential for inflation argues in favor of equities rather than bonds. (Disclosure: I am a child of the 1970s and the Jimmy Carter “malaise” years so I probably have an irrational fear of inflation.) With tax rates on income having been increased, but capital gains rates still being reasonably low, stocks again look more attractive than bonds. The question then becomes… what stocks to buy?
As the Secretary for the MIT Class of 1982, I recently received a report on our school’s $10 billion endowment. It seems that the professional money managers have put just 6 percent of the money into bonds, 8 percent into U.S. equity, and 17 percent into international equity. So it looks as though they are favoring international but the waters are muddied by the fact that the school has 12 percent of its portfolio in real estate (e.g., office buildings in Cambridge) and 8 percent in “real assets” (gold bricks? forests?). There is another 25 percent of private equity (feeding the next Mitt Romney with fat fees) and 23 percent in scary hedge fund-type stuff. MIT seems bullish on its neighborhood (the Cambridge real estate) but bearish on the U.S. as a whole (just 8 percent faith in the S&P 500 and smaller cap stocks). The annualized return of this endowment has been 9.7 percent over the last 10 years. Vanguard says that its Total Stock Market domestic equities fund has returned 8 percent, by contrast.
MIT seems to favor international over U.S. stocks. Is this thumbs down on future U.S. growth reasonable? Naively one would think that the bigger and richer a country is the easier it would be for that country to keep getting bigger and richer. The country has a huge capital base, educated people, fantastic infrastructure, etc., that poorer countries cannot hope to match. Yet we do see Europe and the U.S. both more or less stalled out while much of the rest of the world booms (today’s New York Times: “Unemployment in the euro zone rose to a new record in November”).
Why is it that rich established countries stagnate and leave room for the upstarts? Mancur Olson claimed that it was interest groups tapping into government, e.g., companies, farmers, or unions obtaining favorable regulations that enable them to collect more money than in a market economy. I wonder if his analysis is simultaneously incomplete and overly complex.
Let’s start by considering a primitive economy. The only way to get an income is to work or to get a voluntary contribution from person who is working, e.g., a family member or close friend. As an economy advances, additional mechanisms for earning a cash or cash-equivalent income are developed. Let’s consider some of what we’ve got in the U.S. right now:
- “I am old and worked for at least a few years.” : collect Social Security
- “I drove a city bus from age 18-41.” : collect full pension from Massachusetts public transit system
- “I am disabled.” : collect Social Security Disability Insurance
- “I am able-bodied, ready to work, had a job 1.5 years ago, but don’t have a job now.” : collect unemployment insurance
- “Twenty years ago, I was married.” : collect alimony
- “Twenty two years ago, I had a child.” : collect child support (Massachusetts at least enables a parent to collect child support until a child reaches the age of 23)
- “I am poor.” : collect free or nearly free house, medical care, food, etc. (partial list)
One can argue about the merits of these various schemes, but it seems beyond doubt that in the aggregate they reduce the percentage of people in our economy who are working. Much of this effect, e.g., above-market public employee salaries and pensions, Mancur Olson budgeted for in his analysis.
Something that Olson did not consider at all, however, if memory serves, is loss aversion and the fact that wealthy societies have much more to fret about losing. Loss aversion is a massive cognitive flaw that leads to a lot of terrible decisions (see Thinking, Fast and Slow by the Nobel laureate Daniel Kahneman for a good overview). In the simplest form, an investor would be reluctant to sell a stock that they believe is likely to go down because to do so would lock in a $10/share loss already suffered. Kahneman cites research showing loss aversion will lead companies to spend millions in legal fees defending lawsuits that they expect to lose, simply because the idea of confronting the loss is too painful (so they end up losing the case, paying twice as much as they would have paid to settle it, and then paying legal fees on top).
Let’s look at where the U.S. has been beefing up spending in recent years. We spend more than any other country on health care though we know that none of it will make us healthier or feel better day to day. So really we are spending because we are afraid of losing our health or our lives. We can say that 1 percent of GDP is spent on actual health care and the other 17 percent is spent on loss aversion (total of 18 percent of GDP is spent on health care in the U.S.). How about military? We spend money because we don’t want someone invading the U.S. and taking everything that we have worked for. We spend money because we are afraid of losing our influence in the world. I think we can chalk up all military spending and all of the spending on the Iraq and Afghanistan wars to loss aversion. That’s somewhere around 5 percent of GDP (worldwide average is closer to 2.5 percent).
We spend a lot on firefighters to prevent the loss of houses and commercial buildings. We spend a lot on police, district attorneys, criminal defense lawyers, and prisons to avoid losses due to crime. A country without such expensive buildings and/or expensive property to steal would probably not invest so much in fire and police protection.
Then let’s look at private security guards (roughly 2 million in the U.S., says Wikipedia). Are you waiting in line at the guard’s desk in the lobby of a skyscraper rather than going in and engaging in a meeting? That’s a drag on potential economic growth both because you’re not working and because the security guard is being paid to make sure that you don’t do something bad to the expensive building or the expensive property inside. We’ve got a lot of fancy airplanes and airports, more so than a up-and-coming country, but then we end up having to spend billions to protect it (more than $8 billion on the Transportation Security Agency plus whatever individual airports and airlines are spending).
Planning, zoning, and environmental delays are all part of loss aversion as well. We don’t want to lose open space, members of an endangered species, or some good feature of our neighborhood. So it took us about 10 years after the 9/11 attacks to begin rebuilding the World Trade Center. By contrast, one construction firm in China “put up a 15-story hotel in just 48 hours back in 2010 and a 30-story tower in 15 days in 2011″ (now they are planning to build the world’s largest skyscraper, 220 stories high, in 90 days).
As a society we spend a huge amount of money on insurance (and then billions more to bail out AIG!), but I couldn’t find a good source for property and casualty insurance total revenues.
[It is actually kind of hard to come up with government spending that does not fall into either the "paying someone for doing something other than work" or the "loss aversion" categories. Education is the only sizable government program that comes most easily to mind (parks and recreation are obvious as well, but they are tiny in terms of dollars). Since government is over 40 percent of GDP that means a huge chunk of national income spent on loss aversion even before private expenditures kick in.]
The more that you have, the more than you worry about losing it. It seems to be true for individuals. Not too many college students have renter’s insurance, for example. It also seems to be true of societies and loss aversion may ultimately impose a drag on the economy comparable to the interest groups that Mancur Olson cited.
How as investors can we put this theory into practice? We could invest in countries that are really poor. Congo and Zimbabwe, for example, are at the bottom of the CIA’s list of countries ranked by purchasing power parity. They probably aren’t spending too much on insurance to protect whatever is left of their societies, but on the other hand they aren’t easy places to do business. What about the middle income nations? They should have enough money to support a decent physical and legal infrastructure but not so much money that they spend most of their time and effort protecting what they’ve already got. If we were to say that we wanted to invest in countries that had purchasing-power adjusted incomes of between $5000 and $25,000 per year, what would we have? Nauru and Syria are first on the list. That doesn’t seem very practical. We could further refine our criteria and say that the country has to be big enough to have a stock market, needs to have a government that the inhabitants accept, and cannot have its income based purely on a natural resource of some sort. Now we’re looking at countries such as Jordan, Armenia, Georgia, Belize, China, Ecuador towards the bottom. Brazil, Costa Rica, Panama, and Uruguay are in the middle. Botswana, Russia, Latvia, Chile, Argentina, Croatia, Hungary, Poland, Estonia, Portugal are near the top. Maybe we need some more refinement that the country has to be on its way up rather than on its way down or stagnating. So we get rid of Argentina and Portugal, for example, because workers there will be depressed thinking about the good old days.
Finally we have the challenge as individual investors of finding a way to buy stocks in companies that are headquartered in and/or mostly do business in these countries.
So… questions for the readers:
- does this theory of why rich countries stagnate make sense/add anything to Mancur Olson’s time-honored analysis?
- are middle-income countries likely to grow faster than the U.S. and Europe?
- if so, what’s a reasonable way to invest in that growth?
[This posting is also available in a Czech translation.]