Monday, December 18, 2006

Paging Marty Feldstein: Please Read This

by Edward Hugh

This is a quick follow-up to my lengthy post at the end of last week about immigration and population ageing, which was a review of a recent paper by Marty Feldstein.

Now in his paper Marty says this:

But because the rate of return on an investment based account is much greater than the implicit return in a pure tax-financed system, the amount of saving that is needed is much less than the amount of additional taxes that would otherwise be required.

to which I made the following point:

Again formally speaking this is surely true, but just what rate of return can be offered? No-one really knows. In fact the issue of just the level of the rate of return on private pension funds is much more a problem than that old bogey of 'stock market meltdown', but the problem isn't being thought about sufficiently.

Well lo-and-behold, just take a look at what came in over the Bloomberg wires this morning, in relation to the problems Pennsylvania's 200,000 public employees are having getting 'return' on their investments:

Dirty Wall Street Secret: Hedge Funds of Funds Pay T-Bill Rates

Pennsylvania's 200,000 public employees are paying Morgan Stanley some of the money-management industry's steepest fees to get returns that aren't much better than yields on U.S. Treasury bills.

For the privilege of investing in the $2.6 billion Institutional Fund of Hedge Funds, the Pennsylvania State Employees' Retirement System gives up about 2 percent of assets and 20 percent of any profits to Morgan Stanley and the management firms it hires. The so-called fund of funds is supposed to reduce the risk of investing in hedge funds while beating stock or bond returns. Instead, Pennsylvania made 5.1 percent through September when it could have earned 3.6 percent on T-bills, the world's safest investment.

Securities firms will collect more than $1 billion in fees this year to keep clients such as the New Jersey and Philadelphia pension plans invested in funds of funds. Those who assumed that Goldman Sachs Group Inc.'s Global Tactical Trading LLC would provide the best returns for the lowest risk in the hedge fund industry were mistaken. They got 1.7 percent through October -- a situation all too common on Wall Street, where every firm selling funds of funds is a winner even when their customers aren't.

``For these large institutions gathering assets is the name of the game, not performance,'' said Edward Bowman, a partner at Veritable LP, the Newtown Square, Pennsylvania-based consulting firm that oversees $8 billion for wealthy families.

Another of Goldman's funds of funds, Hedge Fund Partners LLC, made 5.6 percent for investors in the first 10 months of this year, compared with an industry average of 6.5 percent, according to Chicago-based Hedge Fund Research Inc. The $681 million fund, which is registered with the U.S. Securities and Exchange Commission, has trailed the industry by between one and three percentage points for each of the past three years.

The underlying problem here is that in an age where underlying demographic transitions mean we are more than likely going to see a global savings glut, good rates of return - like good lovin - are going to be hard to find. Incidentally emerging markets are once more on the up and up, and the Thai Baht is now being protected, not from foreign exchange outflows, but from local currency ones.

Oh, and Marty, if you ever do read this, check out the bigger and longer post of mine linked to at the top. That is where the real argument is, this is just a side dish.


jwenck said...

"we are more than likely going to see a global savings glut"

First-order nonsense.
1) Petrodollars are being recycled at triple the rate they were being recycled at in the 70s and 80s
2) Informal data on the lending intentions of large Asian banks allow us to expect them to lend out between 50% and 250% more - not over the next decade, but just the next one or two years!
3) A rise in American-style credit-financed consumption is also behind the fact that German growth will continue beyond the date of the VAT rise (which was almost universally held to be impossible not so long ago). Just as in Japan, exports are only part of the picture.
4)This leaves us with the country where the savings-glut thesis originates from. The U.S. may indeed well see a rise in the savings rate. That´s what Bernanke´s policy aims for, after all. An increase in U.S. savings, however, won´t suffice to cancel out a confluence of crosscurrents in Asia, Europe and the emerging markets.

Of course, you don´t really want to find out what´s going to happen next but to prove that demography is the dominant factor in economic development. A few years ago you claimed that the U.S. would continue to grow much faster than Europe and claimed that that would verify your demographic thesis. Now we are seeing the U.S. losing steam amid statements that the U.S. trend growth rate might not be significantly higher than the rate that happens to be featured in other news as the current German growth rate. Consequently you now say that the period of "good demographics" putting the U.S. at an advantage is over.
Run that past me once more, please: the fertility rate comparison hasn´t changed, but somehow it only matters when it fits the concept, while it can be safely disregarded whenever it doesn´t?

Admin said...

Hi Joerg,

"Run that past me once more, please"

Ok, I'll try.

"A few years ago you claimed that the U.S. would continue to grow much faster than Europe and claimed that that would verify your demographic thesis."

Well, this is oversimplifying a bit, since France and the UK (and of course Ireland, but it is too small to dent the data here) are in Europe, and they have pretty similar demographics to the US, especially the UK after all the Polish migration. The UK is NOT of course in the Eurozone, and I may well have said that the US would continue to grow faster than the Eurozone, and since I said this, when, back in 2002, it looks like a pretty good prediction to me.

2006 is the odd year, since we don't have the final call on the eurozone or the US for 2006 yet, so we still don't know who is growing faster this year. Looking forward over the 2006 - 2010 horizon I would say I am once more onto a pretty good bet.

"Now we are seeing the U.S. losing steam amid statements that the U.S. trend growth rate might not be significantly higher than the rate that happens to be featured in other news as the current German growth rate."

If you look at the next post, the best estimate of trend growth in the US is around the 2.8 to 3.0% rate, German trend growth is around the 1% mark, it has been for some time. 2006 is just a statistical blip, produced in part by very strong investment growth in China, and construction brought forward to avoid the 3% VAT next year.

You doubt this I imagine, so lets go and see what happens next year, and then check back again in a couple of years, since you are undoubtedly follwing me over the long haul :).

"Consequently you now say that the period of "good demographics" putting the U.S. at an advantage is over."

I'm not saying this. Where do I say this? What I AM saying is that the very, very favourable US demographics have now peaked, and that this is unlikely to recur. The US will now most likely continue with its demographic transition but it will (like France and the UK) continue to have a twenty year advantage over the EU cases with the worst demographic profile and Japan.

joeimp said...

I am an expert in hedge funds.

Hedge funds do not have to beat the market to be a good investment. Hedge fund of funds with no correlation to equity indexes only have to beat the cost of borrowing. An institution seeking to optimize the risk and return tradeoff will recognize that the addition of marginal investment dollars in an asset class that is either negatively correlated, or uncorrelated, with the rest of the portfolio need only achieve a return above the risk free rate.

This is the beauty of hedge funds - an investor can borrow to buy hedge funds and it would actually reduce the risk, for the same level of return, for his/her investment portfolio.

Criticizing a hedge fund for beating the market is unwarranted - their goal is usually only to beat the risk free rate.

Admin said...

Hi Joe,

"Criticizing a hedge fund for beating the market is unwarranted - their goal is usually only to beat the risk free rate."

Yep, I agree. But this isn't the force of my point. The thing is what sort of rate of return can we forsee on retirement savings - whether in hedge funds or conventional ones - and what sort of pensions will people be able to obtain on the basis of their savings.

Here it is the - inflation adjusted - absolute values that matter, not the differential between risk free and the rest. The big unknown is just how low can 'risk free' go, and then how long can it stay there?

joeimp said...


But with leverage a portfolio that includes a hedge fund returning one or two percent over the risk free rate can be made to provide a MUCH greatr return than that same portfolio minus the hedge fund.

The key is leverage. Although this may seem counter-intuitive, the heavily leveraged portfolio with the hedge fund may have a higher return AND a lower risk (i.e. volatility) profile.

The ability to generate returns uncorrelated to other asset classes is a prized possession. Sophisticated investors already know this. Pension laws which are at times restrictive will be the next to realize this.

Admin said...


Thanks for this. I am sure you know much more about how hedge funds work in theory and in practice than I do. I think I can see how it works, but this isn't really what catches my interest at this point (of course I agree with you that pension funds at some point will get into all this).

What I am trying to see is the big picture about future interest rate movements. Obviously my way of doing this is rather unconventional, and simply consists of applying Modigliani's Life Cycle Theory (or Friedman's Permanent Income Hypothesis, which for present purposes amounts to the same thing) rather crudely to populations.

Now the other important detail to keep in mind is the SIZE of China and India. It is this factor really that is going to dominate everything.

One of the objectives of this blog might indeed be to try and work out how they got to be so large in the first place, since of course, at the time of the industrial revolution there wasn't this huge imbalance between European and Asian populations. But I digress (although the digression could turn out to be an important one, since given what happens next it could be useful to try and understand how we got here, since I doubt anything in all this story simply happens 'porque si').

Now let's do a mental leap forward to the time when per capita incomes in India and China are roughly what they are now in the Europe/America range. We can argue about how long this will take, but it will happen eventually.

But at this point both India and China will have quite high median ages, rather like Germany and Japan do today. So this means they will have an excess of savings, and given the whopping scale of their economies (which at this point could be 4 or 5 times the US one in absolute terms), this is going to mean a massive excess of savings, and very low (zero, if not negative) interest rates. Possibly we will have some sort of version of a global liquidity trap, if we simply project what has been happening in Japan onto the global level.

As it happens China will obviously get to this point in terms of median ages much sooner than India (maybe by 2025) although we just don't know how rich China will be in per capita terms at this stage.

At present we have a savings glut due to the fact that some of the very richest societies are saving a lot, but this may well change as some large developing economies approach the current median age of the US (around 36) and approach developed economy standards of living the global demand for debt may well rise considerably.

OTOH if we look at S Korea which is already in this range, we will see that savings patterns are rather different from those in the US, so cultural factors do seem to be important.

All-in-all this seems a very complex picture, and what I am saying is just a first stab at conceptualizing one version of what might happen. My guess is that we are going to see a lot of excess saving, and for some considerable time to come, as cultural attitudes change more slowly than median ages in some key countries, but this is only a guess.

Meantime, and looking at what just happened to Thailand, expect some developing economies to grow very quickly indeed (India eg) as money comes flooding in in search of yield, and development suddenly gets to be a lot cheaper, a bargain basement you could almpost say.

joeimp said...


I think that you are right about the savings glut. Many Western people will find that they have over-saved as a result of over-investing in their own incomes, relative to what a person trying to maximize his/her "reproductive fitness" would rationally do. A million dollars in the bank and only one offspring does not seem to be an example of someone appreciating Darwin's rules. While Friedman believed that people saved for their descendants, surely a half million in the bank and two children is a better reproductive gambit than one child with a million in the bank.

There will have to be, to borrow a stock market term, a "correction" in the future. The excess savings will have to go somewhere to chase a return.

It is interesting that this future savings glut makes the consumer debt of Americans that much more rational. They are anticipating that they will have extra funds in the future and are rationally deciding that they should be in debt now. Americans are subject to much less government intervention in their lives so it is not suprising that they would, as a group, behave in a more rational way with respect to their finances.

Anyway, if Friedman is right that people save for their descendants, then another way that these only children could "use" their money is to decide to have a large family. This lends itself to Longman's theory of the return of patriarchy.

J said...

There will have to be, to borrow a stock market term, a "correction" in the future. The excess savings will have to go somewhere to chase a return.

Correction usually means that a stock or the market is worth less today than yesterday. The savings that have to do the chasing for a return will find nowhere to go, and they will lose value. Saving when everybody else is saving like crazy is irrational. What are the Chinese thinking they will do with all their savings?

Admin said...

"Saving when everybody else is saving like crazy is irrational."

You raise a very interesting question here Jaimito, and I suppose it is addressed to JoeImp, who suggests that people are rational (Aristotle I suppose, man is a rational animal). Personally I have my doubts about this as a generalisation. Stock market booms and crashes seem to suggest if not the contrary, well at least that this needs seriously modifying as a view.

I have already drawn attention to what seem to me to be serious flaws in the reasoning process as deployed by Marty Feldstein (the "all" and "some" question) and he is a very able economist, so what chance has the gentleman on the clapham omnibus?

Traditionally the way round this has been to suggest that people have only access to very imperfect information, and this would be the explanation, for example, of why people have been investing heavily of late in the downtown Tokyo and Berlin property markets, given what we already know about elderly societies and continuing weak consumption in Germany and Japan. Read such phenomena as you will.

"What are the Chinese thinking they will do with all their savings?"

Well funnily enough Ben Bernanke recently tried to address this:

"Policies aimed at increasing household consumption would clearly benefit the Chinese people, notably by improving standards of living and allowing the fruits of economic development to be shared more widely. Such policies, by reducing saving and increasing imports, would also serve to reduce China's current account and trade surpluses."

Equally interestingly Greg Mankiw made this very valid point on his blog about this comment from Bernanke:

"The positive economics here is impeccable, but the normative economics is open to debate. If a friend of yours is saving a high fraction of his income, how can you tell him he is saving too much without knowing his personal rate of time preference and his desire for precautionary savings? Judging another person's saving rate is difficult. Judging another nation's saving rate cannot be any easier."

In other words it isn't really clear what free market economists can coherently say about all this. The Chinese could be thought to have the right to save whatever they want to save. Simply telling them they aren't being rational probably won't help too much.

Curiously, Mankiw also has this post up yesterday:

"I don't know if Gerald Ford ever read economist Friedrich Hayek's Road to Serfdom (or if he speechwriters did), but this Ford quotation strikes me as a good one-sentence summary of the book: A government big enough to give you everything you want is a government big enough to take from you everything you have."

So those who wan't to follow in Freidman and Hayek's footsteps need to think very carefully about the implications of recommending certain kinds of policies to the Chinese government, especially in the light of the fact that there are no obvious policies short of Freidman-type helicopter money which would be sure to work.

Of course Bernanke is a central banker, and central bankers in principle can't be dogmatic free market economists, since the very function they serve is to try to alter the course of the free market. At the end of the day central banks are big government without any voting rights (which doesn't mean to say they aren't necessary, but then I'm not a Friedmanite, and I don't 'believe' in market mechanisms in quite the same way Joe Imp does).

Anonymous said...

I am too old to tell my hardworking, frugal Chinese friend to save less and enjoy more. I was asking (myself) what they are thinking they will do with their growing treasure. If history is any indications, some Manchu, Viking or Hungarian chieftain and/or speculator already is eyeing it. Or the English Embassador may be in its way to Peking with its "tribute" of very ingenious toys.

In a general way, I would agree that saving behaviour is not always rational, as childless people leave fortunes to their cats, and saving less vs having more children never seems to come up in real life.

Anonymous said...

The Chinese are still building their basic infrastructure.

In fact, given their very rapid aging, you could say that they're in a race to get it into place so their single grandchildren will have enough capital equipment to support the 6 oldsters who will be standing on their shoulders.

It illustrates how both very high (China, 1950-70) and very low (China, 1985-) birthrates create massive problems.

The Chinese, by some weird alchemy, seem to have managed to saddle themselves with both sets.

joeimp said...


The "rationality" I refer to is that many Westremers have made their, what I would call irrational, life choices up to the age of 40 - career first, kids second. In the sense that their fertility window has closed, it seems rational now to save the money over the next 20 years for the one or two children that they did manage to find the time to have. Why not leave your children with a fortune by continuing to work? At least this will provide more options for their progeny.

I certainly wouldn't call rampant materialism rational - they have the income - why not save it?

Anonymous said...

joeimp, I can agree with that. I didnt understand the half-a-million dollar baby option. I was thinking: Would it have been more rational to organize my life in such a way that the first part (say 17 to 37) was dedicated to produce children and the second part (say 37 on) to career and saving? In my life-circumstances, that would have been very difficult. First, even if I found a girl ready to share prolonged poverty ("Amor, pan y cebolla", in my Argentinian slang), my chances to engage in a career at age 37 would have been slim. Universities discourage "older" students, they are made feel "foreign", and then at the workplace, there is a strong discrimination against over 30 people (I would even say they hate older people. I hated them). The right thing would have to have rich parents and live a balanced life. Next time, may be.

Admin said...

Hi Joe (again) and Jaimito

"Why not leave your children with a fortune by continuing to work?"

I have no problem with this, or with saving or borrowing or whatever. As Greg Mankiw suggests, I accept my neighbours right to do whatever they want with what is theirs.

I am trying to look at the macro economics of all of this, and to see what, given the demographic imbalances we are now playing around with, the consequences might be.

Now we know we are moving over the present horizon into a huge savings glut as more and more societies approach that 43 year median age mark.

So lets take a topical example - money laundering - and think about the rationality of things (actually we aren't really talking about either rationality or lack of it here, but rather their time and intergenerational preferences, and since we leave preferences out of the screen we can assume any preferences are more or less rational, and just look at whether people implement their preferences in a consistent fashion or not).

Now there was a time when if you had a lot of money to launder here in Europe, then the best thing to do was to buy a golf course. This was the case because golf courses were normally in remote or semi remote areas (maybe you have all heard of Marbella by now) and as such the local politicians were too busy wondering how to spend all the extra revenue that would come in to think too much about where the money came from (I don't think you need to imagine too much corruption here, just people who don't spend much time watching the magicians hands).

Again at one time you could get yourself a golf course for around 5 million euros (I've no idea what the going rate is these days, but let's do 1990 type prices). Then, of course, the last thing you want is anyone to actually play golf. No, what you want is for the whole thing to go bankrupt (I was actually invited for a round of golf by one of these characters somewhere in the South of France, I'd been invited to the restaurant by the local binman who was a friend of the cook, and since there were no customers and the menu was reasonable, we could eat very well. Of course I enjoyed the food and refused the golf).

Anyway, then what you do is sell the place for around a million euros (which is what actually happened) and walk away happy, since the money is now legal.

So if we hit the kind of excess liquidity I suspect we may well hit at some point (this is the thing about Jaimeto's what are all the Chinese going to do with their savings) and a general deflationary environment (remember I got into all this demography stuff by asking myself why there was such protracted deflation in Japan) then of course we could see widespread and sustained negative interest rates, and thus the intergenerational transfer of resources can become simply a much more sophistocated version of money laundering.

And if these returns on people's work are consistent with their preferences between time and working, then fine, but I just hope they know what they are getting into, that's all.


""Amor, pan y cebolla", in my Argentinian slang"

Where's the slang here :)

Actually this is now absolutely off the point, but you made me think of "Sobre Heroes y Tumbas" which is both one of my favourite books, and a fitting epitaph for what I have said above. Of course I do wish more people had read "the report on the blind"and tried to understand what the man was getting at.

Anyway, how can you tell it is New Years Day. A Happy New Year to you both in the United States and in Argentina.