Summer Reading

This set of book reviews originally appeared in the July 2008 issue of the HS Dent Forecast month and cover a wide variety of topics: financial bubbles, pension funding, healthcare, immigration, population control, and of course, age demographics. Before your next trip to the beach, make a stop by the bookstore and toss one of these in your bag.

The New Paradigm for Financial Markets
by George Soros

We will start our summer reading list with George Soros’s most recent book, The New Paradigm for Financial Markets. In the opening pages, Soros gives a good history and analysis of the 2007-2008 credit bubble and crisis using some rather sobering language:

We are in the midst of a financial crisis the likes of which has not been seen since the Great Depression of the 1930s. To be sure, it is not the prelude to another Great Depression. History does not repeat itself. The banking system will not be allowed to collapse as it did in 1932 exactly because its collapse then caused the Great Depression. At the same time, the current crisis is not comparable to the periodic crises which have afflicted particular segments of the financial system since the 1980s…. This crisis is not confined to a particular firm or a particular segment of the financial system; it has brought the entire system to the brink of a breakdown, and it is being contained only with the greatest difficulty. This will have far-reaching consequences. It is not business as usual but the end of an era.

After his initial comments on the credit crisis, Soros launches into a detailed explanation of his trademark Theory of Reflexivity, his refute to classical economics and rational expectations theory. Classical economics would tell you that market participants coldly and continuously calculate the “correct” price that they are willing to pay for, say, a given share of stock. Few people would argue that this theory holds up in the real world, as stock prices deviate wildly and are prone to bubble and bust cycles. In the classic models, asset bubbles are impossible: every tick in the price of a security is the result of careful deliberation by the buyers and sellers.

In the Soros model of Reflexivity, market participants react to changes in the fundamentals. When earnings go up, the share price is bid up. But at the same time, the fundamentals themselves are affected by changes in the price. When a company’s stock price rises, it finds itself with more investment capital that can be used for expansion or acquisitions. This, in turn, increases earnings and causes speculators to drive the stock price even higher. This virtuous cycle continues until it becomes unsustainable and collapses. Likewise, a falling price can lead to a vicious cycle in which the company is starved of capital as sees its business fundamental deteriorate as a result.

In the Soros analysis, market participants do not merely observe reality and act accordingly; they actually change the reality by their own action.

For someone unfamiliar with Soros’s ideas, The New Paradigm is worth reading. Unfortunately, there is little “new” about it. Much of the material is a repeat of his 1987 cult classic The Alchemy of Finance.

While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC subways, Bankrupted San Diego, and Loom as the Next Financial Crisis
by Roger Lowenstein

You might recognize Roger Lowenstein’s name. He is the author of When Genius Failed, the definitive history of the 1998 Long-Term Capital Management collapse. His new book is a good history of the pension crisis and would be a good compliment to William Graebner’s A History of Retirement and Dora L. Costa’s The Evolution of Retirement.

At the root of the problem, the pension and health bills are paid by future generations but the benefits are enjoyed today by the current workers who receive payment, the current tax payers who temporarily dodge payment, and the current politicians that can take credit. This is a classic example of moral hazard in action.

One of Lowenstein’s key themes is that “retirement” is a relatively new concept. It was never considered a guaranteed “right” that all Americans are entitled to until very recently. Is his historical recap, Lowenstein writes,

But in the United States, until very late in the nineteenth century, pensions were almost unheard of. Union Army veterans got pensions, but they had begun as compensation for war injuries, and only later had been extended to older veterans generally. Private employers simply did not offer pensions. ‘Retirement’ as we know it – that is, a distinct phase of life devoted to family and to leisure after one’s working years – did not exist. Nor did the concept of unemployment.

Most people worked on farms on in small shops or mills. As they got older they didn’t stop working, they simply worked a little less. If old age did catch up with them, they turned to their families for food and shelter. The ‘problem’ of old age was in any case not widespread…. Retirement was less one of life’s standard passages, like adolescence or middle age, than it was an infrequent and brief preamble to the grave.

So what was the impetus for the creation of “retirement”?

The man who tended a farm could gracefully age on the job; the factory worker couldn’t. Shop stewards and department managers wanted the graybeards out, to make room for younger blood…. Pensions were created by companies that reckoned it to be in the corporate interest. They were a tool for managing labor, not an entitlement due to labor….

Government employers began to offer pensions somewhat before those in private industry. Predictably, the practice started in hazardous lines of work. The first modern pension was the Police Life and Health Insurance Fund, established in New York in 1857. Only cops who had been disabled (or the widows of cops who had been killed) were entitled to benefits, but in 1878 the pension was extended to all policemen who had served twenty-five years and reached the age of fifty-five. Benefits were liberal, but the fund was virtually insolvent almost from the start.

The transformation of retirement from a benefit to the company to a benefit for the worker was gradual, but it greatly accelerated during World War II:

Government policy further stimulated the pension bandwagon. The United States levied an excess profits tax on corporations during the war, which sent companies scurrying for the tax shelter offered by retirement plans. Also, the government froze wages while still allowing firms to grant (or increase) noncash benefits. Thus pensions became a way to give something to strapped employees. The result was a pension stampede, tripling the number of Americans with coverage….

The American private pension and health system was not really planned; it evolved based on labor market conditions from a bygone era mixed with muddled and ill-conceived government regulations. Yet because it has become the status quo, it is treated as somehow being sacrosanct and untouchable. But as Lowenstein writes, “…there us no reason for [pensions and] healthcare to be tied to the workplace (any more than there is for companies to provide schooling, shelter, or basic needs.) In any case, they can’t afford it.”

On thing is certain: This problem is not going away. With the coming retirement of the Baby Boomers, pension and health funding at the corporate, city and state, and national levels will be the next major fiscal crisis for the United States.

Let Them In
by Jason L. Riley

In Let Them In, Wall Street Journal editorialist Jason Riley makes the case for a more open immigration policy. In a country where aging demographics loom as the biggest obstacle to future growth and prosperity, young immigrants can add much needed consumer spending and entrepreneurial energy. Unfortunately, we do not see this happening. In the post-9/11 era, the country has turned far more insular, and sentiment towards free-trade, globalization, and immigration have all worsened as a result. The confident swagger of the 1990s has been replaced by feeling of vulnerability. Rising anti-immigrant sentiment coupled with a stagnant economy have already kept a fair percentage of would-be immigrants at home. We see this trend accelerating in the coming years, as America becomes a more closed economy.

With that said, let us now review what Mr. Riley has to say about immigration.

Most pro-immigration economists view immigrants primarily as a source of labor. But as many anti-immigration commentators have retorted, automation and mechanization can replace much of the low-end labor that immigrants do. Mr. Riley understands  immigrants as both producers and consumers. In response to calls for automation of agricultural work, Riley says: “Unlike the machines, immigrants not only pick produce but also consume products and services, thus helping the U.S. economy expand.”

Immigrants have also been blamed for rising health costs. But as Riley explains, “And so it goes with health care. Health-care costs aren’t what they are because of immigrants but because we have employer-provided health insurance. A third party rather than the patient is paying most of the medical tab. When people are spending other people’s money, they tend to spend more of it, which drives up costs.”

The children of immigrants are often blamed for “flooding” American schools and driving up costs. But this assumes that education is an “expense.” As Riley explains, “Such human capital expenditures, properly understood, are a net investment, and the children of immigrants – including Latinos – typically do better then their parents in terms of schooling and income. It’s a strange logic that assumes American children are a fiscal burden to society.”

Across all fields of study, people tend to extrapolate current trends into the future. This is probably the main reason why most economic forecasts are so terribly wrong: the future generally does not look like the past.

Americans have witnessed enormous numbers of Mexican immigrants, both legal and illegal, entering the country over the past twenty years, and as a result they believe this trend will continue indefinitely. This is what led Fox News commentator Bill O’Reilly to recommend using the US Army to patrol the US-Mexican border. But as Jason Riley writes, “In fact, we may have already reached the high-water mark for illegal immigration from our main ‘sending country,’ Mexico. Demographic trends south of the border show that the size of the young adult Mexican cohort, from which most immigrants are drawn, is declining.”

Demographer Phillip Longman noted the same trend in his book The Empty Cradle, which we also highly recommend. Longman went so far as to suggest there will come a time in which Mexican border guards will be patrolling the border to prevent their promising young nationals from leaving for the United States!

Finally, Riley acknowledges that sentiment towards immigrants tends to run in cycles. All of the negative views towards immigrants expressed today have been heard before. There is nothing new under the sun:

Most every anti-immigrant argument rolled out today is a retread. Benjamin Franklin was complaining about bilingual sign posts and “swarms” of unassimilable Germans migrating to Pennsylvania 250 years ago. Later, in the nineteenth century, people like Samuel Morse, inventor of the telegraph and a leading nativist of his day, would pick up Franklin’s banner. Morse was a founder and generous financier of the anti-immigrant and anti-Catholic Know-Nothing movement, and in lieu of Germans he railed against Irish immigration in the antebellum decades. In his 1835 treatise against the political influence of Catholicism, Morse argued that poor, uneducated Irish Catholics were subverting the values and ideals of Anglo-America and should therefore be kept out of the country.

Opposition to Asian immigration came next. By the late nineteenth century, “Yellow Peril” was all the rage, stoked by increased Chinese immigration to the American West. A famous 1881 illustration first published in The Wasp, a San Francisco-based literary magazine edited by Ambrose Bierce, depicts Lady Liberty as a Chinese coolie gripping an opium pipe. The rays of light emanating from the statue’s head are labeled “Immorality,” “Filth,” “Disease,” and “Ruin to White Labor.”

Fatal Misconception: The Struggle to Control World Population
by Matthew Connelly

Matthew Connelly, an Associate Professor of History at Columbia University, has written the first global history of population control by both governments and non-governmental organizations. He includes the histories of both pro-natal and anti-natal positions, and even touches on related issues such as eugenics and immigration. The book is largely critique of the neo-Malthusian “Population Bomb” mentality and the flawed (albeit well-intentioned) efforts of Westerners to limit population growth in their own countries and in the developing world.

As Connelly writes, “The idea of population control is at least as ancient as Plato’s Republic, which described how a “Guardian class” could be bred to rule, the unfit left to die, and everyone sold the same myth that political inequality reflected the natural order of things.” This harsh sentiment is reflected in policies ranging from today’s One Child policy in China to the eugenics movements in the United States and Western Europe in the 1930s that attempted to limit the reproduction of the “unfit.”

Of course, today many of the countries that attempted to limit population growth in the past are now desperately trying to foster it. Pro-natal policies abound in North America and Europe, with former president Vladimir Putin’s offer to pay Russian women $10,000 for each baby being the most extreme example. In words that echo Phillip Longman, Connelly writes,

Some have now declared a new population crisis…and we are told that we should fear too many elderly rather than too many children. Now most pronounced in Europe and Japan, the “aging” of populations may proceed much and more rapidly in countries where fertility fell the fastest, such as China and Mexico, this time without the benefit of a societal safety net.

In Summary

We see several recurring and interrelated themes in the books reviewed: financial bubbles, demographics, the looming pension and healthcare crisis, immigration, and population policies. As we enter the next economic season, each of these themes – and the way that each of these themes interact with the others – will become more prominent in the popular press. Understanding these themes will help you to navigate the rough seas ahead.

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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