Category: Society

Why does America encourage debt?

America (and the world!) is now being punished for its relentless accumulation of debt during the housing bubble and before. Commentators of all stripes have laid blame for the credit bubble, whether upon Alan Greenspan, lack of regulation, greedy Wall Street, or otherwise.

But it’s interesting to note that US credit bubble has in fact been building for decades, as shown here:

US Household Debt to GDP Ratio
US Household Debt to GDP Ratio

I have a basic question: Why does America encourage debt? Both individual and corporate debt are encouraged through federal and state law, through mortgage interest deductions for individuals, and through similar deductions on interest payments by corporations.

The home mortgage deduction is a relatively recent invention, while business interest has been deductible since the advent of the income tax. Both deductions encourage us to borrow and increase leverage – and as we know now, leverage cuts both ways. The home mortgage deduction raises home prices and encourages Americans to take on excess debt. But what about the business interest deduction?

Businesses can typically raise money by either borrowing it or by selling equity in their business. Since borrowing is subsidized through a tax deduction, this encourages businesses to borrow money rather than selling shares to raise money. The downside is apparent in hard times: creditors demand repayment, whereas equity investors share in both gains AND losses*.

The home mortgage and business interest deductions formed the foundation of the credit bubble by creating a tax benefit for borrowing rather than saving.

These deductions also collectively cost taxpayers $250 Billion** per year, more than the Iraq war and almost as much as Medicare. Perhaps the next Administration should consider restoring the balance of incentives between saving and borrowing as part of its tax reform initiatives. While an immediate end to these preferences is impractical, a phased reduction coupled with broad-based tax relief might help transform America back into a nation of savers.

*From a business perspective, interest has always been treated as just another business expense, and is thus deductible just like the electric bill. But debt and equity are often competing forms of ownership in a business, and so making interest deductible makes debt more appealing than issuing shares. For example, a a pizza shop could borrow $10,000 for a renovation and deduct the interest as a business expense, or it could bring in a partner to buy 10% of the business in order to raise capital. If the owner of the pizza shop brings in a partner, he doesn’t get a deduction, and now he has to share any additional income with his partner. Thus debt is favored over equity – this principal is even taught in business schools.

** The home mortgage deduction costs totals $100 Billion per year, while the business interest tax deduction can be estimated at $150 Billion per year with total corporate debt of $10 Trillion, an average interest rate of 5% (conservative estimate), and a corporate tax rate of 33%.

Posted on by praveenghanta 4

Just One More Boom

PLEASE GOD, Just Give Me One More Oil Boom. I Promise Not to Blow It Next Time.

– Bumper sticker seen in Texas oil country after the 80’s oil bust

I wonder if any in the oil patch cashed out in the wake of the recent boom and bust? With the stock market, real estate, and commodities all down in tandem, a great many investors probably feel this way!

Posted on by praveenghanta 1

Crash of 2008: Three Potential Scenarios

The Financial Panic and subsequent stock market Crash of 2008 are now a boldface reality. So where do markets go from here? Here are three scenarios that we might confront:

1. Good: The market enjoyed a relatively quick recovery after the 1987 crash, surpassing the 1987 peak by mid-1990. Could we be so lucky this time?

2. Bad: The Dow peaked near 1000 in 1966, and then went on a rollercoaster ride, never permanently crossing 1000 until 1983! That’s an effectively flat market for 17 years.

3. Ugly: Japan’s phenomenal postwar growth and an associated bubble peaked with the Nikkei index above 37,000 in 1989. The Nikkei subsequently crashed, and is now trading at the same levels as in 1983, 25 years ago! If this sounds impossible, consider that Japan’s bubble was fueled by reckless lending and a real estate bubble, and that Japan resorted to fiscal stimulus and banking system intervention not dissimilar to the global approach today.

While no one can be certain, I think the middle scenario is not unlikely. Given that the current bear market is now dated to have begun 8 years ago, with the dot com bust, we may still have another decade to go.

Posted on by praveenghanta 0

We Need a Good Recession

“I believe if the credit markets are not functioning, that jobs will be lost, that our credit rate will rise, more houses will be foreclosed upon, GDP will contract, that the economy will just not be able to recover in a normal, healthy way.” – Ben Bernanke, Fed Chairman, Sept. 23rd, 2008

“that our American economy’s arteries, our financial system, is clogged and if we don’t act the patient will surely suffer a heart attack — maybe next week, maybe in six months, but it will happen.” – Hank Paulson, Secretary of the Treasury, Sept. 23rd, 2008

Even before testimony concluded yesterday on Capitol Hill, reports with headlines like “Bernanke: Recession Certain in Absence of Bailout” and “Bush Administration Tells Congress to Act Quickly or Risk Recession” hit the wire services. Both Ben Bernanke and Hank Paulson stated clearly that a recession would occur if the proposed $700 Billion dollar bailout plan were not enacted. Similar threats of recession were used earlier this year when President Bush and Congress enacted a tax rebate stimulus program.

Let me ask a simple question: why is everyone so afraid of a recession? Recessions and boom times are both natural parts of the business cycle in market economies, and the United States experienced twenty recessions (including the Great Depression) in the 20th century alone. Economic downturns, with the associated bankruptcies and layoffs, help trim inefficient investments made at the peak of economic cycles, thus paving the way for the next round of economic growth.

The alternative to business cycles can be found in state-controlled economies, where inability to reallocate capital to new enterprises slows overall economic growth dramatically. Governments presiding over market economies also attempt to tamper with business cycles, and while intervention may soften the landing in a recession, it may also delay the recovery. Japan’s “lost decade” of the 90’s, where poor economic growth was the norm, resulted after Japan’s incredible economic boom of the 80’s. The extraordinary length of Japan’s recovery stemmed partly from the Japanese government’s inability to allow corporate and bank bankruptcies progress at the rate needed to clear out bad loans and start a new economic cycle.

The US would do well to heed Japan’s allegory. Ideally, any intervention in the financial markets should enable orderly collapse and restructuring of businesses overridden with bad debt. No one gains in a financial panic, but an unwinding of the excesses of the US housing bubble is inevitable. Creative Destruction is at the heart of the business cycle, it’s at the heart of the American economy, and it will be necessary in this cycle as well. Let’s not make it take longer than necessary.

Posted on by praveenghanta 4

Mortgages and Health Insurance: The Biggest Subsidies of Them All

Economists decry government subsidies, because they distort the market and cause inefficiencies, thus wasting taxpayers’ money and decreasing overall economic growth. Taxpayers and advocacy groups rightly decry government subsidies to corporations as pork-barrel spending.

Where then is the indignation regarding the two biggest subsidy programs of them all?

I’m talking about the home mortgage interest deduction and the employer health insurance deduction. The home mortgage interest deduction subsidizes homeowners at the rate of $100 billion per year, while employer health insurance is similarly subsidized at $250 billion per year. These subsidies carve a large hole in government revenue, which could otherwise be used to reduce the deficit or reduce taxes for everyone.

Both subsidies also have a more insidious effect – they raise prices for both homes and medical care, thereby making it harder for those with low incomes to afford either one. The mortgage deduction lowers the effective cost of a house for all buyers, thus increasing demand and raising prices. The net effect of the subsidy is to cause Americans to live in bigger houses than they otherwise would, without raising rates of home ownership significantly. Similarly, the employee health care deduction raises the cost of health care for everyone, and causes Americans to spend more on health care than they otherwise would.

Neither deduction is designed to help those with the greatest difficulty in getting a home or health insurance. Lower income families can’t afford the down payment required to avail themselves of the mortgage tax break, and most low-paying jobs don’t provide health care as a benefit.

These subsidies are popular because they target middle and upper-income America, but that doesn’t make them any more effective than much-maligned corporate subsidies. $350 Billion is a lot of money, and should either be given back to ALL American taxpayers, or spent paying for the deficit, recent wars, or other priorities.

Posted on by praveenghanta 6

What People Make III: Career ROI is as important as salary

What is the purpose of higher education? While a minority of college students have enough wealth to study as a hobby, college students generally view college as a step towards a career, with higher earnings potential as one motivation. But while a four-year college education generally has the same price tag regardless of degree, an individual’s future earnings potential vary widely depending on the degree chosen. Here is a partial ranking of careers, ranked by NPV and rate of return (details on the methodology at bottom):

Career ROI Rankings:

Career Average Salary NPV After-tax earnings (lifetime) Rate of Return
1. Law $124,230 $188,000 $4,825,000 15%
Attorneys rank high on the list since their education is complete just three years after college, and they can step right into six-figure salaries.
2. Computer Science $83,160 $184,000 $3,534,000 19%
Computer science grads start work immediately after college with salaries above 50k, giving them the fastest payback on their investment. Lifetime earnings potential is lower than in some professional fields, however.
3. Pharmacy $98,960 $168,000 $3,885,000 16.2%
Pharmacists typically must complete a six year program before starting work, but high demand for pharmacists enables them to move directly into $90k per year positions upon graduation.
4. Medicine $179,000 $151,000 $5,908,000 12.9%
Doctors have always enjoyed good incomes, but their educational investment is so high that it reduces their educational ROI more than is commonly realized.
5. Accounting $69,500 $148,600 $3,151,000 17.9%
Accountants can start work right after college, and their pay increases considerably once they’ve completed their CPA certification.
6. Airline Pilot $148,410 $125,000 $3,578,000 14.25%
Airline pilots must work for years at low paying regional air or charter jobs before making it to a major carrier, but the final payoff is a relatively high salary and reasonable working hours.
7. Nursing (RN) $62,480 $100,000 $2,633,000 16.3%
Nurses can finish training in as little as three years, and earn relatively good salaries right from the start, with job prospects virtually anywhere in the country.
8. Architecture $73,650 $54,000 $2,839,000 12.3%
Architects have decent salaries in the long run, but they must first complete a five year Bachelor’s program, and then spend several years as interns before becoming full-fledged architects.
9. Graphic Design $45,340 $24,850 $2,125,000 11.6%
Graphic Designers can start work right after finishing college, but competition for positions is high, keeping salaries down.
10. Teaching (K-12) $52,450 -$10,100 $1,986,000 9.4%
Teachers are not particularly well compensated in the US, and since their starting salaries are particularly low, the NPV of an investment in a teaching career is actually negative.
11. English (PhD) $60,000 -$14,000 $2,301,000 9.3%
At the bottom of the rankings are Humanities majors. If an English or Humanities PhD candidate tells you that they didn’t go into it for the money, they’re not lying: this career path has a negative return on investment in income terms.

Annotated spreadsheet with all calculations: HTML | XLS with formulas

Law, Computer Science, and Pharmacy majors take top honors in terms of career ROI, while (perhaps not surprisingly) artists, teachers, and Humanities professors come out on bottom. Doctors and airline pilots are further down the list than one might suspect, principally because they spend so many years in training before achieving high compensation.

Definition of Terms:

NPV: This is the Net Present Value of the student’s investment in education, based on a 10% discount rate. 10% is a common rate of return expected for long-term investments, and it helps provides a fair benchmark of the value of each career path.

IRR: This is the Internal Rate of Return of the educational investment. IRR tends to favor shorter time horizons, so shorter educational paths like computer science are rewarded when measured via IRR.

Lifetime Earnings: This is a simple sum of the lifetime after-tax earnings of each career path from age 18 through age 65.

More info on Methodology:

All salary data was taken from the BLS May 2007 Occupation Employment and Wages Estimates. College was assumed to cost $20,000 per year (this sounds low, but is an average for public and private colleges, after all scholarships, grants, and student work are taken into account). Professional school costs, and graduate and resident stipend data were sourced variously, and are noted in the spreadsheet. Inflation at 2% and progressive taxation were also accounted for in the calculations.

The rate of return for each field was calculated by determining the IRR for each field, taking into account the cost of college and measuring total after-tax gains from age 22 to age 65. The NPV of each career path was also calculated with a discount rate of 10%. Finally, lifetime after-tax earnings were calculated as a simple sum to provide another measure of earnings potential.

Posted on by praveenghanta 6

What People Make II – Salary Data from the BLS

Here’s a more detailed analysis of salaries and a ranking of careers based on ROI (return on investment).

The US Bureau of Labor Statistics gathers detailed data on wages across the US economy, and even breaks it down by industry and occupation:

http://www.bls.gov/oes/current/oes_nat.htm

The data is updated annually, and is available by region and industry. Though it doesn’t include information on bonuses and benefits, which can be a substantial component of compensation, the BLS data is a great starting point for quality salary data. Keep in mind that these statistics tend to underestimate the total compensation of those in corporate jobs, since bonuses and benefits are generally greatest in large companies. Where available, the median wage is provided.

Here are some highlights:

Assorted Salaries by Occupation (Incomplete):

  • CEO – $170,000 (Private sector only; since BLS data excludes bonuses, real CEO pay is somewhere between 2 and 10 times this number)
  • Management Positions – $105,000 (For white-collar management positions, excluding CEOs)
  • Doctors, Primary Care – $153,000 (Family Practice, Pediatrics, Internal Medicine)
  • Doctors, Specialists – $180,000 (All other specialties)
  • Attorneys – $125,000 (Private sector only)
  • Petroleum Engineers – $114,000
  • Pharmacists – $100,000
  • Computer/Software Engineers – $85,000 (Excludes technicians and other less-skilled positions)
  • Chemical Engineers – $82,000
  • English Professors – $54,000 (All post-secondary teaching positions)
  • Farmers – $54,000
Posted on by praveenghanta 0

Affording the American Dream, Then and Now

How many people do you know that can afford the American Dream? In the post-war America of the 50’s, the modern notion of the American Dream crystallized: families aspired to a single family home, an automobile (or two), and modern comforts like a television, refrigerator, and washing machine. These seem like modest goals now, until you consider that in the fifties, most families got by on a single income! What percentage of households today can afford a median-priced house, two cars, and common comforts on a single income, and how does that compare to yesteryear?

According to the Economic Policy Institute, the median family budget for a family of four was around $40,000 in 2004, including all major household expense categories and taxes paid. The EPI family budget must be adjusted for inflation, and to account for ownership of a home and two cars. Excluding housing and transportation, the EPI median budget would be roughly $33,000 in 2007 dollars. Two low-cost Honda Civics would add another $12,000 per year, and $1600 per month would pay for a US-median $200,000 house, for a total budget of $64,000 per year. The EPI family budget excludes entertainment, consumer electronics, vacations, and other discretionary spending. Padding the budget to $70,000 might account for these expenses. A family breadwinner making $70,000 per year is in the 88% percentile, making it clear why most families now get by on two incomes.

While it’s difficult to reconstruct an accurate family budget for 1950 using available data, data on the change in housing prices and median incomes can be used as a starting point. Median home values rose 151% from 1950-2000, and in 1950 a single family home cost only $53,000 in 2007 dollars. Median income was around $22,000 in 2007 dollars. This equates to roughly $4800 per year in mortgage, taxes, and insurance, or almost 75% less than in the modern example. The 1950’s earner would thus have to earn 2.5 times the median income to afford the American dream budget of $55,000. If one car is excluded (since few families at the time had two cars), this ratio drops to 2.2 times median income.

In 2007, an individual would have to earn 2.7 times the median income of $26,000 to afford the American dream. This ratio is higher than it was in 1950, and most of the difference can be explained by rising home prices, particularly in the last decade. At the same time, the ratio isn’t significantly higher, and even in the 50’s the idealized American dream was only affordable by a small percentage. Why then do many today feel the 50’s and 60’s were such better times? Perhaps, as this blog suggests, it’s because we’re working harder today to afford consumer lifestyles and modern luxuries, rather than sacrificing comfort for family time.

Posted on by praveenghanta 0

Paper or Plastic? A true cost analysis

Plastic grocery bags have been banned or taxed to discourage their use in other countries, and recently San Francisco approved similar measures. While reusable bags are touted as an obvious alternative to disposable bags, paper bags are also seeing a resurgence, and are the standard bags at upscale grocers like Trader Joe’s. Paper bags are often assumed to be more environmentally friendly, which begs the question: what is the true cost of both bag varieties?

Numerous reports have been published on this topic, with the Washington Post and Environmental Literacy Council providing particularly good comparisons. On most counts, plastic bags come out ahead, even after comparing the true cost of two plastic bags against one paper bag (to make up for differences in bag size). Plastic bags require 50% less energy to produce and cause significantly less pollution during manufacturing. Paper bags are recycled more often, but over 85% of paper and 97% of plastic bags end up in landfills, where neither biodegrades, and where plastic bags take 90% less space. Plastic bags are criticized for endangering certain marine animals, and because they often end up as litter since are easily blown about.

Another good measure of cost is the price of the two items, since neither is heavily subsidized, and since the price that stores pay for bags represents the direct cost involved in production. Plastic bags cost 50% less than paper bags in the US (2 cents for two plastic bags versus 3-4 cents for one paper bag). Advantage plastic.

On most counts plastic is the clear winner for the consumer, the environment, and businesses. In fact, after weighing the costs and benefits, the Natural Resources Defense Council recommends plastic bags to everyone unable to use a reusable bag, and recommends paper bags only for those living on the coasts (to protect marine wildlife). Perhaps, as with ethanol, paper bags have just become another easy way for politicians to score points for being green, rather than taking more beneficial (and difficult) steps to protect the environment.

Posted on by praveenghanta 6