Author: conversableeconomist

The financial sector needs some defenders, and John H. Cochrane steps forward with a bracing essay,
\”Finance: Function Matters, Not Size,\” in a symposium in the Spring 2013 issue of the Journal of Economic Perspectives.  (Full disclosure: I\’ve worked as Managing Editor of the JEP since 1987.) Here, I\’ll list some of the main points that I took away from Cochrane\’s essay in boldface type, with quotations from the article following.

Economists have been arguing for a half-century that active portfolio management isn\’t worth the fees paid for it (for example, see my post from yesterday). But when high-fee active portfolio management has persisted for decades in the face of such criticism, perhaps it\’s the critics who should be wondering if they are correct. 

\”High-fee active management and underlying active trading have been deplored by academic finance for a generation. … It seems the average investor should save 60 basis points a year and just buy a passive index such as Vanguard’s Total Stock Market Portfolio. It seems that the stock pickers should do something more productive, like drive cabs. Active management and its fees seem like a total private, and social, waste. Yet this hallowed view—and its antithesis—do not completely make sense. After all, active management and fees have survived 40 years of efficient-market disdain. Economists who would dismiss “people are stupid” as an “explanation” for a pricing anomaly that lasts 40 years surely cannot use the same “explanation” for the persistence of active management.\”

There are lots of inefficiencies in financial markets that can be exploited, at least for a time, to make profits.

\”But the last 20 years of finance research is as clear as empirical research in economics can be: There is alpha relative to the market portfolio—there are strategies that deliver average returns larger than the covariation of their returns with the market portfolio justifies—lots of it, and all over the place. … Examples of such strategies include value (stocks with low market value relative to accounting book value), momentum (stocks that have risen in the previous year), stocks of companies that repurchase shares, stocks of companies with accounting measures of high expected earnings, and stocks with low betas. The “carry trade” in maturities, currencies and, credit—buy high-yield securities, sell low-yield securities—and writing options, especially the “disaster insurance” of out-of-the-money put options, all generate alpha. Expected returns on the market and most of the anomaly strategies vary predictably over time, implying profitable dynamic trading strategies.\”

Highly sophisticated investors pay for active management of their financial assets, and apparently believe they are getting a good deal.  

\”Delegating active management and paying large fees is common and increasing among large, completely unconstrained, and very sophisticated investors. For example, the Harvard endowment was in 2012 about two-thirds externally managed by fee investors and was 30 percent invested in “private equity” and “absolute return,” largely meaning hedge funds. The University of Chicago endowment is similarly invested  in private equity and “absolute return.” Apparently, whatever qualms some of its curmudgeonly faculty express about alphas, fees, and active management are not shared by the endowment. … Why have these decision procedures become standard practice? Vague reference to “agency problems” and “naiveté” seem unpersuasive. Harvard’s endowment was overseen by a high-powered board, including its president Larry Summers, possibly the least naive investor on the planet. The picture that Summers and his board, or the high-powered talent on Chicago’s Investment Committee are simply too naive to demand passive investing, or that they really want the endowments to be invested in the Vanguard total market index, but some “agency problem” with the managers they hire and fire with alacrity prevents that outcome from happening, simply does not wash.\”

The existence of financial bubbles suggests that markets are inefficient, too. But many of those who are most insistent that financial markets are inefficient often shy away from the logical implication that if the market is inefficient, it might benefit from additional trading. 

\”The common complaints “the financial crisis proves markets aren’t efficient,” or that tech and mortgages represented “bubbles,” are at heart complaints that there was not enough active information-based trading. All a more “efficient” market could have done is to crash sooner, by better expressing the pessimist’s views. … If information is not incorporated into market prices and to such an extent that simple strategies with big alphas can be published in the Journal of Finance, there are not enough arbitrageurs. If asset prices fall in “fire sales,” only to rebound later, there are not enough buyers following the fire trucks. If credit constraints are impeding the flow of capital, there is a social benefit to loosening those constraints.\”

Do we care about the size of the financial sector or the instability of the financial sector? (And no, they aren\’t the same thing.)

\”The increase in fees for residential loan origination is easily digested as the response to an increase in demand. The increase in housing demand may indeed not have been “socially optimal” (!). There are plenty of government policies and perhaps a few market dislocations to blame. But it doesn’t make much sense to criticize growth in the financial industry for responding to this increase in demand, whatever its source, or for passing along the subsidized credit—which was and remains the government’s explicit intention to increase—with the customary fee. … There was a lot of financial innovation in mortgage-backed securities, some of which notoriously exploded. But here again, whether we spend a bit of GDP filling out forms or paying fees is clearly the least of the social benefit and cost questions. The “shadow banking” system was prone to a textbook systemic run, which happened. This fragility, not the size or fraction of GDP, is the important issue.\”

We don\’t really understand the process of price discovery in financial markets, and as a result, passive investing may be less intuitively attractive on a second glance.

\”The fact staring us in the face is that “price discovery,” the process by which information becomes embedded in market prices, uses a lot of trading volume, and a lot of time, effort, and resources. And we are only beginning to understand it…. [P]erhaps we should work just a little harder before dismissing the hundreds of years of trading activity, and the entire existence of the New York Stock Exchange, Chicago Mercantile Exchange, and other markets, as monuments to human folly, or before advocating regulations such as transactions taxes —the perennial favorite answer in search of a question—to reduce trading volume whose size, function, and operation we do not understand. Are we sure that they should not be transactions subsidies? And before we deplore, it’s worth remembering just how crazy passive indexing sounds to any market participant. “What,” they might respond, “would you walk in to a wine store and say ‘I can’t tell good from bad, and the arbitrageurs are out in force. I sure won’t pay you 1 percent for recommendations. Just give me one of everything’?”\”

The important aspects of the financial sector that we don\’t understand are a good basis for research, but in the real world of political economy, they could well be a bad basis for additional regulation.

\”Surveying the current economic literature on these issues, it is certain that we
do not very well understand the price-discovery and trading mechanism, nor the
economic forces that allowed high-fee active management to survive so long.
Unless we adopt the arrogant view that what we don’t understand must be bad,
it is clearly far too early to make pronouncements such as “There is likely too much
high-cost, active asset management,” or “Society would be better off if the cost of
this management could be reduced.” Such statements are not supported by theory
or evidence. Nor is their not-so-subtle implication that resources devoted to greater
regulation—by politicians and regulators no less naive than current investors, no
less behaviorally-biased, armed with no better understanding than academic economists,
and with much larger agency problems and institutional constraints—will
improve matters.\”

Cochrane\’s paper is part of a five-paper symposium on \”The Growth of the Financial Sector\” in the Spring 2013 issue of the Journal of Economic Perspectives.

The total assets managed by domestic equity funds rose from $26 billion in 1980 to $3.5 trillion in 2010. Would you expect the expenses charged by such funds to rise in proportion to the amount that they manage? Or by less?

Burton G. Malkiel argues in \”Asset Management Fees and the Growth of Finance,\” in the Spring 2013 issue of my own Journal of Economic Perspectives,  that there should be considerable economies of scale in managing a stock portfolio. (Like all articles in JEP back to the first issue in 1987, it is freely available on-line compliments of the American Economic Association.) Malkiel writes:

\”There should be substantial economies of scale in asset management. It is no more costly to place an order for 20,000 shares of a particular stock than it is to order 10,000 shares. Brokerage commissions (which are usually set in a flat dollar amount per transaction, at least within broad ranges of transaction size) are likely to be similar for each purchase ticket, as are the “custodial fees” paid to the bank that holds the securities that are owned. The same annual report and similar filings  to the Securities and Exchange Commission are required whether the investment fund has $100 million in assets or $500 million. The due diligence required for the investment manager is no different for a large mutual fund than it is for a small one. Modern technology has fully automated such tasks as dividend collection, tax reporting, and client statements.\”

Malkiel also cites more rigorous academic studies that find economies of scale. But despite the more than 100-fold increase in share of assets under management for these funds, the average amount paid as expenses has not declined in three decades. Here\’s the table, showing an expense ratio of 66 basis points of assets under management in 1980, but 69.2 basis points as a share of assets under management in 2010.

As Malkiel writes: \”Surely, there had to be enormous economies of scale that could have been passed on to consumers, resulting in a lower cost of management as a percentage of total assets. But we will see below that the scale economies in asset management appear to have been entirely captured by
the asset managers. The same finding appears to hold for asset managers who cater to institutional investors.\”

The table shows some other interesting factors. Equity funds can either be \”actively managed,\” by those trying to anticipate where the market is headed, or \”passively managed,\” by index funds that seek only to replicate what happens in the market. In 1980, 99.7% of all stock market funds were actively managed; by 2010, 71% were actively managed. 

The expense ratios for passively managed funds are often very low, at 7 basis points or less. The expense ratios for actively managed funds alone (shown in the second column of the table) have actually risen from 66 basis points back in 1980 to over 90 basis points as a share of assets in the last decade or so. And remember, this is during a period when economies of scale should have been a force for driving down expenses as a share of assets!

Back in 1973, Burton Malkiel published the first edition of his classic A Random Walk Down Wall Street.  (I think the 9th edition came out a couple of years ago.) The book offers a readable and persuasive statement of the argument that stock prices are based on past information, and that they will rise and fall based on new information. Because new information is, by definition, not predictable (or else it would be part of past information!), stock prices will move up and down unpredictably. Malkiel has been making the case for 40 years that while actively managed equity funds  charge higher fees than passively managed funds, they do not on average have higher returns.  In this essay, he writes:

\”Clearly, one needs some active management to ensure that information is properly reflected in securities prices. Those professionals who act to exploit any differential—however small—between price and estimated value deserve to be compensated for their efforts. But it appears that the number of active managers and the costs they impose far exceed what is required to make our stock markets reasonably efficient, in the sense that no clear arbitrage opportunities remain unexploited. Worldwide, vast numbers of highly trained independent experts are expressing estimates of value each day. Outperforming the consensus of hundreds of thousands of professionals at the world’s major financial institutions is next to impossible, as it has been for decades. … The major inefficiency in financial markets today involves the market for investment advice, and poses the question of why investors continue to pay fees for asset management services that are so high.\”

I\’m sure there are people and institutions that can benefit from sophisticated investment advice that seek to hedge the specific risks they face while leaping to exploit the occasional profit opportunities provided by temporary anomalies in financial markets. But most average investors in actively managed funds are not following this pattern. They are following either their own gut reactions, or the gut reactions of an active portfolio manager, about what is likely to rise and fall. In doing so, they are paying much higher fees over what an index fund would have cost. Malkiel cites one study that found if the average mutual fund investor in actively managed funds had just bought and held a passive index fund from 2000 to 2011, rather than trying to chase every trend, that average investor would have increased return on investment by almost 2 percentage points per year–a gain of more than 20% over the decade.

It\’s widely known that the U.S. financial sector has grown substantially in recent years. But by how much? And in what specific areas? Robin Greenwood and David Scharfstein offer a useful breakdown in \”The Growth of Finance,\” which appears in the most recent (Spring 2013) issue of my own Journal of Economic Perspectives. Like all JEP papers from the most recent back to the first issue in 1987, it is freely available on-line compliments of the American Economic Association. Greenwood and Scharfstein write at the start: \”During the last 30 years, the financial services sector has grown enormously. This growth is apparent whether one measures the financial sector by its share of GDP, by the quantity of financial assets, by employment, or by average wages. At its peak in 2006, the financial services sector contributed 8.3 percent to US GDP, compared to 4.9 percent in 1980 and 2.8 percent in 1950.\”

But what is actually meant by \”the finance sector\”?  Here\’s a useful figure dividing the sector into three parts: securities, credit intermediation, and insurance.

In their discussion, they set aside the insurance part of the financial services sector. Of course, there are important issues in health insurance, liability insurance, and other types of insurance. But when people argue that \”the financial sector\” is too big, or that an over-expansion of the financial sector helped to bring on the Great Recession, they aren\’t referring to standard insurance markets. Greenwood and Scharfstein summarize the other two main sectors in this way:

\”The securities subsector … includes the activities typically associated with investment banks (such as Goldman Sachs) and asset management firms (such as Fidelity). These activities include securities trading and market making, securities underwriting, and asset management for individual and institutional investors. The credit intermediation industry performs the activities typically associated with traditional banking—lending to consumers and corporations, deposit taking, and processing financial transactions.\”

The authors turn over the available evidence on what happens within these sectors over time (and no, this sort of data is not easily available), and argue (citations omitted here and throughout):

\”Our main finding is that much of the growth of finance is associated with two activities: asset management and the provision of household credit. The value of financial assets under professional management grew dramatically, with the total fees charged to manage these assets growing at approximately the same pace. A large part of this growth came from the increase in the value of financial assets, which was itself driven largely by an increase in stock market valuations (such as the price/earnings multiples). There was also enormous growth in household credit, from 48 percent of GDP in 1980 to 99 percent in 2007. Most of this growth was in residential mortgages. Consumer debt (auto, credit card, and student loans) also grew, and a significant fraction of mortgage debt took the form of home equity lines used to fund consumption. The increase in household credit contributed to the growth of the financial sector mainly through fees on loan origination, underwriting of asset-backed securities, trading and management of fixed income products, and derivatives trading.\”

Their conclusions on these points are balanced, but lean toward the view that even if much of the growth in financial services has been productive, it went too far on the margin. They write:

\”Thus, any assessment of whether and in what ways society benefited from the growth of the financial sector depends in large part on an evaluation of professional asset management and the increase in household credit. In our view, the professionalization of asset management brought signififi cant benefits. The main benefit was that it facilitated an increase in financial market participation and diversification, which likely lowered the cost of capital to corporations. Young firms benefited in particular, both because they are more reliant on external financing and because their value depends more on the cost of capital. At the same time, the cost of professional asset management has been persistently high. While the high price encourages more active asset management, it may not result in the kind of active asset management that leads to more informative securities prices or better monitoring of management. It also generates economic rents that could draw more resources to the industry than is socially desirable.\”

\”While greater access to credit has arguably improved the ability of households to smooth consumption, it has also made it easier for many households to overinvest in housing and consume in excess of sustainable levels. This increase in credit was facilitated by the growth of “shadow banking,” whereby many different types of nonbank financial entities performed some of the essential functions of traditional banking, but in a less-stable way. The financial crisis that erupted late in 2007 and proved so costly to the economy was largely a crisis in shadow banking.\”

The Spring issue of the JEP actually includes four other papers with varying perspectives on the growth of the financial sector. In the next couple of days, I\’ll post about some of these very divergent views.

But as a prelude, I\’ll point out that most of the time, when economic activity grows in a certain area, those of us who believe in economic prosperity tend to view that growth as a good thing. If the U.S. car industry or computer industry racked up large sales, that would be viewed in a positive light. Clearly, many people feel differently about the financial sector. But is that negative reaction just a manifestation of the long-standing generalized prejudice against finance? After all, I\’m delighted that I can put my retirement savings into a no-load mutual fund, and that I don\’t have to try to construct and manage such a fund on my own. I\’m delighted when it\’s easy for me to get a mortgage.

It seems undeniable to me that excesses in the financial sector played a large role in the run-up to the Great Recession. But maybe the problem isn\’t the size of the financial sector, but rather its instability. After all, many of the proposals for a higher level of regulation will impose higher costs that in turn will tend to make the financial sector larger, not smaller.

\”There is enormous variation in the so-called return to education depending on factors such as institution attended, field of study, whether a student graduates, and post-graduation occupation. While the average return to obtaining a college degree is clearly positive, we emphasize that it is not universally so. For certain schools, majors, occupations, and individuals, college may not be a smart investment. By telling all young people that they should go to college no matter what, we are actually doing some of them a disservice.\”

ewer than 60 percent of students who enter four-year schools finish within six years, and for low-income students it’s even worse. 

\”About 60% of high school students go on to college. For the purposes of a quick-and-dirty estimate, let\’s say that it\’s the top 60% by academic qualifications. Thus, if you are at, say, the 70th percentile of your high school class, you are in the middle of those going on to college. Given that many of those who go on to college don\’t finish a degree, being at the 70th percentile of your high school class may mean that you can expect to be ranked in the bottom quarter of those who complete a college degree. Sure, some students will improve dramatically from high school to college, but it\’s a statistical fact that half of college graduates will be below the median, and one-fourth will be in the bottom quarter, and especially if you are advising a large number of high school students, it\’s unrealistic to tell each of them that that they can all end up in the upper part of the college distribution.\”

Productivity growth is the main determinant of an overall rise in the standard of living. And whether U.S. productivity growth in the future will be higher, as it was in the second half of the 1990s and into the early 2000s, or lower, as it was during the 1970s and 1980s, is a live controversy.
The Spring 2013 issue of the International Productivity Monitor has a group of lively and readable arguments on both sides.

As a starting point, here\’s a summary figure from a recent Congressional Budget Office working paper by Robert Shackleton,  \”Total Factor Productivity Growth in Historical Perspective.\” 
Notice that productivity growth looks relatively high in the 1960s, then plummets around 1970 and, although the path is a bumpy one, stays relatively low until the mid-1990s. There is then a surge of productivity growth, which has since sagged. Shackleton projects that future productivity growth will sag a bit from its 1960-2010 average, but not by much. The symposium in International Productivity Monitor offers voices on either side of his prediction.

Martin Neil Baily, James Manyika, and Shalabh Gupta lead off with \”U.S. Productivity Growth: An Optimistic Perspective\” They write: 

The pessimistic role is ably filled by Robert J. Gordon in his essay: \”U.S. Productivity Growth: The Slowdown Has Returned After a Temporary Revival.\” He readily admits that many new technologies are available to help manufacturing, but memorably says that “manufacturing is performing a magnificent ballet on a shrinking stage.\” In Gordon\’s view, the short interlude of faster productivity growth from about 1994-2002 is now over.

To emphasize that recent productivity developments just aren\’t all that large compared with historical developments, Gordon writes:

\”I have often posed the following set of choices. Option A is to keep everything invented up until ten years ago, including laptops, Google, Amazon, and Wikipedia, while also keeping running water and indoor toilets. Option B is to keep everything invented up until yesterday, including Facebook, iphones, and ipads, but give up running water and indoor toilets; one must go outside to take care of one’s needs; one must carry all the water for cooking, cleaning, and bathing in buckets and pails. Often audiences laugh when confronted with the choice between A and B, because the answer seems so obvious.

\”But running water and indoor toilets were not the only inventions between 1870 and 1970 that made it possible for U.S. labour productivity to grow at the 2.48 per cent rate … The list is endless – electric light, elevators that made possible the vertical city, electric machine tools and hand tools, central heating, air conditioning, the internal combustion engine that replaced the horse, commercial aviation, phonographs, motion pictures, radio, TV, and many others including fundamental medical inventions ranging from aspirin to penicillin. By comparison the computer revolution kick-started productivity growth between 1996 and 2004 for only eight years, compared to the 81 years propelled by the second Industrial Revolution of the late nineteenth century.\”

Gordon further notes that the U.S. economy faces severe challenges in the years ahead: an aging population, high and rising levels of government debt, high levels of inequality, and a lack of improvement in educational attainment. He writes: \” The United States reached an educational plateau more than 20 years ago. It is the only developed nation in which the 55-64 age group is as well-educated as the 25-34 age group. The United States has steadily slipped down the league table of post-secondary education completion and currently registers 15 percentage points lower than Canada.\”

At least some of this dispute revolves around whether one sees the boost to productivity growth from information technology as a stage that is now largely behind us, or as a long-running play in which we may have only seen the first of several acts. David M. Byrne, Stephen D. Oliner, an d Daniel E. Sichel tackle this question in their paper, \”\”Is the Information Technology Revolution Over?\”

\”Just as a long lag transpired from the development of the PC in the early 1980s to the subsequent pickup in labour productivity growth, there could be a lagged payoff from the development and diffusion of extensive connectivity, handheld devices, and ever-greater and cheaper computing power. In 1987, Robert Solow famously said “You see the computer revolution everywhere except in the productivity data.”… [C]computers comprised too small a share of the capital stock in 1987 to have made a large contribution to overall productivity growth. But, several years later, the imprint of the revolution became very evident. In a parallel vein, one could now say: “You see massive connectivity and ever-cheaper computing power everywhere but in the productivity data.” Subsequently, those contributions could become evident in aggregate data.\”

In a comment on their paper, Chad Syverson points out that the productivity growth in the early 20th century, following the spread of electrical power through the economy, had periods of faster and slower productivity growth. He writes:

\”To be clear, I do not interpret this as predicting that labour productivity growth must again accelerate in 2013. … Rather, I simply make the point that we have been here before: sluggish labour productivity growth at the beginning of the diffusion ofa general purpose technology (if one believes, as I do, that the 1890-1915 period for electrification is a reasonable analog to the 1970-1995 period for IT), a decade-long acceleration, and then another multi-year slowdown. In the electrification era, this was followed by another acceleration. Whether this will also occur for IT remains to be seen, but we know it has happened before. History shows that productivity growth driven by general purpose technologies can arrive in multiple waves; it need not simply arrive, give what it has, and fade away forever thereafter.\”

As I contemplated these various perspectives, I found myself thinking back to my early years of running the Journal of Economic Perspectives, and in particular to a paper by Zvi Griliches in the Fall 1988 issue called \”Productivity Puzzles and R&D:Another Nonexplanation.\”  (As with all JEP papers from the most recent issue back to the first, this paper is freely available on-line compliments of the American Economic Association.) Griliches makes the case that it\’s hard to trace the productivity slowdown starting in the early 1970s to changes in R&D spending, and then ends with these thoughts:

\”What is then the culprit? Why has productivity grown so slowly in the last decade or so? My prime suspect remains the rise in energy prices and its macro consequences. It is not just that many industries had to face new prices, change the way they used their factors of production, and scrap much of their now unprofitable capacity, but also a long worldwide recession induced by the fall in real wealth caused by OPEC, by the fall in aggregate demand caused by the governments trying to control the resulting inflation, and the subsequent fall in U.S. exports and the increase in import competition in the early 1980s as the result of rising dollar exchange rates. These factors combined together to produce one of the longest worldwide recessions and growth slowdowns from which the world may not yet have emerged. The resulting prolonged periods of capacity underutilization in many industries is the proximate cause of much of the observed declines and slowdowns in productivity growth. …\”

\”Of course, there may not be a single cause—one murderer. Perhaps it is more like the Murder on the Orient Express—they all did it! From the longer run point of view there are still lingering doubts about the crime itself: perhaps the 1970s were not so abnormal after all. Maybe it is the inexplicably high growth rates in the 1950s and early 1960s that are the real puzzle. This thought, however, is a sad one. I still hope that when the world finds its way out of this worldwide growth recession, we will find that productivity will bounce back, that it has not left us motherless forever.\”

Of course, the aftermath of the Great Recession is still upon us, and it is far more severe that the period in the mid-1980s that Griliches was discussing. It seems to me very difficult to draw any firm conclusions about future productivity growth given that economic output was pumped up by the housing boom in the mid-2000s before being crushed by the economic and financial crisis that followed, and its continuing legacy of stagnant growth.

That said, when I discuss future economic opportunities for the U.S., I tend to focus on four areas.

• First, the continuing growth in information technologies. Moore\’s law has not yet slowed down, and the processing power of computer chips continues to double every couple of years.  
• Second, I confess that I personally lack the imagination to think in any full way about what will be possible a decade or so from now, when computing power may have doubled another five times, and thus will be a multiple of 32 more powerful than current computing. But when I think about the hardware and software that will need to be installed in homes and businesses, and the potential linkages to health care, energy conservation, education, and entertainment, it seems to me that sustained growth remains quite possible. 
• Third, the possibility of enormous reserves of natural gas at moderate prices has potentially enormous influences for the U.S. economy: it may be the flip side of how high energy prices rocked the U.S. economy in the 1970s and other times. 
• Finally, the world economy seems poised for a period of faster-than-usual growth, led not only by China, India, and Brazil, but by a wide range of economies across Asia, Latin America, eastern Europe, and Africa. The U.S. economy is in many ways, by its institutions, connections, and culture, wonderfully positioned to benefit from facilitating and participating in this growth.

Of course, there are also any number of significant policy challenges in these issues, and in others. But my point is that we are not doomed to a future of low productivity growth. Instead, for better or worse, our economic future is in our own hands.

Each year, the Federal Trade Commission and the Antitrust Division of the U.S. Department of Justice publishes a report required by the Hart-Scott-Rodino Act on merger activity the preceding year. The news from the 2012 report, which is here, is that there isn\’t much news. The number of mergers in 2012 look a lot like it did in 2011–that is, up from the depths of 2009–but not near the peak of 2007.

Under the Hart-Scott-Rodino legislation, all mergers above a certain size (about $68 million in 2012, rising to $71 million in 2013) are required to notify the antitrust authorities in advance when a merger is proposed. Here\’s a figure showing merger transactions reported over the last 10 years.

And here\’s a breakdown by size. There were 156 acquisitions in 2012 that exceeded $1 billion. The very small number of mergers below $50 million, of course, is because it is not required to report these.

After receiving notification of a proposed merger, the antitrust authorities can allow it to happen, or they can make a \”second request\” for more information. In 2012, of the 1400 or so proposed mergers, there were second requests in 49 cases–a little over 3%. This percentage may look remarkably low! But remember that companies thinking about a merger have good knowledge about what criteria have been used to judge mergers in the past, and so mergers that would obviously lead to a lot less competition don\’t get proposed in the first place. Also, remember that the job of the FTC and the U.S. Department of Justice is not to second-guess whether a merger is a wise and sensible business decision. In a market economy, the presumption is that businesses have the freedom to make investment decisions that may turn out to be foolish. Instead, the mission of the FTC is \”to prevent business practices that are anticompetitive, deceptive, or unfair to consumers.\” 

With the second request information in hand, the antitrust authorities can then decide whether to let the merger proceed as proposed, to propose that the merger can only be allowed to occur if the company takes some additional action like divesting certain parts, or if the merger should just be blocked outright. In 2012, the FTC brought 25 enforcement actions. None of them rise to the level of the epic lawsuits involving Microsoft, IBM, or AT&T. But they help to set the ground-rules and expectations that competition is important, and where it seems threatened–even on everyday products like sliced bread or sticky notes–the government will push back. Here\’s a summary of some of the main activities involving mergers in 2012.

\”One of the notable matters handled by the Division was United Technologies Corporation’s $18.4 billion acquisition of Goodrich Corporation. The transaction was the largest merger in the history of the aircraft industry. As originally proposed, the acquisition would have resulted in higher prices, less favorable contractual terms and less innovation for several critical aircraft components. The Division challenged the merger in U.S. district court, and the subsequent settlement required UTC to divest assets used in the production of electrical power systems and aircraft engine control systems. … In addition to UTC, the Division challenged a number of mergers that would have had a direct effect on the pocketbooks of U.S. consumers. The Division challenged, and reached pro-competitive settlements, in mergers involving sliced bread (United States v. Grupo Bimbo, et al.), electricity (United States v. Exelon Corporation, et al.), health insurance (United States v. Humana Inc., et al.) and parking services (United States v. Standard Parking Corporation, et al.). Additionally, 3M Co. abandoned its proposed $550 million acquisition of Avery Dennison Corp.’s Office and Consumer Products Group, its closest competitor in the sale of adhesive-backed labels and sticky notes, after the
Division informed the companies that it would file a lawsuit to block the deal. The transaction would have substantially lessened competition in the sale of labels and sticky notes, resulting in higher prices and reduced innovation for products that millions of American consumers use every day.\”

I\’m always hesitant to proclaim that economic growth is finding a foothold in sub-Saharan Africa. There were just too many reports in the 1960s, 1970s, 1980s, and even the 1990s that growth in Africa was on the verge of taking off–only to see disappointment a few years later. But Africa\’s economic and social statistics in the last decade or so do look genuinely promising. The World Bank puts out an \”Africa\’s Pulse\” report twice per year, and the most recent edition offers some statistics.

Here are some rates of real GDP growth for sub-Saharan Africa, shown by the yellow line. The blue bars, for comparison show the annual growth rates for real GDP among the other developing economies of the world, although excluding China, which is now classified by the World Bank as an \”upper-middle-income\” economy. The red line leaves out South Africa, which is also classified as an \”upper-middle-income\” economy by world standards, and which has been lagging the growth rates of the rest of sub-Saharan Africa for most of the last decade. There\’s clearly a hiccup with the global financial and economic woes of 2009, but a rapid and quick bounce-back in the last few years.

Africa\’s faster-than-average-for developing-countries growth rates are paying off in lower poverty rates. The share of the population in resource-poor countries in sub-Saharan Africa that is below the $1.25/day level of consumption fell from 65% in the late 1990s to 49% in the last few years. Rates of inequality as measured by the Gini coefficient are down as well. More detailed data also show gains in a wide variety of areas: child mortality, life expectancy, school attendance, access to sanitation, and others.

Perhaps the main overall question about Africa\’s growth performance in the last decade is how much it has been driven by higher global prices for raw materials and commodities–and thus if Africa\’s growth will again plummet if these prices sag.  As the report says:

\”Continued demand for Africa’s natural resources as well as the recent discoveries of oil, gas and minerals in, among others, Ghana, Uganda, Kenya, Tanzania and Mozambique, together with an improved macro-economic environment, sustain prospects for robust economic growth. The pertinent question is how more of the new found resource wealth can be converted into fiscal revenues and effective public spending to foster sustainable development, improve human welfare, and generate more rapid income poverty reduction. In other words, how can we avoid another “resource curse.”  …  Three core legs of natural resource management, each embodying their own political dynamics, are highlighted: 1) extraction—transparency regarding terms of contracts; 2) taxation—efficiency in tax collection; and 3) investment of resource rents—careful prioritization of public investment.\”

This figure divides economic growth between resource-rich and resource-poo countries of sub-Saharan Africa. Clearly, growth has been faster in the resource-rich economies. But the future also shows that compared with Africa\’s truly dismal economic record in the 1980s and 1990s, the last decade doesn\’t look so bad.

The question for Africa is to build broad-based growth: that is, not just economic growth based on higher prices for natural resources and commodities, but growth more broadly based on raising productivity in agriculture and manufacturing, on connections in global markets, on provision of services in expanding cities, on expanding infrastructure, and more. Maybe Africa\’s time in the economic sunshine is coming.

The Spring 2013 issue of my own Journal of Economic Perspectives has two main symposia: one on \”The Growth of the Financial Sector,\” and one on \”Early and Late Interventions.\” It also has several individual articles on topics like the the political reasons why good economics can make for bad policy outcomes, Latin America\’s social policy challenge, and the investment strategies of sovereign wealth funds. The back of the issue has my own \”Recommendations for Further Reading\” column, and some correspondence about neuroscience and economics.

I\’ll probably do some blogging about specific articles in the next week or so, but for now, here\’s a list of the articles, with abstracts and links. Like all issues of JEP back to the first issue in 1987, this issue is freely available on-line compliments of the American Economic Association. It\’s also possible to go to the JEP website and download the journal in a format that works on an e-reader.

Symposium: The Growth of the Financial Sector

 \”The Growth of Finance,\” by Robin Greenwood and David Scharfstein

The US financial services industry grew from 4.9 percent of GDP in 1980 to 7.9 percent of GDP in 2007. A sizeable portion of the growth can be explained by rising asset management fees, which in turn were driven by increases in the valuation of tradable assets, particularly equity. Another important factor was growth in fees associated with an expansion in household credit, particularly fees associated with residential mortgages. This expansion was fueled by the development of nonbank credit intermediation (or \”shadow banking\”). We offer a preliminary assessment of whether the growth of active asset management, household credit, and shadow banking — the main areas of growth in the financial sector — has been socially beneficial.
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\”Finance: Function Matters, Not Size,\” by John H. Cochrane

It\’s fun to pass judgment on waste, size, usefulness, complexity, and excessive compensation. But as economists, we have an analytical structure for thinking about these questions. \”I don’t understand it\” doesn\’t mean \”it\’s bad,\” or \”regulation will improve it.\” That attitude pervades policy analysis in general and financial regulation in particular, and economists do the world a disservice if we echo it. I will not offer a competing black box [to explain the size of the finance industry]. I don’t claim to estimate the socially optimal \”size of finance\” at, say, 8.267 percent of GDP. It\’s just the wrong question. Hayek and the failure of planning should teach us a little modesty: Pronouncing on socially optimal industry size is a waste of time. Is the finance industry functioning well? Are there identifiable market or government distortions? Will proposed regulations help or make matters worse? These are useful questions.
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\”Moore\’s Law versus Murphy\’s Law: Algorithmic Trading and Its Discontents,\” by Andrei A. Kirilenko and Andrew W. Lo

Financial markets have undergone a remarkable transformation over the past two decades due to advances in technology. These advances include faster and cheaper computers, greater connectivity among market participants, and perhaps most important of all, more sophisticated trading algorithms. The benefits of such financial technology are evident: lower transactions costs, faster executions, and greater volume of trades. However, like any technology, trading technology has unintended consequences. In this paper, we review key innovations in trading technology starting with portfolio optimization in the 1950s and ending with high-frequency trading in the late 2000s, as well as opportunities, challenges, and economic incentives that accompanied these developments. We also discuss potential threats to financial stability created or facilitated by algorithmic trading and propose \”Financial Regulation 2.0,\” a set of design principles for bringing the current financial regulatory framework into the Digital Age.
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\”An International Look at the Growth of Modern Finance,\” by Thomas Philippon and Ariell Reshef

We study the rise of finance across a set of now-industrial economies. The long-run pattern of the growth of the income share of finance from the nineteenth century to current times in the United States is similar to some economies, but not all economies reach the same size and instead reach a plateau. The relationship between financial output and income is nonhomothetic and changes three times in this sample. Most of the increase in real GDP per capita from 1870 occurred while financial output and the income share of finance were smaller than their size in 1980. After 1980 the elasticity of income with respect to financial output falls significantly. We find considerable heterogeneity in the size of finance in recent times. There is no evidence for an increase in the unit cost of financial intermediation. We find that information technology and financial deregulation can help explain the increase in relative skill intensity and in relative wages in finance, while common trends, which may be related to financial globalization, also play a role.
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\”Asset Management Fees and the Growth of Finance,\” by Burton G. Malkiel

From 1980 to 2006, the financial services sector of the US economy grew from 4.9 percent to 8.3 percent of GDP. A substantial share of that increase was comprised of increases in the fees paid for asset management. This paper examines the significant increase in asset management fees charged to both individual and institutional investors. One could argue that the increase in fees charged by actively managed funds could prove to be socially useful if it reflected increasing returns for investors from active management or if it was necessary to improve the efficiency of the market for investors who availed themselves of low-cost passive (index) funds. But neither of these arguments can be supported by the data. Actively managed funds of publicly traded securities have consistently underperformed index funds, and the amount of the underperformance is well approximated by the difference in the fees charged by the two types of funds. Moreover, it appears that there was no change in the efficiency of the market from 1980 to 2011. Thus, the increase in fees is likely to represent a deadweight loss for investors. Indeed, perhaps the greatest inefficiency in the stock market is in \”the market\” for investment advice.
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Symposium on Early and Later Interventions

\”Investing in Preschool Programs,\” by Greg J. Duncan and Katherine Magnuson

We summarize the available evidence on the extent to which expenditures on early childhood education programs constitute worthy social investments in the human capital of children. We provide an overview of existing early childhood education programs, and then summarize results from a substantial body of methodologically sound evaluations of the impacts of early childhood education. The evidence supports few unqualified conclusions. Many early childhood education programs appear to boost cognitive ability and early school achievement in the short run. However, most of them show smaller impacts than those generated by the best-known programs, and their cognitive impacts largely disappear within a few years. Despite this fade-out, long-­run follow-ups from a handful of well-­‐known programs show lasting positive effects on such outcomes as greater educational attainment, higher earnings, and lower rates of crime. It is uncertain what skills, behaviors, or developmental processes are particularly important in producing these longer-­‐run impacts. Our review also describes different models of human development used by social scientists, examines heterogeneous results across groups, and tries to identify the ingredients of early childhood education programs that are most likely to improve the performance of these programs.
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\”What Can Be Done to Improve Struggling High Schools?,\” Julie Berry Cullen, Steven D. Levitt, Erin Robertson and Sally Sadoff 

In spite of decades of well-intentioned efforts targeted at struggling high schools, outcomes today are little improved. A handful of innovative programs have achieved great success on a small scale, but more generally, the economic futures of the students at the bottom of the human capital distribution remain dismal. In our view, expanding access to educational options that focus on life skills and work experience, as opposed to a focus on traditional definitions of academic success, represents the most cost-effective, broadly implementable source of improvements for this group.
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\”Beyond BA Blinders: Lessons from Occupational Colleges and Certificate Programs for Nontraditional Students,\” by James E. Rosenbaum and Janet Rosenbaum

Postsecondary education mostly focuses on the four-year BA degree. Community colleges are often promoted as the first step toward the ultimate goal of a four-year degree. However, community colleges have extremely poor degree completion rates. There is evidence suggesting better results for their private, two-year counterparts — particularly for certificate completion. We will focus on occupational colleges — private accredited colleges that offer career preparation in occupational fields like health care, business, information technology, and others. These institutions challenge many of our preconceptions about college. They are less wedded to college traditions, which raises some interesting questions: Do private colleges offering certificates or AA degrees use different procedures? Should community colleges consider some of these procedures to reduce student difficulties and improve their completion rates? For many community college students, earning a more likely, quick sub-BA credential — perhaps followed by a four-year degree in the future — will be preferable to the relatively unlikely pathway from a community college program directly to a four-year BA. In sum, this paper suggests that nontraditional colleges and nontraditional credentials (certificates and AA degrees) deserve much closer attention from researchers, policymakers, and students.
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Individual Articles

\”Economics versus Politics: Pitfalls of Policy Advice,\” Daron Acemoglu and James A. Robinson

The standard approach to policy making and advice in economics implicitly or explicitly ignores politics and political economy and maintains that if possible, any market failure should be rapidly removed. This essay explains why this conclusion may be incorrect; because it ignores politics, this approach is oblivious to the impact of the removal of market failures on future political equilibria and economic efficiency, which can be deleterious. We first outline a simple framework for the study of the impact of current economic policies on future political equilibria — and indirectly on future economic outcomes. We then illustrate the mechanisms through which such impacts might operate using a series of examples. The main message is that sound economic policy should be based on a careful analysis of political economy and should factor in its influence on future political equilibria.
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\”Latin America\’s Social Policy Challenge: Education, Social Insurance, Redistribution,\” by Santiago Levy and Norbert Schady

Long regarded as a region beset by macroeconomic instability, high inflation, and excessive poverty and inequality, Latin America has undergone a major transformation over the last 20 years. The region has seen improved macroeconomic management and substantial and sustained reductions in poverty and inequality. In this paper, we argue that social policy, including human capital and education, social insurance, and redistribution, need special attention if achievements of the last two decades are to be sustained and amplified. Starting in the mid 1990s, many governments in the region introduced a variety of programs, including noncontributory pensions and health insurance, and cash transfers targeted to the poor. Social spending in Latin America increased sharply. These policies have been widely praised, and we believe they have resulted in substantial improvements in the lives of the poor in the region. However, a more nuanced view shows some worrisome trends. Moving forward, we believe it is necessary to pay much closer attention to the quality of services, particularly in education; to the incentives generated by the interplay of some programs, particularly in the labor market; to a more balanced intertemporal distribution of benefits, particularly between young and old; and to sustainable sources of finance, particularly to the link between contributions and benefits.
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\”The Investment Strategies of Sovereign Wealth Funds,\” Shai Bernstein, Josh Lerner and Antoinette Schoar

Sovereign wealth funds have emerged as major investors in corporate and real resources worldwide. After an overview of their magnitude, we consider the institutional arrangements under which many of the sovereign wealth funds operate. We focus on a specific set of agency problems that is of first-order importance for these funds: that is, the direct involvement of political leaders in the management process. We show that sovereign wealth funds with greater involvement of political leaders in fund management are associated with investment strategies that seem to favor short-term economic policy goals in their respective countries at the expense of longer-term maximization of returns. Sovereign wealth funds face several other issues, like how best to cope with demands for transparency, which can allow others to copy their investment strategies, and how to address the problems that arise with sheer size, like the difficulties of scaling up investment strategies that only work with a smaller value of assets under investment. In the conclusion, we discuss how various approaches cultivated by effective institutional investors worldwide — from investing in the best people to pioneering new asset classes to compartmentalizing investment activities — may provide clues as to how sovereign wealth funds might address these issues.
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\”Recommendations for Further Reading,\” by Timothy Taylor 

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Correspondence: Are Cognitive Functions Localizable? Colin Camerer et al. versus Marieke van Rooij and John G. Holden

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I\’m conflicted about big-time college sports. I watch them, I enjoy them–and in a number of ways, they seem inappropriate to me as an activity for colleges and universities. The student-athletes often must make an enormous and year-round commitment of time and energy, in a way inevitably creates tradeoffs with the academic and social dimensions of college life. At many large universities, the football and basketball coaches are the highest-paid employees. The spectacle of middle-aged men, like me, yelling at 19 year-old athletes is not edifying. Neither is the spectacle of inebriated students from one school yelling at 19 year-old athletes from other schools. Frankly, the only participants in big-time college athletics who consistently come off well are the athletes themselves.

The NCAA has just released \”Revenues and Expenses, 2004-2012, NCAA Division I Intercollegiate Athletics Programs Report.\” The report is a bunch of detailed tables with a few bullet points. The NCAA divides its Division 1 schools into three groups. The Football Bowl Series is schools with big-time football programs. In  January, Alabama won the football title for this group, beating Notre Dame 42-14. The Football Championship series is medium-level football programs. Last season, North Dakota State beat Sam Houston State 39-13 in the championship game at this level. And the Division 1 schools without football programs include many well-known universities that have scholarship athletes and prominent programs in other sports: Gonzaga and Marquette are two examples. 

Here\’s a table showing median revenues generated by sports activities, along with total spending for these three categories of schools in 2004 and 2012. Generated revenues increased a lot. Spending increased by about the same amount, or more.

Of course, these figures are medians. Some schools are considerably above the median, while some are below. Here are the medians for each quartile of the Football Bowls Series schools in terms of revenue generated by sports and spending on sports.

The report sums up some of these patterns by noting: \”[A] total of 23 FBS athletics programs reported positive net generated revenues in both 2011 and 2012. It should be noted, however, that
the 23 profitable programs are not the same for the two reporting years. …The median net generated revenues for those surplus programs was $8,976,000 in 2011 and $5,419,000 in 2012, while the median net deficit for the remaining programs was $12,140,000 in 2011 and $14,645,000 in 2012. The gap between the financially successful programs and others dropped to $20,000,000 in 2012 from $21,000,000 in 2011. … A related observation is the portion of total athletics revenues that
are allocated by the institutions — 20 percent in the FBS; 71 percent in the FCS; 77 percent in DI w/o FB. …  This number representsthe extent to which the institution is subsidizing athletics.\”

A few thoughts follow:

1) For all the rhetoric about how athletics serve the larger purposes of academic institutions, the financial numbers tell a different story. The large revenue gains in recent years from reorganizing conferences, renegotiating TV rights, and the like, are by and large not being shared with the academic side colleges and universities. Instead, the additional revenues are being plowed back into the athletics programs.

2) A couple of dozen of the big-time football schools generate enough revenue from sports to cover their athletic department expenses. The median school does not make money in any direct way from its athletics program: instead, it subsidizes these programs. There is perhaps an argument to be made that athletics can encourage alumni donations to other programs, and there are examples of where donations spike for a time when a school\’s athletics program does unexpectedly well. But I haven\’t seen persuasive evidence that the median school gets more donations to its academic programs because of its sports teams.

College athletics is a sort of arms race, where institutions that define themselves as focused on \”higher education\” aggressively pursue sports revenues, and then spend those revenues on sports activities. Of course, the sports revenues are available because of demand from fans, like me, and it\’s hard to blame colleges for seeking a share of that money. But it\’s easier to blame colleges and universities for not finding a way to funnel a much larger share of that growing pot of money to what is supposed to be the core academic function of their enterprise.

You would expect countries with a higher per capita GDP to spend more on education, and they do. In fact, a graph that plots the relationship across countries between per capita GDP and per student spending on primary and secondary education almost traces out a straight line. But for spending per student on post-secondary education, the U.S. spends far more one would predict based on per capita GDP. Here\’s the graphs from The Condition of Education 2012, published by the National Center for Education Statistics at the U.S. Department of Education, using OECD data.

First, here\’s the relationship from per capita GDP to per student spending on primary and secondary education. The U.S. has higher per capita GDP, and accordingly spends more per student, but the relationship is close to a straight line.

Now here\’s the relationship from per capita GDP to per student spending on postsecondary education. While the relationship remains generally upward-sloping, there are clearly countries that spend less per student than you would expect given their level of per capita GDP, like Iceland, which is labelled, and Italy, which is the unlabelled point more-or-less under Spain. There are also countries that spend more per student than you would expect given their GDP, including Ireland, Canada, and especially the United States. 

One can of course make an argument that that the quality of postsecondary education in the United States is very high, which in turn accounts for much of its higher cost. It\’s a fair point. But for the U.S., the arithmetic of having per student postsecondary education spending so far above the best-fit line with per capita GDP has two difficult implications. First, given these high costs per student, relative to the income level in the economy, it becomes much harder for the U.S. to finance a substantial expansion in the number of students who receive postsecondary education–unless those additional students receive an experience quite a bit less expensive than the current average. Second, the economic payoff to postsecondary education will be harder to justify in the United States, given that the per student costs are so out of line with per capita GDP.