In praise of pessimists

Buttonwood, The Economist

Sometimes it helps if investors are gloomy

BARELY a week goes by without a report on the level of confidence among consumers, businesspeople and investors. Optimism is what’s wanted—Keynes talked of the “animal spirits” that influence economic activity. Pessimists are routinely denounced as Jeremiahs. Those who try to bet on falling prices find their activities are restricted.

A cheery disposition may be necessary for societies to function. Daniel Kahneman, a psychologist and Nobel economics laureate, has a chapter in his book “Thinking Fast and Slow” which describes overconfidence as “the engine of capitalism”. No entrepreneur can be sure that his planned investment will succeed but if no one took a risk, new products and jobs would never be created. A certain blindness to the odds may be necessary. According to Mr Kahneman, the chances of an American small business surviving for five years are just 35%. But ask individual entrepreneurs about their prospects and 81% think they have a better than seven-in-ten chance of success.

This self-confidence may be innate, just as most people think they are better-than-average drivers. And it would seem logical that the most optimistic people gravitate towards entrepreneurship. That is good for consumers, who can select from a wider variety of products. Even the failed businesses serve a purpose. Daniel Gross, a journalist, wrote a book claiming that bubbles were good for economies since they leave behind infrastructure (canals, railways, fibre-optic cable) that can last for generations.

But it is hard to make such a case for all bubbles. Anyone who has driven past a row of empty houses in the Irish countryside will realise that optimism can lead to wasteful investment. And Mr Kahneman cites studies that show how overoptimistic chief executives (as measured by the amount of stock they own) were more likely to gear up their balance-sheets and pay too much for acquisitions.

The problem with overoptimism was illustrated by the investment-bank collapses of 2008. The men who reached the top of such risk-taking organisations had, by definition, been successful in their previous bets. They believed this was due to skill, not luck, making them too sanguine about their ability to ride out the crisis.

A further problem with optimism is thus that it is pro-cyclical. The greatest moment of success for optimists will occur at the peak of a boom, when they will feel their instincts have been justified. Previous house-price rises will make buyers more optimistic about borrowing more money; and banks will be more optimistic about the prospect of being repaid.

Financial assets are highly unusual in that rising prices tend to elicit higher demand. Analysts extrapolate recent rapid profits growth into the future, even though profits cannot rise faster than GDP indefinitely. If markets were truly efficient, price-earnings ratios should be lower than average at the top of the cycle, since investors should anticipate a reversion to the mean. Instead, high p/e ratios and rapid profits growth tend to go together.

It used to be the role of central bankers to take away the punchbowl when the party was in full swing. Under Alan Greenspan, however, the Federal Reserve ended up spiking the punch with more rum by cutting rates whenever markets wobbled. The hope is that in future central banks will keep an eye on asset bubbles under the guise of “macroprudential” policy. This might involve the use of broader measures than just interest rates. For example, the Fed could pop housing bubbles by imposing a maximum loan-to-value ratio for mortgages.

But what if the bubble this time is in government bonds, not equities? The last time long-term Treasury bonds yielded 2.1% was in 1949. Investors who took the plunge into Treasuries then earned an annual negative real return of 1.6% over the following 30 years.

On this occasion, however, the central bank is one of the main purchasers of Treasury bonds in an effort to keep yields low. Such low yields could be attributed to optimism that American politicians will agree on a long-term plan to sort out the government’s finances. But it seems likely that the main driver is pessimism about the outlook for other asset classes.

In this case the gloom seems entirely beneficial. Low rates stimulate the economy and are good news for the American government, which can finance its deficit cheaply and without facing the dilemmas that beset the Italian and Spanish governments, which must impose austerity at a time of economic slowdown. But the pessimists can’t expect to be thanked.

The Zero Decade

Editorial do WSJ

The two most powerful men in Washington have a big disagreement. No, not President Obama and Speaker John Boehner. We mean Mr. Obama and Federal Reserve Chairman Ben Bernanke, who can't seem to agree on the health of the U.S. economy.

On Tuesday night, the President proclaimed that the "state of our Union is getting stronger," employers are hiring faster than they can find skilled workers, and manufacturing is booming. Less than a day later, Mr. Bernanke and his Open Market Committee (FOMC) downgraded their already modest growth outlook and said the recovery is so vulnerable that the Fed must keep interest rates at near-zero for another three years.

The contradiction may not be as profound as it seems. Mr. Obama is running for re-election and this time he needs to sell audacity more than hope, while the Fed is still trying to reflate the housing market that it seems to believe is the main driver of economic growth. The Fed is straining to deliver the asset-price "stimulus" that Mr. Obama can't any longer get out of Congress.

That's the best way to understand the FOMC's remarkable announcements on Wednesday, followed by Mr. Bernanke's quarterly press conference. The central bank had already promised to keep short-term rates near-zero through most of 2013, but now it feels the need to assure investors it will keep them there through the end of 2014. That would be six years in total, more than half of what may eventually become known as the Fed's Zero Decade.

Mull that one over: The Fed is declaring that it needs to run the same super-easy monetary policy when the economy is growing by 2% or 3% as it did amid the worst of the financial panic. And keep doing it past the horizon. The unavoidable implication is that the Fed doesn't think the economy will grow any faster until what would be halfway through Mr. Obama's second term. The other implication is that the Fed has no idea what to do other than to push even harder on the monetary accelerator. Maybe this time, it hopes, the economy's clutch will engage.

This not-so-quiet desperation was clear in a second Fed release that hasn't received as much attention as it deserves. In a statement redefining how it interprets its policy mandate from Congress, the FOMC said it has "reached broad agreement" on new operating principles.

The Fed's dual mandates are stable prices and full employment, and the Fed said sometimes the two are complementary. But from now on when they're in conflict, the Fed essentially said, it will put inflation aside and instead focus principally on cutting joblessness.

It's no coincidence that such a restatement of principles is coming now, when the Fed is looking to justify its extraordinary monetary interventions. If there were any doubt about this intention, Mr. Bernanke put it to rest in his press conference when he said more "quantitative easing" is likely if growth doesn't accelerate soon.

One problem with all of this was pointed out yesterday by Kevin Warsh, who as a Fed governor sat on the FOMC until early last year. Speaking at Stanford, Mr. Warsh said that "exceptionally accommodative monetary policy" has its uses in a crisis or recession. But the Fed's "recent policy activism—measures that go beyond a central bank's capacity or traditional remit—threatens to forestall recovery and harms long-term growth."

That's a useful warning for markets to hear. Consider that Mr. Bernanke's transparent goal is to drive down long-term interest rates to reduce mortgage rates to reflate the housing bubble. But intervening so directly to keep rates artificially low has made the bond market useless as a price signal or indicator of risk across the larger economy.

The Fed is thus pushing investors of all kinds further out on the risk curve, with consequences no one can foresee—least of all the Fed, as we are now learning from the just-released FOMC transcripts from 2006.

Recall that during the last decade the Fed assured everyone there was nothing to worry about as it kept rates too low for too long, only to create a housing bubble it never did recognize. Recall, too, how its second round of bond-buying (QE2) in 2010-2011 was supposed to lift stock prices but in addition sent commodity prices soaring. Consumer confidence plunged as Americans felt the strain of higher prices for food and energy, and the economy has done notably better since QE2 ended.

Where will the risk-taking excesses show up this time? Who knows, and perhaps the Fed will retreat before the worst happens. But it was fascinating to see last week that investors were willing to buy $15 billion in 10-year Treasury inflation-protected securities, or Tips, despite a negative real yield. That's right, investors were willing to accept negative current returns in exchange for security against a future inflation breakout.

We mean no counsel of doom because the good news is that the U.S. private economy is performing remarkably well considering all of the burdens government has put on it. Imagine what it could do if our politicians promised not to stick it with new taxes, and the Federal Reserve returned to a normal policy that focused on long-term growth rather than reflating bubbles.

O fim da meta de inflação?

Rodrigo Constantino, para o Instituto Liberal

A ata do Copom divulgada nesta quinta-feira possui um tom extremamente “dovish”, ou seja, suave em relação ao combate à inflação. Os argumentos citados para manter a trajetória de queda da taxa Selic são muito questionáveis, para dizer o mínimo. Se a queda prematura e ousada em 2011 contava como justificativa com o agravamento do cenário externo, por conta do risco de ruptura na Europa, desta vez o mesmo não ocorre. Restou ao Copom forçar a barra para sinalizar que a taxa de juros vai seguir rumo a um dígito.

Nas últimas decisões de reduzir os juros, o Copom apelou até para o SAMBA (do crioulo doido). Trata-se de um modelo econométrico com inúmeras variáveis incertas e, portanto, enorme arbitrariedade. Muitos economistas sérios apontaram, à época, para a ousadia que beirava à irresponsabilidade do BC. O governo, à medida que a crise europeia se deteriorava, cantou vitória: o BC fora preventivo e estava correto. Talvez tenha se empolgado cedo demais.

Com a recente atuação agressiva do Banco Central Europeu, o risco de uma ruptura na Europa se reduziu bastante, ao menos no curto prazo. Além disso, o Fed resolveu adotar um tom mais “dovish” ainda, e afirmou que as taxas de juros devem ficar extremamente reduzidas até pelo menos 2014. Com este cenário de nova rodada de liquidez nos países “desenvolvidos”, aumentam as chances de alta no preço das commodities.

Este não é um quadro deflacionário. Fora isso, o Brasil apresentou índice de inflação acima do esperado na última semana, sem esquecer que fechou 2011 no topo da meta, já muito elevada. A taxa de desemprego está em patamares extremamente baixos, mostrando um mercado de mão de obra bastante aquecido. O crédito segue em expansão. O governo conta com o corte nos gastos fiscais para conter a inflação, mas já vimos que tais promessas são vazias.

Em suma, o país corre sérios riscos de ver a inflação sistematicamente acima da meta. E isso não parece incomodar muito o BC. Será que estamos vendo o fim do modelo de metas inflacionárias no Brasil? Será que o BC mira agora em uma meta de juros? O governo Dilma, com maior ingerência sobre o BC, está dando sinais preocupantes nesta direção. Seria um retrocesso institucional incrível, ameaçando o retorno de uma inflação fora de controle. Todo cuidado é pouco.

No Need to Panic About Global Warming

WSJ

There's no compelling scientific argument for drastic action to 'decarbonize' the world's economy.

Editor's Note: The following has been signed by the 16 scientists listed at the end of the article:

A candidate for public office in any contemporary democracy may have to consider what, if anything, to do about "global warming." Candidates should understand that the oft-repeated claim that nearly all scientists demand that something dramatic be done to stop global warming is not true. In fact, a large and growing number of distinguished scientists and engineers do not agree that drastic actions on global warming are needed.

In September, Nobel Prize-winning physicist Ivar Giaever, a supporter of President Obama in the last election, publicly resigned from the American Physical Society (APS) with a letter that begins: "I did not renew [my membership] because I cannot live with the [APS policy] statement: 'The evidence is incontrovertible: Global warming is occurring. If no mitigating actions are taken, significant disruptions in the Earth's physical and ecological systems, social systems, security and human health are likely to occur. We must reduce emissions of greenhouse gases beginning now.' In the APS it is OK to discuss whether the mass of the proton changes over time and how a multi-universe behaves, but the evidence of global warming is incontrovertible?"

In spite of a multidecade international campaign to enforce the message that increasing amounts of the "pollutant" carbon dioxide will destroy civilization, large numbers of scientists, many very prominent, share the opinions of Dr. Giaever. And the number of scientific "heretics" is growing with each passing year. The reason is a collection of stubborn scientific facts.

Perhaps the most inconvenient fact is the lack of global warming for well over 10 years now. This is known to the warming establishment, as one can see from the 2009 "Climategate" email of climate scientist Kevin Trenberth: "The fact is that we can't account for the lack of warming at the moment and it is a travesty that we can't." But the warming is only missing if one believes computer models where so-called feedbacks involving water vapor and clouds greatly amplify the small effect of CO2.

The lack of warming for more than a decade—indeed, the smaller-than-predicted warming over the 22 years since the U.N.'s Intergovernmental Panel on Climate Change (IPCC) began issuing projections—suggests that computer models have greatly exaggerated how much warming additional CO2 can cause. Faced with this embarrassment, those promoting alarm have shifted their drumbeat from warming to weather extremes, to enable anything unusual that happens in our chaotic climate to be ascribed to CO2.

The fact is that CO2 is not a pollutant. CO2 is a colorless and odorless gas, exhaled at high concentrations by each of us, and a key component of the biosphere's life cycle. Plants do so much better with more CO2 that greenhouse operators often increase the CO2 concentrations by factors of three or four to get better growth. This is no surprise since plants and animals evolved when CO2 concentrations were about 10 times larger than they are today. Better plant varieties, chemical fertilizers and agricultural management contributed to the great increase in agricultural yields of the past century, but part of the increase almost certainly came from additional CO2 in the atmosphere.

Although the number of publicly dissenting scientists is growing, many young scientists furtively say that while they also have serious doubts about the global-warming message, they are afraid to speak up for fear of not being promoted—or worse. They have good reason to worry. In 2003, Dr. Chris de Freitas, the editor of the journal Climate Research, dared to publish a peer-reviewed article with the politically incorrect (but factually correct) conclusion that the recent warming is not unusual in the context of climate changes over the past thousand years. The international warming establishment quickly mounted a determined campaign to have Dr. de Freitas removed from his editorial job and fired from his university position. Fortunately, Dr. de Freitas was able to keep his university job.

This is not the way science is supposed to work, but we have seen it before—for example, in the frightening period when Trofim Lysenko hijacked biology in the Soviet Union. Soviet biologists who revealed that they believed in genes, which Lysenko maintained were a bourgeois fiction, were fired from their jobs. Many were sent to the gulag and some were condemned to death.

Why is there so much passion about global warming, and why has the issue become so vexing that the American Physical Society, from which Dr. Giaever resigned a few months ago, refused the seemingly reasonable request by many of its members to remove the word "incontrovertible" from its description of a scientific issue? There are several reasons, but a good place to start is the old question "cui bono?" Or the modern update, "Follow the money."

Alarmism over climate is of great benefit to many, providing government funding for academic research and a reason for government bureaucracies to grow. Alarmism also offers an excuse for governments to raise taxes, taxpayer-funded subsidies for businesses that understand how to work the political system, and a lure for big donations to charitable foundations promising to save the planet. Lysenko and his team lived very well, and they fiercely defended their dogma and the privileges it brought them.

Speaking for many scientists and engineers who have looked carefully and independently at the science of climate, we have a message to any candidate for public office: There is no compelling scientific argument for drastic action to "decarbonize" the world's economy. Even if one accepts the inflated climate forecasts of the IPCC, aggressive greenhouse-gas control policies are not justified economically.

A recent study of a wide variety of policy options by Yale economist William Nordhaus showed that nearly the highest benefit-to-cost ratio is achieved for a policy that allows 50 more years of economic growth unimpeded by greenhouse gas controls. This would be especially beneficial to the less-developed parts of the world that would like to share some of the same advantages of material well-being, health and life expectancy that the fully developed parts of the world enjoy now. Many other policy responses would have a negative return on investment. And it is likely that more CO2 and the modest warming that may come with it will be an overall benefit to the planet.

If elected officials feel compelled to "do something" about climate, we recommend supporting the excellent scientists who are increasing our understanding of climate with well-designed instruments on satellites, in the oceans and on land, and in the analysis of observational data. The better we understand climate, the better we can cope with its ever-changing nature, which has complicated human life throughout history. However, much of the huge private and government investment in climate is badly in need of critical review.

Every candidate should support rational measures to protect and improve our environment, but it makes no sense at all to back expensive programs that divert resources from real needs and are based on alarming but untenable claims of "incontrovertible" evidence.

Claude Allegre, former director of the Institute for the Study of the Earth, University of Paris; J. Scott Armstrong, cofounder of the Journal of Forecasting and the International Journal of Forecasting; Jan Breslow, head of the Laboratory of Biochemical Genetics and Metabolism, Rockefeller University; Roger Cohen, fellow, American Physical Society; Edward David, member, National Academy of Engineering and National Academy of Sciences; William Happer, professor of physics, Princeton; Michael Kelly, professor of technology, University of Cambridge, U.K.; William Kininmonth, former head of climate research at the Australian Bureau of Meteorology; Richard Lindzen, professor of atmospheric sciences, MIT; James McGrath, professor of chemistry, Virginia Technical University; Rodney Nichols, former president and CEO of the New York Academy of Sciences; Burt Rutan, aerospace engineer, designer of Voyager and SpaceShipOne; Harrison H. Schmitt, Apollo 17 astronaut and former U.S. senator; Nir Shaviv, professor of astrophysics, Hebrew University, Jerusalem; Henk Tennekes, former director, Royal Dutch Meteorological Service; Antonio Zichichi, president of the World Federation of Scientists, Geneva.

The Buffett Ruse

Editorial do WSJ

Obama's ploy means the highest capital gains tax rate since 1978

Remember the moment in 2008 when Charlie Gibson of ABC News asked Senator Barack Obama why he would support raising the capital gains tax even though "revenues from the tax increased" when the rate fell? Mr. Obama's famous reply: "I would look at raising the capital gains tax for purposes of fairness." Well, we were warned.

Here we are four years later, and President Obama on Tuesday night linked the term "fair" to U.S. tax and economic policy seven times. The U.S. economy is still hobbling out of recession, real family incomes are falling and 14 million Americans are unemployed, but Mr. Obama declared that his top priority is not to reform the tax code to promote growth and job creation. His overriding goal is redistributing income.

Mr. Obama endorsed the political ruse he calls the Buffett rule, which asserts as a matter of moral principle that millionaires should not pay a lower tax rate than middle-class wage earners. Specifically, Mr. Obama is proposing that anyone earning more than $1 million pay at least 30% of that income to Uncle Barack.

The White House says that if a millionaire household's effective tax rate falls below 30%, it would have to pay a surcharge—in essence a new Super Alternative Minimum Tax—to bring the tax liability to 30%. For those facing this new Super AMT, all deductions and exemptions would be eliminated except for charity.

The Buffett rule is rooted in the fairy tale that taxes on the wealthy are lower than on the middle class. In fact, the Congressional Budget Office notes that the effective income tax rate of the richest 1% is about 29.5% when including all federal taxes such as the distribution of corporate taxes, or about twice the 15.1% paid by middle-class families. (See "How Much the Rich Pay," January 23, 2012.)

This is because wealthy tax filers make most of their income from investments. Such income is taxed once at the corporate rate of 35% and again when it is passed through to the individual as a capital gain or dividend at 15%, for a highest marginal tax rate of about 44.75%.

This double taxation is one reason the U.S. has long had a differential tax rate for capital gains. Another reason is because while taxpayers must pay taxes on their gains, they aren't allowed to deduct capital losses (beyond $3,000 a year) except against gains in the current year. Capital gains also aren't indexed for inflation, so a lower rate is intended to offset the effect of inflated gains.

One implication of the Buffett rule is that all millionaire investment income would be taxed at the shareholder level at a minimum rate of 30%, up from 15% today. The tax rate on investment income from corporations would rise to 54.5% from 44.75%, a punitive tax on start-up or expanding businesses.

The new 30% capital gains rate would be the developed world's third highest behind only Denmark and Chile, according to the American Council for Capital Formation. This is on top of the 35% corporate rate that is already the second highest rate in the world after Japan. That giant sucking sound you hear come January 2013 would be hundreds of billions of investment dollars fleeing to China, India, Korea and other U.S. competitors. Lower capital investment in the U.S. means less wage growth, and so the people hurt most by this tax hike would be workers, according to a study by the Institute for Research on the Economics of Taxation.

Mr. Obama conceded on Tuesday that the high U.S. corporate tax is an economic loser. Yet he misses the crucial point that business owners assess the combined corporate and capital gains tax on those business profits. Lowering the corporate tax rate makes the U.S. more competitive, but the tax change is self-defeating if it is combined with an even larger rise in investment income taxes on capital gains and dividends.

Mr. Obama isn't setting himself apart merely from conservatives with this Buffett ploy. He is rejecting 35 years of bipartisan tax policy that began with the passage of the Steiger Amendment by a Democratic Congress that cut the capital-gains rate to 28% from 35% in 1978.

As the nearby chart shows, the rate has never since risen above 28%, and the last time it moved that high was in 1986 as part of the Reagan-Rostenkowski tax reform that also cut the top marginal income tax rate to 28% from 50%. With income-tax rates so low, a differential was arguably less necessary—though it's worth noting that capital gains revenues fell dramatically after that rate increase.

A decade later Bill Clinton agreed to cut the rate back to 20% as part of the balanced-budget deal with Newt Gingrich. Capital gains revenues soared, helping to balance the federal budget. Nearly every study estimates that the revenue-maximizing tax rate from the capital gains tax is between 15% and 28%. Doug Holtz-Eakin, the former director of the Congressional Budget Office, says that a 30% tax rate "is almost surely above the rate that maximizes tax revenues." So it's likely the Buffett trick would lose revenue for the government.

Yet in a time of the highest deficits since World War II, Mr. Obama wants to double the capital gains tax rate even as he raises the top income-tax rate to 42% or so. Mr. Obama really is taking us back to the worst habits of the 1970s. And not because he thinks higher rates will raise revenue, but merely so he can score points against Mitt Romney and stick it to the successful.

This isn't tax fairness. It's tax folly.