What Should You Be Thankful For?

One Thanksgiving tradition my family has is to state what each person is thankful for before eating. This is done in place of grace (the prayer before eating). To my recollection, nobody has stated what we should truly be thankful for at our gatherings. It is this: freedom. If it weren't for freedom, most of us that currently live in North America would not exist. Many would have perished in those first harsh winters at the Plymouth colony.

But freedom did prevail, and the Plymouth colony, which had been previously organized in a communistic structure, was reorganized in a free market or capitalistic structure. Whereas upon arrival everyone worked common land and contributed to a common fund, after reorganization everyone worked their own land and contributed to their own well being. The effect? Harvest yields went up, way up. Theft and other commercial crime went way down. Given these two effects, I speculate that life in the colonies was much better under the free market than under the communism that prevailed beforehand.

So today, give thanks for freedom. And, by God, do everything you can to promote it.

Characteristics of a Price Bubble

 “A true bubble is when something is overvalued and intensely believed,” he says. “Education may be the only thing people still believe in in the United States. To question education is really dangerous. It is the absolute taboo. It’s like telling the world there’s no Santa Claus.”

After the tech bubble and real estate bubble each burst, there is much discussion as to the next bubble. From what I can tell, there are two popular candidates: education, i.e. tuition, and health care, i.e. insurance premiums. In this post, I’ll discuss the two first bubble candidate. I want to first discuss in general terms what constitutes a bubble.

            

Define the capitalized value of an asset as the present value of its future expected net cash flows (revenues less expenses). A general formula looks like this:

P0 = CF/(r-g)

where P₀ is the price of the asset (capitalized value today), CF is the net cash flow per period, r is the discount rate, and g is the expected growth rate in the cash flow. The discount rate should reflect the time value of money and all the risks faced by the asset holder due to the asset ownership.

For stocks, CF is the free cash flow available to equity holders (FCFE). Free cash flow is available for reinvestment in the firm or to be paid out to equity holders as dividends or stock buybacks. Negative free cash flow means the firm needs financing from outside, whereas positive free cash flow means the firm is generating more internal cash flow than needed to maintain its business.

The capitalized value of the asset increases if expected future cash flows increase, or if the discount rate decreases. Of course there is a lot of noise in those expectations, so we expected capitalized values of assets with noisy information to be at least somewhat volatile.

A price bubble is defined as a price increase that is not generated by changes in expectations of future cash flows or the discount rate. In other words, it is a price increase that is not connected to the fundamentals of the asset. The trouble with identifying a bubble is that market participants can have legitimate (i.e. based on sound research and reasoning) differences in their expectations of the future cash flow that an asset will generate. Further, people can have a different personal discount rate and attitude toward risk, which leads to differences in discount rates.

Now, in stock/bond pricing, discount rates should not deviate much across investors, since the required return is priced by the marginal investor. That means the only thing driving discount rate differences should be risk factors. But, for things like education, I think the story is different.

With education the asset being purchased is predominantly a signal, with some human capital development. It’s not clear at all that the human capital development can only be done through higher education, but that’s another topic. The point is, the expected cash flow generated from the asset is the so-called education premium. In other words, the student is purchasing a higher expected salary. These expectation differ by degree level (Bachelor’s, Master’s, Ph.D.) and by type (Business, Engineering, Arts, etc.).  

The premium of the typical bachelor’s degree over high school is $20,000/year (data here). Now that includes degrees of all types. I don’t have data for different majors. Using data on average tuition from here, the average state school costs is $33,000 for all four years for an in-state student. But wait one minute! Not only is there tuition, there is the opportunity cost of not working full time while in college. Let’s assume the full-time student won’t work, so we’ll add four years of high-school earnings to the investment. That’s $112,000.

Let’s see what the implied capitalization rate is. Take the average degree premium as the dividend and the total investment as the price, we find the implied capitalization rate is 13.7% in this case. This is an enormous discount. The lower the capitalization rate, the higher is the price relative to the dividend. Implied discount rates for out-of-state students are 12.3%, and for private schools it’s 9%.

At first blush I would say there is little evidence of a bubble in higher education. The problem is coming from bad combinations of tuition and degree (major). If your major does not promise greater than $28,000/year in earnings, on average, the college degree you’re getting is (guaranteed) not worth it.

Now, if you go to an in-state school, in order to get a 5% return on your money, you need a salary premium of $7300/year, after tax. That’s $10,400 before tax, assuming an average tax rate of 30% (federal and state). So if you want to score a job that pays off your education, you need to earn around $40,000/year. If you go with a 10% return, you need closer to $50,000/year. This is reasonable for engineering and some science jobs, and some (not many) business majors. You won’t be getting anywhere close to this with a humanities or social science degree.

My argument is that the average college degree pays off the degree holder. But within that are some very bad choices. In the end, the individual must make careful, informed decisions. 

Some Perspective

The so called congressional supercommittee is charged with coming up with $1.2 trillion in cuts by 23-Nov.  If they fail to reach agreement AND Congress (both houses) doesn’t adopt their proposal by the end of the year, automatic cuts of $1.2 trillion are triggered.  These cuts would begin in FY 2013 (Oct 2012) and would be phased in over 10 years.

Many are predicting doom should Congress fail to meets its deadlines, but let’s calm down.  These cuts are hardly draconian.  The chart below shows two figures: the large bar represents the total budget outlays in FY 2011, and the other bar would be the cuts.    

Question: Would we even notice?

Government Spending

Government spending is front and center these days.  Even now, the new congressional select committee has just a few days to come up with $1.5 trillion in cuts or automatic cuts of $1.2 trillion go into effect starting in 2013 (to be phased in over ten years).  Should this scenario play out, the Department of Defense will shoulder half of those cuts.  November 23^rd is the drop dead date for the committee to submits it’s proposal to the Congress. 

One common and perhaps persistent misperception is that Democratic presidents are much bigger spenders than their Republican counterparts.  To evaluate this, I looked at our two most recent presidents: Clinton & Bush Jr.  I didn’t include Obama because he hasn’t served at least one full term yet.

I used data from the CBO on defense and non-defense spending.  I then graphed spending during the Clinton years and during the Bush years.  The last graph shows percent change from year to year, beginning in 1991.

Looks like Bush, a Republican, is the bigger spender here.  Of course, 9/11 happened on Bush’s watch, and that certainly played a role in the increase in spending.  One thing is for sure, those who claim government isn’t spending enough are flat wrong.

Wise Economists

Plenty of economists are smart people who can do fancy math and create nice models that have real-sounding results. But few economists are wise. Russell Roberts is wise.

A Quote from Mises Daily

From today's Mises Daily:

"Politics and government twist the overwhelming advantages of our unique desires and skills into conflict. Instead of each of us going his own way to satisfy his needs and earning a living satisfying other people's needs in a manner each of us finds most accommodating, we are forced to choose between suboptimal options imposed by institutions. Politics distills options to the most ascetic elements when a cornucopia should prevail."

O, how very true.

Free Education

The internet is simply a wonderful tool, especially for disseminating knowledge and information. Clicking on this link will transport you to another blog where another 12 dozen links await your discovery. 

You will find the whole spectrum, ranging from Harvard Medical School courseware to Boston College Front Row to Standford Law to underwater basket weaving.  (okay, I made that last one up). 

Enjoy.