WEEK OF AUGUST 25, 2008--MAKING SMART DECISIONS

A Univ. of Chicago economist and Harvard Law Professor, Richard Thaler and
Cass Sunstein (the last is advising Barack Obama), have just come out with a wonderfully common sense book entitled, “Nudge, Improving Decisions About Health, Wealth, and Happiness”, (Yale University Press) that may help us to make smarter financial decisions.

Their thesis is that no decision is made in a vacuum. Context helps determine how content is understood, whether in a supermarket line, saving with a 401(k), or buying stock. Their book is based on research that shows people frequently make bad decisions because they don’t take into account the context or circumstances that can influence their decisions.

It is therefore important to provide guidelines or regulations that support wise decision making. So investing in “free markets and open competition (i.e., without regulation) will tend to exacerbate rather than mitigate the effects of human frailty,” say the authors. Unregulated markets tend to benefit insiders, in other words, who tend to be the most strenuous objectors to market regulations.

A simple example of nudging is the supermarket displays. How food items are displayed in supermarkets helps determine which are purchased. Sales and Public Relations people know that presentation is a big factor in sales. Even “small and apparently insignificant details can have major impacts on people’s behavior,” say the authors.

The authors’ goal is to ‘nudge’ people toward healthier, safer, more prosperous lives, says one reviewer. I agree with their thesis because it reinforces Dr. Robert Shiller’s bestseller, “Irrational Exuberance”. He predicted the dot-com stock market bust, as well as the current housing downturn that I have mentioned in past columns. Dr. Shiller’s research found that most investors follow their emotions in making investments, rather than do real research.

Messrs. Thaler and Sunstein take this understanding to another level, by recommending ways to correct the ‘bias’ in order to make more intelligent decisions. The first priority is to set up policies—whether by government or an employer that enable smarter outcomes by clearly explaining the choices. They recommend buying health insurance with the largest deductible that is affordable, for instance, since studies have shown that overall costs tend to be lower. This is something that insurance companies will not tell their clients.

Much decision-making must take into account a basic human trait. It is called cutting corners, inertia, or mental laziness, if you will. However, I believe consumers also have a basic common sense that can protect them. If consumers are given all the facts, they will make smart decisions. But it will take a greater effort by policymakers who formulate the rules and regulations that govern commerce—and prevent the negative ‘nudging’ of those who try to influence what is not in the consumer’s best interest.

© Harlan Green 2008

WEEK OF AUGUST 18, 2008--PRODUCTIVITY EASES THE PAIN

A recent Business Week article highlighted the importance of our rising labor productivity, which is mitigating some of the pain of the current economic slowdown. In a word, it means higher profits for companies and higher wages for their workers. And it will help to push future inflation lower

This is likely to help future growth, rather than the current economy, what with alarums over the possibility that Fannie Mae and Freddie Mac might be nationalized. All that negative news is making so-called conforming and jumbo-conforming conventional mortgages that are insured by Freddie and Fannie more expensive, as investors grow leery over the possibility of their failure.

Mortgage rates should in fact be trending down to historic lows with the 10-year Treasury bond yield now around 3.8 percent. Conforming 30-year fixed rates were in the 5.25 to 5.50 percent range in 2003, the last time Treasury rates were this low, versus 6.25 percent today.

A drop in inflation will also lower interest rates, especially for bonds that are sensitive to inflation trends. The current inflation spike is due to many factors, including the Iraq War and devalued dollar. Higher labor productivity is part of the technology revolution that has transformed the U.S. economy and kept inflation lower than it was in the 1980s and 1990s.

Productivity, measured as output per hour worked in private nonfarm businesses, has increased 2.8 percent in the second quarter from one year ago, versus its 1.1 percent annual rate of the past 2 years. This is good news when we are in the midst of an economic slowdown.

In fact, the current consumer inflation rate of 5.8 percent could be much higher without the savings in labor efficiency, caused by businesses continuing to invest in high technology to cut costs. Fed Chairman Ben Bernanke was optimistic about inflation prospects at the Fed’s recent annual Jackson Hole Conference.

“In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year.”

What are the prospects for growth in this economy that is going to be “short of

potential for a time”? The Conference Board’s July Index of Leading Economic Indicators (LEI) showed “slow growth the rest of the year, and possibly an economy grinding to a halt,” said its press release. Seven of its ten indicators that help to predict future economic activity have been negative over the past 6 months.

But second quarter GDP economic growth may be revised to as high as 3 percent from its 1.9 percent initial estimate, due to higher exports than originally estimated. This second GDP “preliminary” revision will be released by the Commerce Dept. August 28. Q1 growth was just 0.9 percent.

What does that tell us? Some parts of the economy are still growing, including exports, some manufacturing sectors tied to exports, and health care. But the financial industry needs more capital to make up for its horrendous losses (and a recovery of its stock prices) before the rest of the economy (including housing) recovers.

© Harlan Green 2008