Wednesday, July 26, 2017

McDonald's Two Businesses, One Strategy

Feeding people

Managing a franchising operation

Responding to the right competitors?

The risks to the strategy has had a number of very good articles on McDonald's recently. Two of them focused on the balance sheet implications of McDonald's current strategy. Another focused specifically on the strategy. There would be no point to replicating that analysis. Suffice it to summarize by pointing out that, for better or worse, McDonald's has increased its leverage as part of the strategy to shift to a more asset-light model for their business. McDonald's just reported earnings that pleased Wall Street, but this article was largely written before the earnings report and focuses on longer-run issues.

Addressing whether the moves described in the SeekingAlpha articles are for better or worse requires some thought about what McDonald's business is. As one of the articles points out, “The typical consumer experience at McDonald’s (MCD) involves either waiting in a queue or going for a drive-thru at one of its many outlets.” That may be how the consumer experiences McDonald's currently, but it is not the essence of their business. The essence of their business is figuring out how to feed people and leveraging that information.

Feeding people is necessary practical experience relevant to figuring out the best systems for accomplishing the objective of feeding people. Once they figure that out, they maximize the value by franchising their system. Their move to switch many of their outlets from corporate-owned outlets to franchises can be seen as just reflecting a high degree of confidence that they have figured that out.  As a consequence, they have value in the intellectual property embodied in their franchise agreements.

Even at its current price, McDonald's stock is a justifiable core holding. However, it's only justifiable if an investor is willing to hold a company pursuing the strategy outlined above. So, it makes sense to look at some aspects of their operation that are relevant to that strategy.


There are a couple of aspects of McDonald's operations that are often overlooked when assessing the company.

First, it would be an error to view McDonald's as just a restaurant chain. The previous Chief Executive Officer seemed not to appreciate that fact. However, McDonald's serves more customers at the drive-through window than as walk-ins who eat in the restaurant. I believe that corporate wide, drive-through accounts for about 60% of the business, and in some franchises it is as high as 80%. In the 1980s and 90s it was fashionable to discuss trends in consumer consumption of meals at home versus meals eaten away from home when discussing McDonald's. Analysts and McDonald's executives focused on how to feed people, not how to run restaurants. They recognize that competition with other restaurants was only part of the story relevant to McDonald's value. It also explains why the “You deserve a break today” marketing campaign was so successful. It positioned McDonald's against any alternative, not just fast food.

Second, the intellectual property that McDonald's capitalizes on includes the strength of the brand. Consequently, although McDonald's was identified as a potential core holding in a posting as early as January of 2011, as long as it was being operated as if it was a restaurant that competed with the fast- casual restaurants like Chipotle Mexican Grill and Panera Bread, it was hard to see it as other than a “hold.” In the $90s it might be justified as a dividend-paying bond substitute, but in the $90s it was a screaming “buy” once it became apparent that they were going to have to focus on their brand’s strength rather than the brand strengths of other restaurants. The previous CEO was chasing business where their brand did not have value; but once that stopped, the strength of their brand created the potential that McDonald's was going to become a dividend grower.

Third, McDonald's seems to have developed a better understanding of their competition and their customers. That extends beyond just realizing that they were losing market share to other fast food chains, not the fast-casual dining establishments. In fact, the new program referred to as “Experience of the Future” may manifest itself in the form of purchases using a cell phone, ordering on kiosks, or pre-ordering for pickup or something else. However, all of the initiatives, both those that succeed and those that are phased out, represent an effort to keep the brand relevant. In an environment where the definition of convenience and speed, two hallmarks of their brand, are being changed by companies as far afield from fast food as Apple and Amazon, the initiatives represent important steps to defend their brand and, thus, the value of their intellectual property.

Fourth, McDonald's decision to hand over a large number of their company-owned stores to franchisees is not a bit of financial engineering. Granted, pushing the number of franchisee-operated global locations up to 93% of all units will increase profitability. But it will increase profitability because it is an efficient way to allocate capital. Further, it reduces risk since it shifts much of the rest of the operations to the franchisee. Because it shifts some of the operating risk off of the corporate entity, it allows the company to increase financial risk by increasing leverage without increasing the overall risk.

Franchising leverages the intellectual property that has made McDonald's franchises such good investments. It's easy to overlook some of that intellectual property. So, when evaluating the strategy, it's useful to consider some of that intellectual property that isn't immediately apparent:

1.  McDonald's is an expert at locating their outlets. When marketing economic information that could be used to locate outlets, it was not unusual for McDonald's fast food competitors to describe their location strategy as simply getting as close to a McDonald's store as possible.
2.  McDonald's scale has allowed them to develop a supply-chain and supply-chain management techniques that have their maximum value when applied to as many stores as possible, and the effectiveness of their supply chain enhances the value of their franchises.
3.  McDonald's scale also allows their franchisees to benefit from economies of scale in marketing. That was especially true when broadcasting was a primary promotional media, but it is still true even though marketing efforts can now be more targeted.
4.  It's easy to overlook the fact that McDonald's has built up tremendous intellectual property in the form of an understanding of how to operate through franchises. Knowing how to protect your brand and ensure a reasonable amount of uniformity in operations when operating through thousands of independent businesses is a skill McDonald's has, to date, perfected.


This strategy seems sound; however, it is not without risk. One of the principal risks is that by reducing the number of company-owned stores, McDonald's is reducing the scale of their ability to experiment without forcing their franchisees to bear the risk associated with their experiments. Looked at differently, McDonald's is narrowing the scope of their direct interaction with the ultimate customers. It is quite possible that McDonald's is appropriately scaling the company-owned operation in order to maximize value of the information they gained from operating some of the outlets. The risk is that they judged that wrong.

As mentioned, increasing the scale of the franchise operation shifts operational risk to franchisees. That may justify the increased leverage for the corporate balance sheet. The risk is that they misjudge the balance between operational risk and financial risk and in the process of implementing the strategy increase the overall risk to the company.

Finally, if the Corporation errs in its judgment on either the items above, it could stress their franchise system. The success of their strategy depends upon both the success of corporate entity and the success of the franchisees. Historically McDonald's has managed that balance well, but the change in corporate strategy will require that they adjust their thinking regarding the role of the franchisees. For example, they seem to have placed far more emphasis on making sure franchisees understand the strategy behind “Signature” sandwiches than was true of previous similar initiatives. That's totally appropriate to their efforts to streamline the process by which they bring franchisees into new initiatives.

Disclosure: The author of this article owns shares of McDonald's Corporation. It has been part of my portfolio off and on since shortly after Pepsi spun off Yum Brands. However, holdings were expanded significantly when McDonald's was trading in the $90s. I have no intention to buy or sell additional shares over the foreseeable future. 

Sunday, July 23, 2017

Lies, damn lies, and statistics

Intentional false narrative?

Lost in the numbers and not knowing what they mean?

Confirmation bias?

Here's the sort of thing one has to do in order to take any data seriously when the data are quoted by the mainstream media. It's amazing how many times data are used in a way that is totally inappropriate simply because the user doesn't really know how the data is derived.  It may be generous to attribute the misuse of the data to ignorance if there is any reason to believe that it is being misused to create a false narrative. It also seems legitimate to assume that any time a reporter is creating a narrative; they have ceased to be qualified as objective reporters of statistics.

You may not care about the data discussed below, but the demographic (retirees or people over 65) being characterized by the data is growing demographic and one we all aspire to eventually join. If you don't care, you might want to scroll through this posting just to see how crazy the media’s fascination with creating narratives has become. To those who find the topic boring I just state, “In my defense, I would point out that I made a career out of this sort of thing and analyzing forecasting techniques. Silly career, but a lot of fun. I just can't break the habit.”

Unfortunately, once Moody's decided that they were going to retire me, I've been unable to find anybody to pay me for such nonsense. The best I've been able to do was back in September of 2010 when I published six articles analyzing how people were forecasting the impact of the stimulus package. I'm quite proud of those publications since I think I did better than most of the forecasters. I was thinking of doing the same with respect to the CBO estimates of the impact of healthcare proposals, but I decided I’d just do the analysis for my own edification. I don't think anybody really cares what the impact of the proposal will be, and I know from dealing with CBO that they could care less. Everyone seems to be obsessed with the politics rather than the results. I’d probably get flamed by one side or the other.

It's interesting that I was publishing on an Internet investment forum on a fairly regular basis. I got a lot of positive feedback and probably made some people some money. I stuck my neck out and made some recommendations which sometimes worked out and sometimes didn't. But, no one ever flamed me even when they disagreed. It seems people are more willing to lose money than have someone disagree with them on politics, and it's much easier to misinterpret the data to justify your politics than to deceive yourself about whether you've lost money.

When trying to plan for retirement, here's some data to consider:

Two articles (articles, not editorials) quoted different numbers for what they represent as being the same concept. In the United States, is the average (median) retirement income $30,158 or is it $18,657?  Both numbers were quoted recently in two articles which obviously were trying to make two different stories out of the concept. So, let’s look into what the real numbers are when properly defined. It turns out that the number that best represents the concept relevant to the articles is before tax money income available to people over 65. It is probably about $23,000 ($22,887 is one estimate discussed below), but that is income of people over 65 which is different from retirees income. That figure didn't support either of the arguments the articles were trying to make, and both articles confused people over 65 with retirees.

It's interesting that the use of poorly defined terms was unintentional. Both referred to the median as average which is appropriate when talking about income distributions. However, if the article that used the higher figure had instead used the mean, it would have made their case look even stronger. (Using a mean income involves more than just a different calculation; it also necessitates use of different source data. It's inappropriate both because it's a wrong calculation to show representativeness in a skewed distribution and because it would necessitate using data sources that don't really focus on the concept most appropriate to the discussion.).

However, even when measured and defined properly the concept of before tax money income of those over 65 has limitations. First and foremost, those over 65 are receiving significant non-monetary income in the form of Medicare and the tax-advantaged treatment of Social Security payments. What would be more useful would be a measure of the effective monetary and nonmonetary income of those over 65. That's the concept that would be most generally useful.

The figure of $22,887 is probably relevant to comparing current retirees to other generations of retirees, but only those that retired since the passage of Medicare. Even there it ignores changes in both Medicare and Social Security that made them more generous for some retirees. It's totally inappropriate for comparing current well-being between age groups since different age groups receive different forms of public-sector support. It's particularly inappropriate for comparisons to poverty since both those living in poverty and those over 65 are receiving significant non-money benefits. (Poverty also tends to be temporary whereas being over 65 is permanent). 

Household income of over 65

One article said “in the United States, the average retirement income was $30,158.” The term “average retirement income” is used rather loosely here because this is actually the median household income before taxes for all persons who are 65 and older, whether they are retired or not. This figure is estimated directly from United State Census Bureau reports.

Here’s the problem.  A household's income can be calculated in various ways but the US Census, as of 2009, measured it in the following manner: the total of the incomes of all residents of that house who are over the age of 15, including wages and salaries, and/or any kind of governmental entitlement such as unemployment insurance, disability payments, Social Security, or child support payments received, along with any personal business, investment, or other routine sources of income. The residents of the household do not have to be related to the head of the household for their earnings to be considered part of the household's income.

The sum of the income of all people 15 years and older living in the household significantly distorts the measure. If the household consists of a couple where one of the partners is younger than 65 but not the head of the household, the income of the younger partner is included in household income.

Further, a household includes related family members including children over 15 and all the unrelated people, if any, such as lodgers, foster children, wards, or employees who share the housing unit. For example, if adult children are living with their parents who are over 65, household income for the over 65 household is a combination of the income of the parents and children. By contrast, if the adult children live alone in a housing unit, there would be two households whose combined incomes would equal the one household where the adult children live with the parents. If a group of young adults who were unrelated live together sharing a housing unit, it is counted as a household where the household income is the combined income of all the people sharing the housing unit.

AARP also did an estimate of household income for what they referred to as retirees and came up with a roughly similar figure. It was just over 31K. It's interesting that they picked that number. It is one of the higher estimates. It leaves the impression that AARP is more interested in representing itself as a convenient marketing vehicle to reach individuals with disposable income than as an advocacy group for a demographic group that needs an advocate. Interestingly, as described below, other advocacy groups for retirees that don't also act as a direct marketer use a lower estimate to represent the income of those over 65.


Income of individuals over 65

The Pension Rights Center calculates a number for income of all individuals over 65 whether working or not. In 2015, 47.7 million Americans were age 65 and older. Half of all older adults had less than $22,887 in yearly income from all sources.

Measuring income for persons, rather than by households, understates the resources available to some persons and overstates the resources available to others. For example, the income from a pension received by the husband is attributed entirely to the husband, even though that income may be shared by the husband and wife. This measure has the advantage that it does not include persons younger than age 65, who would be included in a household measure. However, this measure still focuses on an age group rather than retirees. Retirees are an employment status not an age group.

Income of Older Adults without Earnings

Individual income of retirees is much lower than household income or individual income when the focus is people who are totally retired and over 65. The average retirement income is probably a lot less than you think. As surprising as it might sound, the average American’s retirement income is barely over $1,500 per month or about $18,000 annually, according to the Pension Rights Center. This figure is for people who are totally retired and breaks down as follows:

About one out of five older adults (23% by one estimate) has income from earnings. In 2015, people 65 and older who are fully retired have a median income of $18,657. The amounts were similar among all older age groups.
Table 1. Median income, by age, with no earnings, 2015

These figures raise an interesting question related to the $4,000 difference between the median income of those who are totally retired and the total population over 65. Is $4,000 the value that people over 65 on average attach to the difference between being totally retired versus partially retired, or does it reflect a hardship imposed on those who can't but would be willing to work after age 65?  If it is the latter, it has major implications for how work should be structured for a population that will include the growing demographic group over 65. Data on those over 65 actually working and surveys about whether those over 65 would accept work indicate that structural limitations are real and disproportionately affect the 65 to 70-year-old group.

It would be equally reasonable to argue that the difference between the average income of all people in all age groups and the average income of those who are totally retired represents the value people attach to not having to work. However, that makes assumptions about the productivity of workers in different age groups that don't square with reality. Further, it ignores the reality that the value of not working changes as one ages, perhaps raises a family, and accumulates assets.

Income of those over 65 estimated independent of household definition

The Pension Rights Center also estimates a measure it calls the “Income of Aged Units.” That figure comes much closer to the Census Bureau estimate of household income and the AARP estimate. It estimates the median income for aged units 65 and older was $30,193 in 2014.  

Median income is higher for aged units than for persons because aged units may include more than one person, and an aged unit could include someone younger than age 65 who was still working. Aged units include single persons age 65 and older, and married couples. The age of the married couple is the age of the husband if he is 65 or older. If the husband is younger than age 55 and the wife is age 65 or older, the age of the married couple is the age of the wife.

This unit of measure allows an assessment of the income of older adults independent of the household in which they are living. Thus, if a single older woman is living with her children, her income as an aged unit would consist entirely of her own income. Thus, this measure may understate the economic resources available to some single older adults. However, age units do seem to approximate taxable entities, and they are probably the unit most relevant to many considerations. The limitation of the age unit measure is that it still includes some people who are less than 65 years old, but it significantly reduces that measurement error from the household measure.

Where Does Most Retirement Income Come From?

According to the Pension Rights Center, older adults get income from the following sources:

Social Security: 85 percent of people 65 and older get Social Security. The average Social Security income in 2014 was not quite $1,300 according to Smart Asset. According to the SS Administration the median Social Security payment is just over $1,294 per month, but they quote that figure without being clear about whether it includes early retirees who are less than 65 years old.

Assets: Sixty-three percent of retirees rely on assets other than their pension for retirement income. According to Retirement USA, the median amount of asset income for households where either the householder or spouse was aged 65 or older was $1,542 per year ($129 per month) for those households who received any asset income. (Their estimate that 63% of those over 65 are receiving income from assets is a bit higher than my estimate which was done quite a few years ago when I had access to a variety of data sources, but it does seem realistic and is consistent with estimates that I saw for 2008. While the exact portion has to be estimated, what is not in doubt is that income from assets is the second most prevalent source of income after Social Security. The dollar figure estimate of $1,542 is representative if it's appropriate to include a large number of individuals whose investment income may be nothing more than interest on small savings account. But 401(k) data, mutual fund data, brokerage fund data, and the Federal Reserve Bank survey of consumer finance all indicate that it is not much higher than $1,542 if one makes reasonable assumptions about the return on the investments shown in those data. There is one problem with these data sources. They all ignore the potential to pull out the capital as a source of cash flow and thus miss regular-emergency sources of money).

Pensions: A mere 32 percent of us have pensions and this number is trending further downward. While it's common to complain that pension payments are lower than earnings and in some cases a very minor source of income, realizing that the vast majority of people over 65 have NO pension changes the perspective.

Earnings: 23 percent of older Americans have work income. There are many indications that the working portion of the population over 65 will increase. Those indications include the stated plans of those 55 to 65 in age, the actual tendency for the working portion to be higher (over twice as high) among those 65 to 70, the fact that the age required to get full Social Security benefits is above 65 for those currently retiring, and the necessity to keep working indicated by the failure of many baby boomers to accumulate any savings/investments to supplement their retirement income. According to the AARP, currently the median income earned by retirees from work is $25,000 a year. Note that this is the highest amount of any income source.

Public Assistance or Veteran’s Benefits: About 7 percent of retirees are getting monetary help from government sources.

These figures are roughly comparable with data from a variety of other sources including both public and private sector data. The conclusion of the Pension Rights Center is: “retirees today are more dependent than ever before on Social Security income. One of the biggest problems with that approach, aside from the fact that the program isn’t incredibly stable, is that Social Security was never intended to be a primary source of income. It was intended as a boost.”

Average Social Security Retirement Income

The Social Security Administration claims that for most people, Social Security is the largest source of retirement income. The majority of retirees (65 percent) get half or more of their income from Social Security. Over a third (36 percent) of people age 65 and older receive at least 90 percent of their income as a monthly Social Security payment. While those claims are representative, there is a problem with them. They're using retired and over 65 as interchangeable and they are not interchangeable. There are people between 62 and 65 who have retired voluntarily or not.  Also, a significant portion of the population 65 to 70 works full or part-time (recently that portion of the 65 to 70 population working at some point during the year has been more than 50%).

In 2014, the average monthly retirement income from Social Security was $1,294. That’s just $15,528 per year in Social Security benefits. ABC News reports that while the average retired worker in 2014 received $1,294 per month in Social Security earnings, the average couple received $2,111. So, the average couple is receiving $1,055 per person per month or only $12,660 per year for each person.

Social Security benefits are on average smaller for a number of groups. If one doesn’t have 35 years of work when starting benefits, if earnings were consistently low, or if benefits started at age 62 rather than waiting until your full retirement age, then the monthly check is smaller and the benefit is probably below the median.

In general, single people depend more heavily on Social Security checks than do married people. Perhaps married couples are more likely to have someone working and are more prone to have accumulated assets. They also may be more likely to have someone with a pension. Further, as noted above, the per person Social Security benefit is lower for couples than an individual. Finally, single Social Security recipients include the survivors of couples. Those survivors are often older, less able to work, and have had more time to deplete their assets.

Many people claim that the more money one made during ones career, the greater the gap between income needs and Social Security benefits. I don't doubt that that's perceived as true, but if you think about it, it's quite silly. The more money one made during ones career the more likely it is that one has accumulated most of what one needs. It seems that the more one has, the more one wants unless one consciously resists the temptation.

One is left with the impression that most of what is written about retirees incomes isn't interested in conveying facts. There is a different agenda at work. It may be present their organization is vital to the well-being of retirees or to advance a commercial interest. They all avoid important issues that ultimately will determine the well-being of retirees.

Monday, July 17, 2017

Loss of Control: An Economist's Perspective

Incentives are not aligned

Commitments lose their value when there are too many of them

A previous postings, introduced the idea that previous politicians have severely constrained the options available to currently-elected officials. The first such posting focused just on debt. It was followed by a number of postings on the loss of control implied by other decisions made by previous politicians. One posting addressed the current situation. It was followed by postings on the outlook for programs that constrain currently-elected officials’ ability to set priorities. The postings all focused on describing the situation (70% of all expenditures are mandated) and the outlook (all the mandated categories of expenditures are going to grow, some exponentially).

A logical follow-on question is: so what? Each individual can reach his or her own conclusions about the appropriateness of constraining the options available to currently-elected officials. Similarly, everyone has his or her own opinion about the benefit of the different programs that create the constraints. However, what can't be denied is that the constraints are real, that all indications are that they will grow, and that some of them will grow exponentially if left unmodified.

The US government was set up to put constraints on politicians. The federal system puts constraints on what any level of government can do. Each of the three branches of the federal government constrains the activities of the other branches. Even our legislature was divided into two houses in order to constrain immediate impulses of the popularly-elected lower house while ensuring that popular impulses would be represented. Importantly, the Bill of Rights is quite explicit in constraining government actions. However, there isn't an apparent similar constraint that operates over time. We’re dependent upon responsible action of previous officials as the only assurance that future officials will have enough latitude to govern.

As an economist and financial planner, I'll leave it to philosophers and political scientists to address whether there are adequate protections in the structure of our government. What is clear is that something will have to be done. Exponential growth is never sustainable. Policy wonks and politicians will undoubtedly put tremendous effort into trying to figure out what to do about the situation we've gotten ourselves into. Economic and financial planning considerations are not irrelevant.

One of the advantages of approaching it from an economics perspective is the immediate realization that there is no good or bad associated with the commitment to future liabilities. Economists have dealt with analogous issues for ages. They use a concept referred to as time preference. Early on it was illustrated by references to the decision to keep part of the harvest as a seed crop versus consuming it. Over time, economics has become much more sophisticated to the point where today behavioral economists working with neurologists can literally identify the areas of the brain involved in making decisions that involve time preference. From that they can imply, or speculate about, how the decisions are being made.

One of the places where economists and financial planners have a supposedly sophisticated approach to time preference is in financial planning. It is usually referred to in the context of the time preference for money. It can be handled by employing a concept known as the risk-free rate of return.

Usually the rate of return on government debt is used as a proxy for the risk-free rate of return. As is argued in an April 1, 2010 posting entitled“Beware the Risk-Free Return,” the very concept of the risk-free rate of return is seldom appropriate. It is particularly inappropriate in this context. As the posting states; “Sovereign entities are not too big to fail. Default isn’t an absolute. There are a lot of ways sovereign risk can be expressed. Rates are one.”

The risk-free rate of return falls apart when addressing issues related to the constraints previous politicians have placed on the US. It uses a variable (a Treasury rate) that is influenced by the constraints and, in turn, feeds back to raise the constraints. To illustrate, one of the concerns is that the interest burden from the debt and other mandated expenditures will cause interest rates to rise. Those higher interest rates will, in turn, exacerbate the debt service burden causing it to grow exponentially.

Conceptually, when dealing with policy issues, the equivalent of the risk-free rate of return would be what might be called the social-rate of return on expenditures. The social-rate of return on expenditures is a useful concept even if it can't be measured directly. It can be used to compare the incentives of different participants in a social-policy decision process. Whether there is misalignment between the incentives to make future commitments and the return on those commitments is a legitimate question.

It makes sense for politicians to commit to future expenditures if the return on the expenditures can confidently be forecast to be greater than the cost. That begs the question of why the politicians should be allowed to commit to future expenditures since, if the return on expenditures will be greater than their cost, future politicians will make the expenditure. Further, by making a commitment based upon a belief that in the future expenditures will be justified, politicians are introducing additional risk. They are introducing the risk that they are wrong in their forecast of future returns on those expenditures. Given those two facts, it's hard to see how to justify the current level of commitments. It suggests that a misalignment of incentives may exist.

However, before reaching that conclusion, one needs to consider another justification for the commitments. That justification is that there is a social return to the commitment itself. The best example familiar to anyone in finance is the low interest rate paid by nations that have a long history of, and thus implied strong commitment to, meeting their sovereign obligations.

It isn't just financial markets where future commitments have value. Theoretically, citizens and businesses benefit from knowing that the government has made a certain commitment. For example, the commitment to Social Security and Medicare is an input into retirement planning. The burden of financial planning for retirement is lightened to the extent one can count on those programs. A commitment to certain rights of property benefits both individuals and the economy in general. Neither individuals nor businesses can plan if they don't know what they own and what ownership implies.

The value of the commitment depends upon two things: (1) The degree to which there is confidence in the commitment, and (2) the nature of the expenditures that are being promised.  The nature of the expenditure that results in a commitment has to be addressed individually for each expenditure. Further, it is very dependent on personal preferences regarding the expenditure. Therefore, it is more fruitful to address how the value of commitment relates to the degree of confidence one can put in the commitment.

For shorthand, one can refer to how the value of the commitment relates to the degree of confidence in the commitment as simply the value of the commitment. The value of a commitment isn’t constant. For example, the April 1, 2010 posting pointed out evidence that, at that time, investors were placing more confidence in certain corporate debt than they were in Treasury debt. Similarly, surveys currently indicate many younger Americans have no confidence that they will receive Social Security benefits. So, there is ample evidence that politicians have made commitments to future expenditures far beyond the point of diminishing returns.

The value of the future commitment is discounted based upon the risk that the commitment will not be met. That risk rises the more commitments there are. In the US, the magnitude and nature of the commitments has reached the point where there are so many commitments that they are all being discounted at a steeper rate than historically. Historically, the first commitment required less of the budget, and therefore was easier to meet. Plus, that commitment didn't have to compete with other commitments made by the government.

Commitments have value even if they are steeply discounted. Economists have techniques for handling situations where costs increase while returns are falling. However, those techniques assume that the costs and returns both affected the same entity. That assumption is inappropriate for government expenditures especially when the commitments are across multiple generations. The costs may be borne by a group totally different from the one that receives the benefits.

It isn't just the distributional issue. The dilemma is that both the costs and returns to the commitments are different from a social perspective versus a political perspective. From a political perspective, as long as the commitment has any value, there is an incentive to make the commitment. The costs are not born by the current politician. By contrast, from a social perspective, the commitment must have value that exceeds the future cost. So, it is highly likely that there are many commitments that have political value that far exceed their value to society. To some extent, that explains why such a large portion of future tax revenue has been committed by previous politicians.

However, it would be very convenient to simply blame politicians. Given the population’s current low regard for politicians as indicated by the polls, it's an easy out.  Unfortunately, the problem is much more serious. Politicians may just be responding to legitimate choices being made by the electorate.

If the value of commitments to expenditures in the future has dropped because of heightened risk that the commitments won’t be honored, one would expect it to be necessary for politicians to make increasingly large commitments to future expenditures. To illustrate, if one gets a commitment for $10,000 and is sure it will be received, it is considered to be worth $10,000 at that future date. If one believes there's only about a 10% chance that the future commitment will be met, the commitment has to be for $100,000 to have the same value of $10,000 at that future date.

A second response would be for politicians to reduce the time horizon over which the value of the commitment is discounted due to risk the commitment will not be met. In other words, politicians have an incentive to make the commitment so immediate that the risk that future politicians wouldn't meet it is irrelevant.

Both affects would encourage politicians to make commitments to mandated expenditures that are immediate and large. In essence, the incentive is to make commitments that have immediate expenditure consequences but delayed cost consequences. By degrading the value of governmental commitments to expenditures, the debt becomes the preferred to option.

To summarize, there is a misalignment of incentives that encourages over-commitment to mandated programs. Over-commitment decreases the value of the commitments by increasing the risk that they won't be met. That shortens the potential time horizon for such commitments and encourages debt financing of those commitments. 

Sunday, July 16, 2017

Loss of Control: Just Enough Left

Enough for the hoopla

Much to-do about nothing?

There is always a reason

Previous postings discussed the degree to which mandated expenditures constrain currently-elected officials. One can debate the details, but it's clear that about 70% of federal expenditures aren't discretionary. Further, that phenomena is going to grow as all of the mandated expenditures will consume more resources. But, our currently-elected officials still have some discretion. This posting addresses that discretion.

It seems there is enough discretion left to justify threatening to shut down the government when the administration made its initial budget proposals. If that isn’t extreme enough, on Mayday the obligatory left-wing riots took on a weird look. The anti-Trump signs gave them the flavor of a childish effort to achieve a political voice. Not to be one-sided, it should be noted that the same tactics have been used by the other side, although the slogans were different and violent street demonstrations were absent. On the other hand, the differences of opinion actually resulted in government shutdowns.

Hoopla about the Budget

It seems reasonable to ask whether the discretion that is available justifies the response, or whether there are other factors at work. There is discretion: after all 30% of the expenditures are not mandated. However, that doesn't explain why people ignore the fact that a monthly change in one of the mandated expenses can be three times the annual net change proposed by a new administration. Perhaps, the discretion is in the detail rather than the net.

Fortunately, the WALL STREET JOURNAL (5/2/2017) included a very convenient way to look at the amount of change being considered. It summarized the proposed budget as it stood on May 2 in the House of Representatives Appropriations Committee. It compared that to the 2016 budget, and for convenience had notes regarding some of the changes. It is unlikely that I could improve upon their presentation so it is reproduced below. It does a very good job of summarizing the expenditures that might be considered discretionary. There are other budgeted expenditures, but they are budgeted to meet mandates. Further, one has to keep in mind that most federal expenditures are not even included in the budget because they are theoretically funded from trust funds and dedicated taxes.

Much to-do about nothing?

Visually the graph conveys an important point to note about discretionary expenditures. Comparing 2016 to the budget proposal for 2017 shows how little change there is in comparison to the levels of expenditures. Comparing the different categories makes it clear that any shift in emphasis still leaves the basic mix of budgetary expenditures unchanged. The ranks are not changed. One might quibble that within the detail of some of the categories that have been grouped together there are important changes within the category. However, that only emphasizes and reinforces the point: the categories were added together because individually they are insignificant.

Every individual can make his or her own decision about the importance of the individual changes reflected in the graph, but the graph makes clear that even in the discretionary expenditures, there isn't that much discretion. The changes are not that great. For example, take defense, the largest category of expenditures, one that accounts for more than half of discretionary spending. The total change is only $20 billion. That is a change of only 3.5% of the expenditures. The proposed change is over a full year of operations. To put it in perspective, one month’s year-over-year change in interest expense cited in the first posting on loss of control was about $7 billion. So, a year’s change in defense expenditures is equivalent to a few months’ change in the debt service interest payments. Three or four months of interest payments could increase expenditures more than a full year’s change in the defense expenditures.

However, one is forced to ask why there is much to-do about the discretionary expenditures to the point of people taking to the street and threatening to close the government. It could be that they have personal interests involved, but that would hardly explain the vehemence of opinions or their frequency within the population. So, it may be productive to look beyond the actual content of the discretionary expenditures to other forces that may explain reactions.

Below is a different way of looking at the data presented in the graph above.  The table focuses just on the change. It shows the size of the change between 2016 in 2017 in billions of dollars. It then shows that change as a percent of the level in 2016.    

Transportation, HUD
State/Fioriegn Operations
Homeland security
Financial services
Legislative branch

Ignoring defense, which is by order of magnitude different from all the other categories, the table highlights curious phenomena. The two categories with the most change both in dollar terms and as a percentage, are agriculture and financial services. A legitimate initial reaction might be a big yawn, but that's the point. Compared to news coverage or the highlighted controversial areas shown in the graph from the WALL STREET JOURNAL, the real changes occurred in areas that are not hot button issues. The hoopla is about items that in dollar terms are trivial. Put seriously, they are rounding errors on the estimates of growth in many of the mandated categories. Further, the growth in agriculture is largely due to mandated increases in the food stamps program.

One could argue that all the hoopla associated with the budget is associated with trivial monetary changes.  But, at this level of disaggregation the absolute value of the change in the remaining categories is $5 billion. Five billion dollars seems like a lot of money.  To put the $5 billion in perspective, over the past 12 months, the deficit stood at $651.5 billion, compared to $460.6 billion a year ago. That's a change of about $191 billion or almost 40 times as much as the $5 billion that is the source of the hoopla.

Undoubtedly, part of the hoopla and wacky reaction is due to the confusion associated with big numbers. The WALL STREET JOURNAL had an article entitled “When Big Numbers Need Bringing Down to Size.” It is quoted below because it does a very good job of illustrating the problems associated with large numbers:

“Here’s a brainteaser. Take a sheet of paper, and draw a line with the endpoints 0 and 1 billion. Then place a tick mark on the line where 1 million should appear. A typical person will place the mark too close to the middle. But that’s where 500 million should go. ‘About 40% to 50% of the people tested get it terribly wrong, and when they get it terribly wrong, they get it terribly wrong pretty much all of the time,’ said David Landy, a cognitive scientist at Indiana University who studies mathematical perception and numerical reasoning.”

“To visualize where 1 million should go in the number-line test, imagine a meter stick with each of its 1,000 millimeters representing a million units. At that scale, the tick mark for 1 million would align with the first millimeter. The final millimeter would represent 1 billion.  Placing 1 trillion at the appropriate spot would require extending the line to the length of a kilometer, with a trillion falling at the end.” (For those who aren't familiar with the metric system, lay a yardstick down and with a pencil mark each end. One ended zero; the other end is 1 billion. Now mark the end at zero with a felt tip pen. The thickness of that felt tip pen mark is one million. To get to 1 trillion you have to go out about half a mile).

“Big numbers befuddle us, and our lack of comprehension compromises our ability to judge information about government budgets, scientific findings, the economy and other topics that convey meaning with abstract figures, like millions, billions and trillions.”

“The president’s 2018 preliminary budget, for example, proposes to cut $2.7 billion from $1.068 trillion in discretionary spending.”

The table below treats that $5 billion in the absolute value of the change as a source of the hoopla. It is then compared to a number of other measures of government activity and the economy. It shows the $5 billion as a percent of the other measures of government and economic activity. In order to illustrate the point of the table, hoopla (i.e., the $5 billion in the absolute value of changes) is shown as a percent of the other measures calculated in two ways. The first shows the percent if whole percentages are the level of accuracy desired. It shows that other than in terms of the annual deficit, the hoopla doesn't even show up. It's irrelevant with respect to total outlays, total discretionary spending, the federal debt, or GDP. It's only when hoopla is shown to the hundredths of a percent that it even shows up in a comparison to the national debt or gross domestic product.

Hoopla Hoopla
Uniform Rounded at the
Item Convenient Units to a hundredth
Description Billions Percent of of a % of
the Item the Item
Source of the Hoopla  $       5.00 100% 100.00%
Total Federal Outlays:  $3.85 trillion  $      3,850 0% 0.13%
Discretionary Spending $1.068 trillion  $      1,068 0% 0.47%
Federal Deficit:  $587 billion   $         587 1% 0.85%
Total Federal Debt:  $19.5 trillion  $    19,500 0% 0.03%
US Current $ GDP $16.66 trillion  $    16,662 0% 0.03%

One might argue that treating the $5 billion in absolute value of the changes as the source of the hoopla is unfair. After all, by leaving out the change in defense, agriculture, and financial services one has biased the analysis. However, if one considers those categories as a source of hoopla, it's easy enough to add them back in and recalculate. Nevertheless, the results will be the same: by showing the portions as hundredths of the percent it should be quite apparent that with respect to the national debt or GDP, the changes in the budget categories remain irrelevant. Further, the absolute value of all changes in discretionary spending is still less than 1% of total spending and really only shows up with respect to discretionary spending where it still only a couple of percent of discretionary spending. It's hard to believe that confusion regarding large numbers isn't responsible for much of the reaction to the budget.

Confusion, however, might be only part of the problem. It may well be that crossing scales and reacting to federal budget numbers as if they could be related directly to family budgets is intentional. One might argue that defense, agriculture, and financial services are too remote to react to in the same way. Similarly, the failure to provide for Social Security and Medicare are too remote in time because reaching 65 is too remote, or dedicated taxes and the fiction of a trust fund conceal those expenditures from consideration.

Thus, the public may be is reacting to the only expenditures which they perceive as immediate and easily identifiable. However, if that's the case, they’re being deceived because clearly the mandated 70% of all expenditures are immediate and identifiable. They will be spent in the same year; revenue has to be raised or the debt increased in the same year. They are no less immediate, and they are clearly identifiable.

There is always a reason

In the discussion above there is the comment: “It could be that they have personal interests involved, but that would hardly explain the vehemence of opinions or their frequency within the population.” There just aren't that many people who are really affected by what's been changed in the budget. However, it may well be that those who feel they are affected are in a position to influence others, perhaps even deceive others, into believing that they are also affected by the changes. It could also be that people who are not affected see it as in their interest for a large segment of the population to believe that they are affected.

There are two groups that have a vested interest in encouraging a large portion of the population into believing that the budget embodies major change. The first is the media. Their interest is commercial. Portraying current events as major news items increases their viewership, and thus it allows them to sell more advertising at higher rates. They can portray the change as good or bad; it doesn't matter. 

What matters is that they portray it as being very important, something everyone should know about. The unfortunate consequence is that they cannot report honestly if it really isn't that important.

The second group with an obvious interest is also pursuing its own self-interest, but in this case it's political. Both political parties have every incentive to exaggerate the impact of anything the other party proposes. By so doing, as the media says, they energize their base. That's just another way to say they get people worked up about nothing. It doesn't matter what the issue is as long as it can be betrayed as important. 

The consequence is that each political party has an incentive to portray the other political party as extreme. It also gives each political party the incentive to characterize any compromise made by the other political party as if it were a major accomplishment.

The combination of the incentives for the media to portray every issue as dramatic and the political parties to portray each decision as major, feed on each other. The media instead of being a filter that separates news and facts from noise, rumor and innuendo becomes a megaphone. Reporting an outlandish rumor becomes more valuable than reporting facts, even if the source is the political opposition or a source known to be unreliable. 

It has degenerated to the point where the more outlandish the statement the more coverage it gets. That in turn feeds back to discourage the political parties from serious factual discussion. Factual discussions get no coverage, and politicians need the coverage.

The consequence seems to be that each issue is portrayed as if it was a matter of principle. One illustration is the wall that Trump proposed between the US and Mexico. During his campaign he portrayed it as defining a difference in attitudes between him and his opponent. The Democrats picked up and carried the torch of exaggerating the importance of the issue. They exaggerated it to the point where they threatened to close down government if it was included in the budget proposal. 

Now, regardless of how you feel about a wall, there is no doubt that whether we spend millions of dollars, even $1 billion, on the wall, it pales by comparison to the trillions of dollars that we will spend on mandated programs. Perhaps, it is the impotency we've imposed upon current elected officials that leads to the bizarre intransigence we witness.

Regardless, what is apparent is the current changes in budgeted expenditures hardly justify the reaction of either the media or politicians. Further, it is quite apparent that given the constraints under which politicians operate, they have incentives to exaggerate the importance of the budget, and the media has an incentive to go along with the charade. The unfortunate consequence is that the voting public has their attention turned away from the important consequences of decisions made by previous politicians.