The Economics of Healthcare

I suspect that I am like a lot of people who have boxes of old documents in storage. I recently began cleaning mine out and I came across some of the lecture notes that I used when I was teaching Economics back in the 1990s.

One particular set of notes originated from a panel discussion I was asked to join about healthcare reform in 1993 or 1994.  Not unlike today, there was a substantial and partisan discussion about healthcare reform in the early years of the Clinton Administration.

There were two main topics covered by the panel. The first was should the government follow the British model and simply provide healthcare to all citizens. The second was a general discussion on what could be done to reduce the cost of healthcare for everyone.

As to the first, I was and continue to be an advocate of free markets.  I thought that if government provided healthcare and paid the providers it would necessarily do so at the lowest common denominator of care.  I have to admit that I was wrong on this point.

In the interim years, I became a large consumer of healthcare. In 2011 I was diagnosed with a very deadly type of leukemia. I had 5 rounds of nasty chemotherapy, two stem cell transplants and spent a total of 148 nights in the hospital. I beat the cancer only because I got world class treatment at the University of California San Francisco Medical Center (UCSF).

Every one of the doctors, nurses, technicians, kitchen staff and parking attendants at UCSF is an employee of the State of California. This is government provided healthcare at its best and I am certain that it is the same at UCLA or UC Davis. I will not dwell on whether or not the government can provide high quality healthcare because I witnessed it firsthand.

A lot of the real problem with healthcare costs in the US can be laid at the feet of the insurance companies. Insurance companies are entitled to make a profit meaning that they will charge consumers as much for coverage as they can while at the same time negotiating the lowest price from the service provider.

During the course of my treatment, when I was not in the hospital I got my blood drawn and tested often.  If I did not want to drive to San Francisco, I could have my blood drawn at the county hospital nearer to my home.  The bill for the same blood test was several hundred dollars more at UC than at the county hospital. How much the insurance company paid either provider for the same test is a different matter. Still, a blood test is a blood test and the cost of one should not vary from location to location as much as it does.

The real focus should be on reducing the cost of providing medical care and services. Economics teaches that basic price theory applies. The cost of healthcare is largely determined by supply and demand, just like the price of anything else.

The supply of doctors and nurses has not kept pace with population growth. Just about everyone agrees that there is a significant shortage of both doctors and nurses.

There are roughly 1,250,000 licensed physicians in the US. Some do not practice or practice part time. Many specialize; some do research.  Overall it works out to about 400 licensed physicians per 100,000 people.  We add about 12,000 net new physicians every year (new graduates minus retirees).

We could add an additional 5000 new doctors per year if we wanted to do so. That comes out to an average of 100 more per state with perhaps 150 from New York and California and fewer from Montana and Alaska.

Medical school is very expensive but does not need to be as expensive as it is. Much of the first year curriculum (anatomy, immunology, genetics) are lecture courses that can be given on-line freeing up classroom space and faculty salaries.  Not that much more laboratory space is needed to accommodate an additional 100 students, especially if there was more than one medical school in the state. Clinical courses and research require patients and supervision and there are enough of both to go around.

Most medical students graduate with piles of debt. We could arrange to let them work that debt off after they become doctors by working part-time over a period of years at free or low cost clinics in rural or inner city areas where they are needed.  That way people without insurance could still get care and a lot of doctors would not have to be concerned about having to charge as much as they can to pay off their debt.

There has also been a shortage of nurses in the US since I first looked in the early 1990s. Current estimates seem to be between 250,000-500,000 unfilled nursing jobs by 2025.  These are good paying, middle class jobs in a rewarding albeit challenging profession. A shortage of this magnitude necessarily increases what nurses earn. If we want the cost of care to decrease, we need to train a lot more nurses.

The demand for healthcare is rising at the same time. More people are becoming insured with the Affordable Care Act and the population of baby-boomers is getting older. The best way to reduce the cost of healthcare might be to reduce the demand.

If we wanted the population to be healthier over all we could, for example, outlaw smoking and tobacco products altogether. We could make a first offense for drunk driving punishable by a permanent loss of driving privileges. Drunk drivers add significantly to healthcare costs every year.

We could reduce diabetes and obesity by imposing a hefty surtax on fried foods or sugared beverages. We could outlaw vending machines that sold potato chips and require that they sell fruit instead.  We could also require school children to spend part of their lunch hour walking around the block a few times. Healthcare costs will not come down in the long term if 30% of school age children are already obese.

I am not suggesting that any of this will happen. We did, however, get rid of asbestos, lead paint and DDT for health reasons and we require seat belts for the same reason. Each action reduced healthcare costs. Somehow sugary drinks and fried food seem a lot harder to regulate.

Perhaps health insurance companies could take a page from auto insurers who offer discounts for good drivers.  If you get a physical every year (which itself leads to early detection of many diseases and reduces the costs of treatment) and are not significantly over weight, you get a discount on your premium.  Economics teaches that incentives usually work better than penalties.

The one place you will never find a solution to the costs of healthcare is the US Congress.  The lobbyists who represent the industries that receive our healthcare dollars will see to that. As I said, Congress has been “fixing” healthcare since at least the early 1990s.  A market driven solution may be our best bet.


Understanding Globalization

When I was teaching economics back in the mid-1990s globalization had not yet made its way into the textbooks in any significant way.  Golden Gate University had a very international student body. Some of the students, who had come from other countries, intended to graduate and stay in the US; some intended to return to their home country.

The basics of economics can be applied to any marketplace, but I often found myself making references to specific American companies or advertising campaigns that were not recognized by everyone. Rather than approach the topic from a US perspective, I tried to find more universal examples in order to explain to the students how the competitive business world was likely to be trending during the first 20 years of their working lives.

The one business model, with which every student was familiar, regardless of their country of origin, was a sweatshop. The image of a group of people huddled over sewing machines in less than ideal working conditions is a universal experience.

Sweat shops are in almost every country. When I gave this lecture in the mid-1990s there were sweat shops within walking distance of the San Francisco financial district where the GGU campus was located.

Sweat shop workers typically get paid by the piece, as opposed to an hourly wage. They get no benefits and if they get ill or injured or fail to produce a sufficient amount of goods, they have no job security whatsoever.  In many countries they are willing to work for a ridiculously small amount because the job is the only thing keeping their families from hunger.

The very first requirement for teaching economics is finding a way to keep the students awake.   I focused the lecture on a fictional pair of entrepreneurs. I told the class that these characters had formally been GGU students that had made a lot of money based upon what they had learned in class. That got the students attention.

The two fictional protagonists were Jane who had studied marketing and was working as a buyer for a small chain of stores selling casual wear in Seattle and Eduardo who had grown up in Manila, studied management and returned home after graduation. Eduardo worked in a factory that made shirts and slacks. The business that they founded together I called JESSE, Inc. (Jane and Eduardo’s Sweat Shop Emporium).

The product that brought them together was unremarkable, except for its price. It was a short- sleeved men’s pull over sport shirt made of woven cotton. Generically they were called “tennis” shirts.  At the time they were very popular with two brands in particular dominating the market.

One of the dominant brands was European; the other American. Neither shirt had a breast pocket; each had their firm’s distinctive logo embroidered on the left side. The European firm had an alligator; the American firm had a polo pony.

Both firms had been around for a while and the shirts were somewhat of a staple among those who played tennis or polo which traditionally had been wealthier people.  Wearing one of these shirts conveyed a certain wealth or status.  They were sold only in upscale retail stores and the retail price at the time was around $60 per shirt. To be fair, the shirts were made from high quality, thick woven cotton.  They were well made and lasted for a very long time.

There were a lot of cheaper shirts on the market that were similar but they were made of thinner cotton or a cheaper cotton/polyester blend. Those shirts were available in less than high-end stores and had an average retail price of $20.

Eduardo worked as a manager in the factory outside of Manila where one of the better shirts was made.  The factory was not a sweat shop. It was clean and well lit. The workers were paid an hourly wage and worked an 8 hour day. The factory was able to deliver a shipping container full of shirts to the company’s distributor in Los Angeles for about $12 per shirt.

The US based distributor paid for an expensive advertising campaign and paid sales people to reach out to buyers representing high-end chain stores and shops. The wholesale price to the retail stores was about $30 per shirt which permitted the stores a 100% mark-up from their cost.  The US distributor was able to derive a nice profit after its costs and paid US taxes on those profits.

Jane approached Eduardo with the idea of producing a similar shirt, different from the cheap knock-offs because it would use the more expensive high quality woven cotton. Except for the distinctive logos the shirt would have the same look and feel of the higher priced shirts because the cloth was the same.

Eduardo initially arranged to buy a single bolt of the material from his boss. He took it to a local sweatshop, along with finished shirts in 4 sizes which were used for patterns. Jane designed her own logo, a palm tree, and created a story about Jesse, a beachcomber who didn’t wear shoes but still wanted to look good. The story would be printed on the outside of the plastic bags that each shirt came in.

Using the sweatshop labor, Eduardo was able to deliver shirts to Jane in Seattle for $8 apiece and still retain a handsome profit.  Jane took a suitcase full of the shirts to a buyers’ convention where she gave them away to other buyers in attendance and began writing orders.

Because she was running a lean operation without a national advertising program, she was able to sell the shirts at a wholesale price of $15. The retail stores could offer them to customers at $30.   Consumers got a product that looked a lot like the shirts that cost twice as much and significantly better than the $20 knock-offs that these same stores had been offering.

As you might imagine, the business took off; new products were added and both partners made a lot of money.  Jane was paying more and more taxes on the profits that she was making.

After a while Eduardo wanted to expand and offered Jane a simple solution to both of their problems. Eduardo raised the price that he was charging Jane to $10 per shirt.  He used the extra $2 to allow Jane to buy into his manufacturing company to fund his expansion.  Jane made a smaller profit and paid less US taxes. She now owned a portion of a Philippine company that was taxed at a far lesser rate.

When I first gave this lecture the internet did not have the bandwidth for moving pictures. Jane was a necessary part of the story because someone had to be the conduit to the US retailers who interacted with the ultimate purchasers.  In the modern internet era, Jane and the retailers are no longer necessary.  Eduardo can have an entire catalog of products on his website. DHL or FedEx will deliver the product directly to the consumer’s door regardless of where in the world that consumer lives.

Eduardo was happy to sell his shirts wholesale for$8-$10 each. He can now sell the same shirts, factory direct to consumer for $25- $30.  Advertising costs using social media and targeted digital ads have never been lower.

When I was young, New York City had a thriving garment center. Much of the labor was unionized. Those jobs are gone because a union shop in the US can never compete with a sweatshop elsewhere. It is not even the cost of the labor that was the determining event in this transition. It was the overnight package delivery which did not become a part of the system until the mid-1970s.

What has happened in the 20 years since I gave that lecture? APPLE for one manufactures overseas using cheap labor and adjusts the price to leave much of the profit overseas exempt from US taxes. Remember that when you are tweeting about the loss of jobs in the US on your iPhone.




Tax Policy and Economics

When a politician tells you that they will bring good paying jobs back to their district you should know that they are lying.  And while it should surprise no one that politicians lie; this lie is particularly insidious because it is something that could easily be accomplished. Politicians lie about job creation because many have themselves swallowed a lie called “trickle down economics” hook, line and sinker.

The idea of paying taxes to fund government operations goes back to the early Chinese emperors. Taxes can be broad based, like the tax on tea that precipitated the American Revolution. Historically governments appreciated that if they wanted to raise a lot of money, they needed to impose taxes on the wealthier people in the system.

The US federal income tax, beginning in 1919, was always progressive. It taxed people who earned higher income at higher rates.  For most of the time between 1919 and 1970, the highest tax rate on people who earned the most was 70%.  That amount seems confiscatory and it was, but for most of that time it applied to a very small portion of the total population.

The highest period of job growth in the US was during the post-WWII era, roughly 1945-1975.  During that time, the US federal government paid for two wars, Korea and Vietnam (which was very expensive), the US interstate highway system, the cold war military buildup (intercontinental ballistic missiles, battleships and aircraft carriers) and the space program.

All of these were very expensive outlays of funds that originated with taxpayers. At the same time, virtually all of these funds were spent within the US, the great bulk of it on salaries of workers who were building the highways and the hardware that the government was purchasing.

In the mid-1970s the US economy was battered with high inflation caused in large part because oil production was taken over by a cartel (OPEC). That raised the cost of everything in the US that moved by truck which was just about everything.

The OPEC oil embargo caused shortages which resulted in people waiting in long lines to get gasoline.  It also caused home heating oil prices to soar causing difficulties and dissatisfaction during the winter months.  Those of you who remember President Gerald Ford on television with a WIN (whip inflation now) button can relate. That dissatisfaction led to the election of President Reagan in 1980.

It is actually a 1978 article that is credited with the birth of “trickle down” economics and the “Laffer curve”. The article related the events that had occurred at a dinner attended by Dick Cheney and Donald Rumsfeld, both of whom worked for Pres. Ford. At this working dinner Prof. Arthur Laffer, then at the University of Chicago, sketched a curve on a napkin as an illustration of the tradeoff between tax rates and tax revenues.

Laffer suggested that tax revenues would increase as rates decreased because the untaxed funds would be used efficiently to create businesses and jobs and hence additional revenue which could be taxed.

For his part, Laffer claims that the restaurant had cloth napkins and he would never have used one for the illustration.  He also is quick to point out that the idea that cutting tax rates increases tax revenues goes back to the 14th Century.

Economics is a science that is very much based in mathematics. At its core is the idea that people will spend money in ways that satisfy their own best interest. The primary interest is getting the same or similar goods or utility at the cheapest price, so that you can get more goods and services with the money that you have.

There are mega gigabytes of data covering income, spending, taxes and a great many formulas and equations to explain and extrapolate that data.  If you took algebra in high school you know that when you change the variables in an equation, you get different results which you can then plot on a graph.

The Laffer curve is a graph that has no equation or data supporting it.  Most economists never accepted the Laffer curve but “cutting tax rates will make the country better off, create more jobs and result in higher tax collections” is an argument that has needs little factual or statistical support. It is a bastardization of a slogan we used to have in the 1960s: “if it feels good, do it.”

The Laffer curve is the basis of the Reagan era tax cuts on the wealthiest Americans and subsequent tax cuts at the state levels that continue to this day. The sales presentation for these tax cuts was that these wealthy individuals would invest the money that they saved creating new businesses and new jobs as the money “trickled down” into the economy.

It never happened.  Several states, (Louisiana and Kansas) continue to cut state taxes and have increasing difficulty funding schools and essential services. But the slogan: “I’m going to cut your taxes so you will have more money in your pocket” wins elections.

There seems to be an abiding desire to return to the “good old days” when there were many good paying jobs in the US.  As we learned with the New Deal and in the post-war prosperity, government can create those jobs. But it also needs to pay for them.

In round numbers, if your adjusted gross income is more than $375,000 per year you are in the top 1% of US taxpayers. The average overall federal tax rate for this group is just about 25%.  This includes some business owners, some doctors, some lawyers, all NBA rookies, many entertainers and hedge fund managers. Not all create that many jobs for others.

If the tax rate for this group were raised by 5% there would be more than enough money to create 1 million good paying jobs in the US; fixing highways, highway bridges, airports, ports and other infrastructure projects that just about everyone agrees need to be fixed. Fixing the highways would also reduce commute times, gasoline consumption, air pollution and the cost of everything that moves by truck.

These workers would pay taxes on their earnings which would fund other government programs and expenditures. They would also buy homes, cars, hamburgers, movie tickets and just about everything else people buy. It is money that would truly trickle down to other businesses. These types of construction jobs usually come with medical benefits as well.

Understand that even these workers will buy products like clothing and iPhones that are manufactured overseas. Overseas workers charge substantially less per hour for their time and Apple does not repatriate the profits it earns overseas or pay US taxes on them.

That is part of the problem with the current tax system and with the current “trickle down” theory. Left to their own devices business owners will use the money that they save from tax cuts to create jobs overseas.

I appreciate that there is a certain amount of “down with the top 1%” in this but I am not advocating a mass redistribution of wealth.  If anything, it is the tax cuts in the last 30 years that have caused the current disparity between rich and poor. Swinging the pendulum back the other way for a decade or two would seem to be a good way to promote growth and overall economic stability.






The Purely Passive Permanent Portfolio

My nephew recently asked me to recommend a good book on investing for someone who was just starting to make contributions to his retirement plan.  Somewhat reflexively, I recommended Prof. Malkiel’s “A Random Walk Down Wall Street” as a good place to start.

I first read “Random Walk” in the 1980s and it was an eye-opener for me at the time. I was and continue to be a dyed in the wool Graham and Dodd fundamentalist. I had met and followed quite a few research analysts when I worked on Wall Street. Their opinions were coveted by institutional investors. The brokerage firms were justifiably proud if one of their analysts was named to the annual “All-American” institutional research team.

The random walk theory was not original to Prof. Malkiel. He popularized it in layman’s terms. He used a coin flip to create a trading pattern for a fictional stock and then attempted to have an analyst apply technical analysis to the resulting chart.  When the technician told him to buy the fictional stock he concluded that analysts could not accurately predict the future price of a stock, so why bother?

In Malkiel’s view, simple asset allocation with periodic rebalancing will outperform the overall stock market. The standard allocation, 60% stocks and 40% bonds will never increase as much in a bull market as stocks alone, but the bonds will buffer loses in a bad market.  Many people believe that this type of allocation is fine for investors over the long term.

Asset allocation requires the construction of a portfolio with non-correlated assets. The stock portion of the portfolio must be selected carefully or the entire purpose of the allocation will be defeated.  Prof. Malkiel currently shills for one of the large robo-advisors that does not perform asset allocation very well.

Correlation is a tricky concept. The idea is to purchase investments that are affected differently by shifts in macro-economic conditions.  A truly diverse stock portfolio should have stocks from at least 15 non-correlated sectors.  You cannot create a truly diverse portfolio by investing in large cap, small cap and emerging market funds or ETFs. The stocks in these funds are correlated to each other in too many ways.  Capitalization does not define a sector for allocation purposes.

If you buy an index fund or ETF such as the Standard and Poor’s 500 you get the average market return in good years and in bad years. If the market happens decline for the 3 years just before you need your money, such as the 3 years before you retire, your portfolio may be worth the same as it was worth ten years earlier. You may have earned nothing during the last 10 years that you were working.  That is ten years in which you could have easily doubled your portfolio’s value if you were 100% invested in income producing investments.

Many people want a portfolio that will give them “higher than average market returns with lower than average market risks.”  It clearly is something that can be accomplished but it takes work to get there.

You can beat any index or sector fund by identifying the “dogs” that are in it. Some of the stocks in an S&P 500 fund are not expected to do all that well in the next 12-24 months. Certainly if you constructed a portfolio of the 250 stocks most likely to do well and leave out the dogs, you should beat that index every year.

Eliminating the dogs requires analysis. Fundamental analysis works and is still the primary way in which most professional investors make their investment decisions.

The “problem” is that a lot of people do not think that anyone can actually analyze individual stocks and pick the winners over the losers. That, of course, is not true.

There are a great many securities analysts and portfolio managers out there who are more than competent. The problem is that the best investment advisors are mixed in with a lot of advisors who are more adept at sales than analysis.

Rather than take the time and put in the effort to understand investing well enough to choose a good advisor, people have fallen back on the idea that they can buy a few index ETFs, rebalance periodically and all will be well. That is the investment philosophy behind robo-advisors. It is an investment philosophy I call “cheap and stupid.”

This brings us to Harry Browne.  Browne developed what he called the “permanent portfolio” back in the early 1970s.  He introduced it to the world in a well received 1987 book called “Why the Best-Laid Investment Plans Usually Go Wrong”.

I came across this book when I started teaching Law and Economics in the early 1990s.  Much of the literature around Law and Economics at the time came out of the University of Chicago and had a very libertarian bias.  Browne was a Libertarian and later became the Libertarian Party candidate for President.

Browne’s book described the virtues of a diversified portfolio whose composition would stay constant year in and year out — permanent, in other words, except for annual rebalancing. Browne’s idea of diversification into non-correlated assets was different from what you might think and very different from the diversified portfolio that you will get with any robo-advisor.

Browne’s portfolio divided your funds into only four asset classes. The portfolio was equally divided between aggressive growth stocks, which do well in times of prosperity; gold which does well in times of inflation; long-term Treasury bonds which increase in price during times of deflation and Treasury bills which do well in times of tight money/recession.

Browne was a “gold bug”. He recommended that you hold the gold portion of the portfolio in bullion or gold coins. This was fairly common advice at the time.

At the time the book came out, Browne reported that the portfolio had produced an annual return equal to 12% over the preceding 17 years. Much of that return was due to the doubling and re-doubling of the price of gold. Gold was still pegged at $35 per ounce when the portfolio began.  The latter half of the 1970s was a period of high inflation which helped the price of gold to move up.

Browne’s permanent portfolio continued to do quite well in its original form until his death in 2006. A number of books and articles have been written about it and several people have modified it with funds and ETFs.

There is a mutual fund called the Permanent Portfolio fund (NYSE: PRPFX) which uses a modified permanent portfolio including real estate and Swiss Francs. The fund holds about $3 billion in assets. If you are really determined to be a passive investor and appreciate that those robo-advisors are a scam you might take a look at this fund.  You will discover that it has done quite well since 2006, when Browne died, until the present.

As always, I do not know anyone at this fund and no one has offered to compensate me in any way for recommending it.

Browne’s permanent portfolio has apparently produced positive results continually since 1970 through the present. It can do so because growth and recession, inflation and deflation are opposites and assets that perform well in each cycle are non-correlated by definition.

Will Browne’s permanent portfolio continue to do well, year in and year out?  It should. It represents asset allocation and diversification in its purest form.










How Much is One Hour of Your Time Worth?

More and more people in the service sector of the economy are independent contractors setting their own hourly rate. For many self-employed people, it is one for the most important business decisions that they make.  It is also often one of the most difficult.

I worked as a lawyer for many years and I would periodically adjust my hourly rate upward, usually on the first of the year, to reflect the added expertise I had acquired during the year. Being self-employed allowed me the luxury of setting my own rate.

My hourly rate took into consideration that I had office rent and employees to pay as well as all of the ancillary expenses that come with running a business. However, that does not mean that I reduced my rate when I moved out of a pricey financial district office tower and into a lower rent office in the suburbs.

I was recently contacted by a very large international consulting firm that wanted to add me to their stable of experts. They had a client in need of a consultation about a fairly new regulation that I had written about and they invited me to call in and sign up.

The person with whom I spoke had all of my information from Linked-in and was happy to sign me up and explain their procedures. The assignment was a one hour phone call with an executive at one of the large Wall Street investment banks.

The last question the interviewer wanted to know was the most important; she wanted to know my hourly billing rate. Now that I am semi retired, I have even lower overhead and fewer expenses. I intended to handle this consultation sitting in the shade on my deck.

I asked my interviewer what she thought the right hourly rate would be.  We settled on a rate that she felt was appropriate.  The rate was the same that other experienced lawyers who were still working and paying overhead expenses would charge. I could have charged less because I had no overhead. Because I had written about the regulation I had demonstrated expertise and did not need to charge less.

Three factors will always come into play when setting your hourly rate; how good you are at what you do, your overhead and expenses and what the market will bear. It sounds much easier than it is.

In a perfect world, if you are very good at what you do, you should be able to charge more. That is not always the case.

In a great many cases, the customer is not looking for the best of the best. The customer is looking for someone who is good enough to get the job done.  I call it the good enough economy and there is a lot of it going around.

Basic economics teaches that the one universal factor determining how much you can charge per hour is what your competition charges. Price matters and it is going to throw the old idea about hiring the best people who went to the best schools and then worked at the best companies out the window.

The easiest example of this is code writers. It is an industry full of freelancers and independent contractors.  I live near Silicon Valley where I have heard many people say that the best code writers congregate.  Except those code writers have priced themselves out of the market.

If you have a fair amount of student loan debt because you learned code writing at Stanford or MIT and you live in Silicon Valley where rents are higher than almost anywhere else outside of San Francisco or Manhattan the amount that you need to earn in order to cover your monthly overhead is substantial.

There are excellent code writers living near Seattle or Austin as well as London, Moscow and Mumbai who will get the job done and charge far less because they need a lot less to pay their bills. I appreciate that Silicon Valley is where the action is, but even the big Silicon Valley companies have been outsourcing overseas for years.

This is not limited to tech jobs.

There are radiologists in India and the Philippines who read x-rays for hospitals and insurance companies in the US and Europe. There are teams of lawyers and paralegals in other countries who handle the volume of documents produced in large cases litigated by large Wall Street law firms. These firms have lawyers and paralegals on staff and would be happy to bill them out to accomplish the same tasks. But the clients do not want to pay Wall Street rates for tasks that they can buy cheaper even if they hire the most expensive law firm to represent them.

The simple truth is that a significant amount of student debt may actually be an impediment to making a lot of money as an independent in your chosen field. It may require you to work at a big company for a big salary. It can restrict your ability to take chances, like working with a start-up that could have a big time pay-off.  It can even rob you of the kind of opportunities, like a business convention in Hong Kong, that could really open up doors for your career.

Self worth is an interesting concept. Many independent contractors have difficulty setting their hourly rate because they do not have a good feel for how they stack up against their competition.  If you post a higher hourly rate you are advertising that you are better than your competitors. Of course, you need to back that up by doing a better job if you are hired.

It seems that a better approach would be to charge a little less and deliver a little more.  I have certainly read articles by many experts who would claim that that is the best way for an independent contractor to build his/her reputation and gain valuable referrals.

Never confuse your hourly rate with your advertising budget.  How you present yourself to prospective clients is still essential. If you want to charge more than your competitors you need to convince potential clients that you are worth more. And you need to reach more potential customers through advertising.

I read business plans and pitch books for start-up companies for free.  I will get on the phone with a budding entrepreneur and spend an hour answering specific questions and offer some suggestions or perspective about their business without charge. I have the experience, a fair amount of free time and I enjoy speaking with people who are starting a business. I often learn a lot more from them about what is going on in the marketplace than I do from reading the business or financial press.

Occasionally, a company wants to hire me to do more.  If I want the assignment, then I often have to charge less than I am worth because the company rarely has the cash to pay me what the NY investment bank paid me.  In most cases the company wants my on-going business and legal advice. In those cases, I usually prefer a monthly retainer to hourly billing.  That way, neither the company nor I are watching the clock.

I was recently approached by a very successful businessman who had started and sold three start-ups.  He had a pretty good idea for start-up number four and offered to give me equity in exchange for my expertise and on-going advice.

He was surprised when I declined because he had spent ten minutes explaining how my small share would be worth millions.  I told him to sell the shares he was offering to me to someone else for a deep discount and use the proceeds to just pay me my hourly rate.

For those of you who think that I was foolish for passing up what may have been a great opportunity, I can only tell you that I have been there before.  If you pay for my advice and then don’t take the advice, well okay, every lawyer has clients like that.  If I have equity and you don’t take my advice then I should not have taken you on as a client in the first place.

Do I really think that my advice is that good?  Yes I do, but mostly I know that advice that is not paid for is often disregarded.

Being semi retired and overhead free, I can give or sell my time to whomever I wish at whatever rate I wish to charge. It is truly liberating.  I only take on clients I like and projects that interest me. I can apply myself to only those projects where my experience and skills will add value.

I am not going to be giving seminars on this but I invite any independent contractor to adopt the same mindset, at least as an exercise.  What would you charge a really nice person who really needs your help?  Someone with a project that you could really enjoy sinking your teeth into even though they cannot pay you what you would like to get paid.

I suggest that amount is your base hourly rate. Charge more for mundane projects or difficult clients. There is no Nobel Prize winning economics behind this but I suspect that you will be happier when you are compensated at above your base rate for work that you do not enjoy and clients that you do not like. I suspect that you will probably be more productive, as well.

Making the new capitalism efficient

Economic theory teaches us that capital in a perfect world would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding, which is still in its infancy, is still remarkably inefficient. Fraud is prevalent because no one really vets the companies that seek funding. Far too many companies sell products that they can never deliver. The process itself can be expensive and is often hit or miss. Only about 30% of the rewards based crowdfunding campaigns successfully raise the funds that they seek.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase. Despite all of the enthusiasm for crowdfunding, this much risk and inefficiency cannot be sustainable.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency, at least in the developing world.

In most developing countries there are universities whose students are  themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university creates a crowdfunding platform to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate. As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.

How I know that the stock market is coming down

Every investor would like to be able to predict the future. It is not always easy to do, but neither is it that difficult. It helps if you stick to the math.

Income investors aside, most people buy stocks that they believe will appreciate in value. If you own a stock and do not believe it will go up any higher then why wouldn’t you sell it?

The majority of shares in all financial markets trade between large banks and institutions. They have access to much more relevant information about the shares they trade, the world economy and the markets in general. Good research is the key to purchasing good investments.

For the average investor good research is a non-starter. Most people do not know how to do basic research on a company or where to obtain it. That has not deterred millions of people from investing trillions of dollars based upon bad information. Much of that bad information comes from the financial services industry itself.

Companies in the financial services industry need to grow and to be profitable. They grow by adding new customers and by encouraging existing customers to add more money into their accounts.

It should be obvious then that the one word that the industry is least likely to utter is: sell. If you sell, you might ask for a check and take your money elsewhere. That is something that the industry would like to avoid at all cost.

This is the reason that many financial professionals will tell you not to “panic” when markets start to go down. They will tell you to “stay the course” and that you should not worry because the market will “always come back”.

This is a sales pitch. It is not based upon facts or analysis. The charts that you will see accompanying this advice are bogus. The facts the charts assume are never about you and the facts they assume about the market are never real.

Consider that the market decline in the last month has been widely attributed to two factors, slower growth in China and a sharp decline in oil prices. Upon examination neither would seem to have a negative effect on the US economy.

The Chinese market for US goods is not growing as fast as it has in the recent past. China is not in recession. Certain industries and certain companies will surely be impacted. Overall, there is no indication that China will buy substantially fewer goods from US companies this year than it did last year.

Volatility in the Chinese stock markets is also cited as problematic for the US markets. In truth, very little US capital is at risk in the Chinese capital markets. Volatility and higher risks in the Chinese markets will usually cause capital to seek safer markets. That means more capital coming to the US. This is positive for the US economy.

Oil has been priced by a cartel since the 1970s. The current sharp decline in its price is being caused by a political decision to increase the international supply and to force US suppliers out of the market. Dramatically lower prices are not good for domestic oil companies and domestic oil workers.

Lower prices are also not good for the very largest oil producers whose margins and profits are likely to decrease. Shares of large oil companies are found in many portfolios and account for a significant amount of the weight in the Dow Jones Industrial Average and other indexes. So, yes, declining oil prices will bring averages down, but do not negatively impact many industries like pharmaceuticals or housing.

For the rest of us, dramatically cheaper gas prices increase our buying power for other goods and services. They should reduce the price of any goods that are shipped by truck which is almost everything.

Cheaper gas prices should not crash the market. Indeed low gas prices coupled with lower prices for other commodities and low borrowing costs should all continue to bode well for the US economy.

Why then do I believe that the market is coming down?

The upcoming market “correction” will be the 7th or 8th of my career going back 40 years. Throughout, the single factor about which most professional investors concern themselves is a stock’s price to earnings ratio.

Historically, across the market those ratios fluctuate between 10 to 1 and 20 to 1 with a mean in the middle at 15. It should cost $15 dollars to purchase one share of a stock in a company that is earning $1 per share.

So ingrained is the notion of price to earnings ratio as a market indicator that each of the corrections that I have witnessed over 40 years has been characterized as beginning from a point where P/E ratios where at the high end of the range. Markets usually fall from there to a point below the mean and then begin to level off.

That P/E ratios will always revert to the mean is a verifiable and well known fact.

At January 1, 2016 the average P/E ratio for the overall market was in the neighborhood of 20 to 1, which is at the higher end of the range. It might go up a little higher first, but history and mathematics would suggest that it is likely to drop to the 12 -13 to 1 range before it starts back up.

If you stay in the market, your portfolio will sustain that loss. It might take several years for the value of your portfolio to return to where it is today. If you “stay the course” you will have wasted the earning power of those years. You will have ridden the market down and back up and essentially be back to where you are today.

The better strategy would always be sit on the sideline while the market is going down and to invest in the companies that you like when they are cheaper. There has never been a better investment strategy than “buy low, sell high”.

If you do stay in the market then your portfolio should contain stocks that pay dividends. Dividend paying stocks generally decline less than stocks that do not pay a dividend. If you do sell now and accumulate some cash, you will be able to buy these stocks at lower prices and lock in a more attractive yield going forward.

I know for certain that all but a few market professionals will tell me that I am out of my mind. I submit that a great many of these professionals will have a personal stake in your decision to leave the market or stay the course. If every customer decides to sit on the sidelines these market professionals will be washing cars or waiting tables.

If you would like to “gut check” your broker, ask him/her what the average P/E of your portfolio is today and what your portfolio’s value would be if you do stay the course and your portfolio’s value does decline to a ratio of 15 to one or less. Like I said, do the math.

If you stay the course, you will be robbed of the profits that this bull market has given to you.

The lesson of Long Term Capital Management

Over the years I have marveled at the fact that some of the most intelligent people in the financial markets repeatedly get blindsided by market action. Frequently it is because in the real world the markets do not act in accordance with their view of how the markets should act.

A great many intelligent people lost money when the markets crashed in 2000 and 2008 because in each instance they did not see the crash coming. Many fall back on “nobody” can predict the market when what they mean is that “they” failed to predict the market.

A great deal of the advice given by the Wall Street firms is conflicted. Even simple tools like asset allocation are grossly misapplied. Finding a better than average financial adviser can be hit or miss.

Many people agree that investing requires time, information, analysis and discipline. There is logic that suggests using computers and mathematics to make investment decisions has merit. Computers will certainly analyze more information in less time and can trade any account subject to a rigid discipline.

Success should be dependent upon analyzing the right information in the right way. Hiring really smart and accomplished people to decide which information to collect and how to analyze it would seem to enhance the chance of success. Except that it does not always work.

The most outrageous example may be the case of Long Term Capital Management (LTCM), a Connecticut based hedge fund that lost about $4.5 billion of investors’ money in 1998 and almost brought the markets down with it. The investors were some of Wall Street’s biggest banks and many of the individual executives who managed them.

LTCM was started in 1993 by Lee Meriwether, a very accomplished trader who had made substantial profits for Salomon Brothers. Showcased members of the team were Myron Scholes and Robert Merton, two economists who had devised a mathematical model for pricing options. Merton and Scholes won the Nobel Prize in Economics for that model in 1997 just before the downturn that wiped out LTCM.

LTCM performed arbitrage with its investors’ money. They looked for small discrepancies in the price of the same or similar instruments in different markets. They assumed that the markets would always efficiently close those gaps.

LTCM created sophisticated mathematical tools to identify those discrepancies and to evaluate the greater markets so they could estimate how those gaps would close. No one has suggested that LTCM’s math was wrong; it is just that the events that occurred were not in the database that they were analyzing.

In 1997 the government in Thailand devalued its currency. The ensuing defaults roiled the markets in Asia and caused a serious decline in the equity markets. Credit markets in Japan, a major US trading partner and the most important capital markets in Asia tightened significantly. It did not help that Russia defaulted on its own sovereign debt shortly thereafter.

Importantly, LTCM did not lose money when the devaluation occurred in 1997 but a year later. The LTCM fund was very profitable into 1998. Losses started to mount up when its mathematical models could not account for the shifting market conditions caused by the devaluation. They were useless to predict the effects of the often conflicting ways in which other Asian governments and central banks would deal with it.

The lesson to learn from LTCM is quite simple. Even the best mathematical models created by the smartest people should not be relied upon to tell us what the markets may do. No computer program can accurately predict the price of securities one month or one year from today.

Despite this fact, there are currently a multitude of “quant” firms that are developing and using ever more sophisticated mathematics to do just that. Most are focused upon making predictions of what will happen in the markets today not next month. I wish them luck but I would not give them any of my money to invest.

The markets will continue to evolve, globalize and expand. Developing mathematical models based upon how the markets have acted up until today will be less and less accurate and have less and less utility going forward.

Millennials think otherwise and are expected to invest trillions of dollars with robo-advisers who use mathematics in the same way. A substantial percentage of those funds will be lost the next time the market turns down.

Then the market”professionals” and pundits who currently sell and endorse robo-adviser programs will remind the millennials that “nobody can predict the market” because some things about the markets never change.

What is an APP worth? Finding Rational Valuations in an Irrational World

Determining the value of any business can be an interesting process. Even in a data-filled discipline like economics, business valuation often remains very subjective.

If you stayed awake in Economics 101 you might have learned that in a liquid market, we believe that prices are determined by rational buyers and sellers of goods and services, each assessing the transactions in regards to their own self-defined best interests.

Price theory was developed in the 18th Century for a mercantile economy where the buyers and sellers were primarily merchants. Adam Smith considered merchants to be rational because they all wanted to buy goods for a price less than the price for which they could re-sell them. Little consideration was given to how the ultimate consumers might act or think.

In our modern consumer economy rationality plays a diminished role. Many consumer transactions are emotionally based. If you do not believe me consider the vast amount of economic activity that emanates from a single, strategically placed dab of perfume. The human mating ritual is full of transactions that are not based upon a rational allocation of resources.

It would seem easier to find rational buyers and sellers in the financial markets. People buy stocks because they believe that the market price of the shares will increase. The people who are selling those same shares in the same transaction may be doing so because they believe that the price will rise no higher. A buyer and seller in each transaction may be assessing the exact same data and reaching opposite conclusions. Each still acts rationally.

We seem willing to accept that a company’s value as being equal to the number of shares that it has outstanding in the market times the last price at which the shares were sold. But is it?

In active trading markets, the price of a stock may change constantly. For any stock, the last trade of the trading day is the price upon which margin accounts are valued and capital computations will be made throughout the global banking system. All that actually occurred between the next to last trade and the very last trade of the day was that one person bid the stock up or down. Valuing a company’s shares at the last trading price of the day eliminates the rational thinking of the other market participants who traded the shares seconds or minutes earlier.

Consider the case of Uber. Recent reports suggest that the not yet public company might have a value of $50 billion.This valuation was assessed at the time of its latest round of financing in mid-2015.

For a private company that is fairly new, an actual value of $50 billion would be quite rare. There are not a lot of larger companies that could spend $50 billion to purchase Uber. It would require $25 billion to take one-half of the company public and more to maintain a liquid secondary market.

Uber has demonstrated that its business model is viable and expandable and should certainly be profitable, given that its direct cost to provide the labor that it sells is zero. Uber operates in more than 200 cities, worldwide, cultivating its brand and customer loyalty.

At its core, Uber is essentially an APP, which the company itself will tell you. The company has structured its business so that the “employees” whose labor is the primary source of the company’s revenue are not employees at all. They are independent contractors.

The independent contractors (drivers) utilize the APP to connect with customers who might hire them. Once hired, the APP does the billing, Uber takes its cut, and the contractor gets a check. It is not a complicated concept.

If one assumes that Uber captures $2 (net) per transaction worldwide, it would need ½ billion transactions per year and a 50/1 price to earnings ratio to achieve a $50 billion valuation. Even with a lot of customers and a lot of drivers to service them, that is a lot of rides. There is no indication that Uber has ramped up to that level.

The replacement cost of Uber’s APP would seem to be a fraction of that $50 billion value. The APP is, of course, just a few million lines of code. Its functionality now defined, could not 1000 code writers replicate the APP’s functions in 1000 days, more or less?

Uber already has credible competitors. Some amount of Uber’s “loyal” customers could be coaxed away with price incentives and clever advertising. Some number of Uber drivers could be incentivized to change firms for a higher payout or a different business model. Certainly the $50 billion valuation for Uber seems high.

Valuation is one of the most elusive concepts in economics. If Uber’s value may be off by $10 or $20 billion despite its simple business model, what values can we trust?

For their first week’s home work assignment, I would send my Economics students into one of the large department stores in San Francisco’s Union Square. I would instruct them to make a purchase but not to pay the price on the product’s tag. Rather, I wanted the students to actively bargain and to convince the sales clerk or department manager to let them have the item for less. You would be amazed how easy it is to accomplish this.

Modern economics is based on price theory. We just have to remember that prices are rarely rational and always negotiable.

Sex and crowdfunding

Crowdfunding is very much an exercise in self-funding. The companies that are raising funds on the crowdfunding platforms are often expected to solicit their own customers, suppliers, friends and family to become investors in the business as part of the crowdfunding process.

There is a burgeoning industry of consultants who will help companies that want to raise money on these platforms. These consultants exist because there is still far too little capital available in this market. These consultants specifically help companies compete for that capital, but the crowdfunding process is still largely hit or miss.

It seems to be common knowledge that a good social media campaign should accompany any equity offering on a crowdfunding platform. Like all advertising, a social media campaign is a “numbers” game. Its goal is to bring enough eyeballs to your offering so that all of the shares you are offering will get sold.

If eyeballs are what you need to successfully crowdfund a company, it would seem logical then that the easiest company to crowdfund might be one selling a line of lingerie. No crowdfunding consultant worth his/her fee would likely tell the company not to include its product catalog in its presentation to investors if that catalog had pictures of models wearing lingerie.

Titillation aside, lingerie companies sell products that may be easily and inexpensively sourced and which can often be sold at substantial mark-ups. But that is not what the conversation is likely to be about.

In a perfect economic world, investors would travel to the “efficient frontier” (a great name for a crowdfunding platform, in my opinion) and select investments suited to their taste for a blend of risk and reward. Illiquid shares received by crowdfunding investors will always be speculative, so reducing the risk or increasing the potential reward seems to be the obvious way for the platforms to gain the most customers.

When a crowdfunded business finally monetizes the investors’ “bet” there should be every expectation that the investors will be well compensated. Greed, not sex, should be the emotional basis for any crowdfunding investment.

The crowfunding platforms are filled with companies seeking funding for real estate projects, technology projects, electronics, toys, bio-tech, consumables, films and office applications. A prospective investor visiting a few of the larger platforms would likely find a few hundred very different offerings to consider. As the offerings attempt to distinguish themselves one against the other, there seems to be more showmanship than substance.

The classic business model for offering new securities to the market would have them underwritten by an investment bank or brokerage firm. This model works for the companies that are being funded because they get funded. It is also exceedingly profitable for the investment banks.

Investors in an underwritten offering can expect to get a reasonably investigated, intelligently structured investment into which someone at the investment bank, independent of the company, has given some time, thought and analysis. The value added to a funding transaction by an investment bank is the judgment that they bring to the transaction. Investors who may know nothing about the company seeking funds will invest if they have relied upon the bank’s judgment in the past and made money.

I was only able to find one crowdfunding platform that even attempted to offer this type of assistance to companies that were listing on it. Only one platform that seems to see what everyone else is missing.

I should not have to tell you that many of the companies that are currently seeking funding on the crowdfunding platforms are very weak. Even companies which have a “cool” new product created by a great team of engineers will often employ no one with the experience to effectively get the product to market.

There are many start-ups on these platforms that are not yet in business. Someone independent of the company issuing its shares still needs to ask the question: “can you get this to market, on time, sell it and make a profit?” In the crowdfunding marketplace, at least up until now, no one really asks this question because no one considers it their job to do so.

Sooner or later, the platforms will likely realize that they are in the business of selling equity shares to investors and step up. Goldman Sacks is also in that same business and makes a lot of money doing it. As billions of dollars find their way to these platforms in the next few years, there will be a lot of money to be made as the crowdfunding industry matures.

The crowdfunding industry will have matured, in my opinion, when the social media messages change direction. Eventually, the current outgoing “please buy my offering” messages will be replaced by the incoming ”I wonder what the ‘Efficient Frontier’ crowdfunding platform is offering this week?”

Looking back ten years from now, will any of the crowdfunding platforms now operating be able to boast that “97% of the companies funded on our platform in the last 10 years are still operating” or anything close? Certainly the platforms should realize that this type of track record would draw a lot of new investors to their offerings and encourage loyalty from the investors that they already have.

Crowdfunding success or failure should never really be determined by sexy catalogs or the size of your social media campaign. The cream should always rise to the top. The crowdfunding market is new and growing rapidly. All that it needs to succeed is an infusion of a little judgment and some common sense.