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In response to Daniel Akst’s piece “Passive Aggressive“: Here at Morningstar we spend most of our days thinking about investment strategies, and rarely does the word “evil” come to mind. Of course, there is vice in the mutual-fund business. Fund companies’ greed-inspired pursuit of assets occasionally leads them to lie, cheat, and virtually steal from their shareholders, through deceptive advertising or outrageous fees and expenses. But index funds rarely commit such sins–they are surely the choirboys of the industry.
Thus, I was surprised to see index funds tarred as “evil” in your article. You allege that greedy index-fund investors take advantage of noble souls doing their own research and thereby threaten to erode the quality of information and research that is the foundation of our efficient stock markets. In fact, this view is almost completely opposite to the truth. The rise of index funds should be seen as triumphant proof that our financial markets are robustly efficient. And it will be impossible for index funds to destroy the efficiency of markets as long as those markets remain free and ruled by greed.
You beguile us with the image of a pastoral commons in which index investors are selfish free riders grazing on the fruits of hard-working financial analysts. Having talked to hundreds of mutual fund managers, I’d suggest that this is not the appropriate vision of the workings of the stock market. Instead, imagine a huge ocean of information populated by vicious, hungry sharks. These sharks patrol the waters looking for juicy tidbits to grow fat on. After they have had their fill of the prey, its carcass falls to the bottom of the sea. There bottom feeders wait patiently to scavenge the remaining scraps. They don’t get fat, but they have a nice, easy life waiting for their dinner to fall to them. In this metaphor, the sharks are the active investors, and the indexers are the bottom feeders. The final crucial detail that ensures that this world and our financial markets will always function smoothly is that the sharks can become bottom feeders, and vice versa.
If this were a true biological world, competition between the species and the drive for survival would ensure that there is equilibrium between the sharks and the bottom feeders. If the lazy bottom feeders become too numerous, there won’t be enough carcasses floating down to the bottom. In this case, the ill-fed bottom feeders will decide to join the sharks, and will hunt their own kills. In the alternate case, when sharks swarm the waters, there will be little reward to their hunting, and some of the sharks will retire to the easy life of bottom feeding.
There is a similar equilibrium in the financial world. Only, in the stock market, the equilibrating force is unfettered greed. Today, aided by an explosion in information technology, there are thousands and thousands of active, aggressive investors pouncing on every nugget of information, thereby making the markets highly efficient. In this world, it makes eminent sense for some investors to give up the hunt and be satisfied with the quiet life of indexing. It is true that the indexers are free-riding on the sharks. But don’t cry for the sharks–they are just as selfish as the bottom feeders. The sharks are free to hang up their fins any time and pursue the lazy life. And they surely will, whenever it pays to do so. As the profits from active investing diminish, there will automatically be fewer active investors and more indexers. And whenever the profits from an active strategy become evident, a feeding frenzy of sharks will appear. It is this freedom that investors have–to follow any strategy, from fundamental analysis to astrology–combined with the powerful drive of human greed, that guarantees that our financial markets will always be highly efficient, and that indexing or any other investing strategy will never pose a threat to market efficiency. As long as at least a few sharks patrol the waters, we will all be safe.
–Todd Portermutual fund analyst, Morningstar
Akst Me No Questions
Although his criticisms in “Passive Aggressive” are right on the mark, Daniel Akst need have no fear of the free-riding index investors who strive for mediocrity by investing passively. If 20 percent of new mutual fund money is now going into indexed funds, as opposed to 3 percent in 1994, we can have some confidence that the indexers are planting the seeds of their own destruction. As more people drop out of the competition to outperform, the marginal research and trading value of the decreasing number of active investors will become significant, and they will begin to beat the market.
Take the argument for passive investing to its extreme: Suppose that tomorrow morning all funds were invested solely in index funds. By definition, that would be the last trade in the stock market. That is, no one would be able to react to new information. Clearly, some investors would break from the pack as new information became public and others were not reacting. Thus, the number of passive vs. active investors will always fluctuate around an equilibrium.
By the way, the “tragedy of the commons” is not a theoretical construct from a 1960s environmentalist. It was coined almost 200 years ago (I think perhaps by David Ricardo), to describe the pre-industrial land-tenure system in Britain, wherein peasants would destructively graze their livestock on commonly held land. Furthermore, the traditional response to the observation is not in favor of “greens, social critics, and other worrywarts who fret over issues such as population growth,” but rather supports the capitalist argument that land tends to be used more efficiently under private ownership, in that the owner is interested in supporting the long-term value of the property.
–John Robertson GrahamVancouver, B.C.
The Wicked Niche of the East
Paul Krugman’s July 17 column, “The East Is in the Red,” uses superficial research and ad hominem attacks to criticize a recent article of mine on U.S. trade with emerging economies like China. Rather than join Krugman in the gutter, I will deal with his few substantive points.
First, Krugman belittles concerns about America’s huge and growing merchandise trade deficits with China because the U.S. government figures I cited have kept Hong Kong and the People’s Republic of China separate. Combine them, he claims, and China’s big global merchandise trade surplus shrinks to insignificance.
What Krugman does not explain is how, if the macroeconomic forces he emphasizes truly explain China’s trade flows, the PRC can be growing at roughly double-digit rates and running a global surplus. In fact, at one point he insists that it is an “arithmetical necessity” for big capital importers like China to run trade deficits. Evidently the Politburo at MIT needs some math lessons.
Further, China’s trade balance with the United States was my focus, not China’s global balance. And for 1996, combining the Hong Kong and China figures reduced America’s China deficit only from $39 billion to $35 billion.
Moreover, the annual export figures for the PRC are considered by the U.S. government to be understated by at least $6 billion–the amount of Chinese textiles and apparel fraudulently shipped to the United States through third countries. Industry estimates place the figure at some $10 billion. But of course, what could matters like customs fraud possibly have to do with trade policy?
Krugman also criticizes my expectation that emerging economies will continue developing as world-class exporters but remain small consumer goods markets. After all, he argues, although countries that produce more than they consume must run trade surpluses, these surpluses will guarantee high consumption because the resulting national income increase “has to show up somewhere.” Moreover, he observes, most emerging economies are running global trade deficits–i.e., consuming even more than they produce–precisely because they import considerable foreign capital.
Yet many countries become major importers but not major consumer markets. How? By concentrating their imports in capital goods, intermediate goods, and industrial inputs–the very products needed to maintain export-led growth. Such growth may indeed one day create big consumer markets. But “one day” may be a long time coming.
For governments in these countries have aims other than enriching domestic consumers. Indeed, many deny individuals and businesses broad freedom to consume precisely because their top priority is building national economic power–especially productive capacity–over the long haul. As the examples of Japan and South Korea show, for strategic reasons they are willing to interfere with Krugman’s vaunted market-equilibrating forces for decades, by mandating high savings and suppressing domestic consumption in other ways, and pushing exports. And when they do consume, they often focus on purchases whose economic benefits do not trickle down or abroad–like weapons. Indeed, most of east and southeast Asia is in the midst of a big, prolonged military buildup.
Finally, numerous statistics belie Krugman’s claim that real wages inevitably rise with productivity. That’s certainly not the case in the United States. Nor is it the case in Mexico. There, manufacturing productivity rose by an annual average of 6.6 percent between 1988 and 1993 (the Salinas years). But just before the 1994 peso collapse, real hourly wages stood nearly 30 percent below 1990 levels. One main reason: Some 1 million Mexicans enter the country’s workforce every year, greatly increasing the labor surplus in a land where unemployment and underemployment were estimated by the U.S. Embassy in Mexico City at a stunning 35 percent in late 1995.
Indeed, labor surpluses and falling wages plague most low-income countries outside east Asia. And even there, anecdotal evidence indicates that once labor costs take off, so does foreign investment–for much-lower-wage, labor-rich countries like China.
Finally, Krugman’s numbers on Asian wages catching up to U.S. wages ignore one big factor contributing to that narrowing: a decline in U.S. wages. Although he calls this trend Panglossian, few other Americans will.
I anxiously await the bucket of mud Krugman is undoubtedly preparing to sling in response.
–Alan TonelsonU.S. Business and Industrial Council Educational Foundation
Paul Krugman replies: I’m sorry that Alan Tonelson’s offended dignity has prevented him from actually taking on board the substantive arguments that I made in my article. Let me try, however, to make four points:
1) Tonelson seems to think that the proposition that a country which attracts large capital inflows must also be running a trade deficit is merely my opinion. It isn’t: It is a matter of sheer accounting–it is, exactly as I said, an “arithmetical necessity.” And I believe that whatever asperity I may have shown in the column is justified by the astonishing fact that he really doesn’t understand that.
The point–which I thought I made clearly in the column, but then what do I know?–is that China’s trade surplus, and actual rough balance on current account, shows that the country is not, in fact, a net recipient of capital. (Capital account plus current account equals zero; that is a fact, not a theory, whatever the Politburo may say.) Any attempt to make sense of the country’s trade must include an explanation of how the money brought in by foreign investors goes out again.
2) Tonelson accuses me of “superficial research,” then says that in his article, “China’s trade balance with the United States was my focus, not China’s global balance.” I have now done a little more research, by rereading his review of Jeffrey Garten’s The Big Ten, which was clearly cited as the source of my quotations (New York Times Book Review, June 15, Page 30). If there is any mention of China’s trade balance with the United States in there, I can’t find it–in fact, the article seems to say quite clearly that emerging economies will not offer large markets to anyone. Maybe Tonelson has some other article in mind?
Doing a bit more research, I discover that in my own column I included a long sidebar which acknowledged that, while the precise numbers are in dispute, China certainly does run a large bilateral surplus vis-à-vis the United States, and tried to discuss the economic meaning of that surplus. But maybe Tonelson had stopped reading by then.
3) Tonelson’s letter makes a big point of the likelihood that advanced countries will export mainly capital equipment rather than consumer goods to the emerging economies. Why, exactly, is this a problem? Is selling tractors and forklifts somehow a less sound business than selling soft drinks? (What fools the Japanese are, selling us all those numerically controlled machine tools.) As the saying goes, “Give a man a fish, and you feed him for a day. Teach a man to fish, and you can sell him equipment.”
4) Finally, Tonelson denies that productivity increases lead to higher wages, insisting that the dramatic convergence in hourly compensation between the United States and the Asian tigers has been achieved through a fall in the U.S. level. Funny: When I check out the “real hourly compensation” number in the back of the 1997 Economic Report of the President (Page 354), a book which I assume Tonelson has on his desk, I find that it went up about 8 percent between 1975 and 1995. We could go on at length about whether workers should have received even more, or what adjustments one might make to that number to move it down (or up) a bit, but by any calculation I can make, the overwhelming picture is one of convergence between wages in the tigers and in the West through a process of leveling up, not leveling down.
I should perhaps say that I have nothing personal against Alan Tonelson. I quoted him only because I often find it hard to convince people that the views of the faction he represents are as crude and naive as they really are. “Surely,” people say, “they can’t really believe that countries can attract massive capital inflows and run big trade surpluses at the same time? They must have some more sophisticated point in mind.” The only answer to such rationalizations is to catch somebody with his hand in the cookie jar. And whatever Tonelson may say, I caught him red-handed.
The Rape of the Lockheed
In James Surowiecki’s article “The Lockheed Redemption,” he stated that Lockheed was “currently building the F-117A Stealth fighter and the thoroughly unnecessary F-22 for the Air Force.” Given that the skies are filling up with planes like the Eurofighter, the Dassault Rafale, the J-10, the JAS Gripen, the MiG-29 and 35, and the Sukoi Su-27 and 35, all of which are comparable or superior to any U.S. fighter, how can the F-22 be “thoroughly unnecessary”? Those other planes are being built by countries which are all pushing hard for foreign sales, so it is not inconceivable that our Air Force might confront some of these high-tech planes in the future. The question is, will they do it with a decades-old plane designed to fight the battles of the past, or one designed to fight the battles of the future?
Don’t Shoot the Messinger
In James Traub’s “New York’s Loneliest Liberal,” he says: “By the time David Dinkins became mayor in 1989, this kind of spending had made New York ungovernable. The economy was dead, the budget was in perpetual crisis, and crime was shooting through the roof. Dinkins did nothing to reverse the trend.”
This is an incredibly ignorant statement. Crime went down the last three of Dinkins’ four years, and much of the current drop in crime can be attributed to the thousands of extra police that Dinkins fought for in Albany. Dinkins balanced the budget all four years, something that Giuliani has not been able to accomplish. The current economic turnaround started in 1993, Dinkins’ final year in office.
–David WhiteNew York City
A Shot in the Arm
Funny the places you find vindication. Steven E. Landsburg seems to be saying in “Property Is Theft” that if an anti-theft device benefits citizens other than the property owner, it should be encouraged. Research indicates that liberal (“shall-issue” concealed carry gun permit laws, not left-wing ideology) firearms laws result in a reduction of crimes against persons. Since citizens legally carrying firearms make those areas safer, firearms restrictions are counterproductive. Thank you for the encouragement.
–Fred NiziolColumbia, Md.
Steven E. Landsburg replies: Fred Niziol is correct in his facts but mistaken in his reasoning. Recent research does indicate that liberal firearms laws reduce crime against persons. But it does not follow that liberal firearms laws reduce crime against persons who do not carry firearms. Therein lies a critical distinction.
Consider three hypotheses: Hypothesis 1 says that when I buy a gun, I discourage people from becoming criminals and so reduce crime against my neighbors. In that case, according to the cost-benefit criterion that economists like to employ, my gun ownership should be subsidized.
Hypothesis 2 says that when I buy a gun, I prevent crimes against myself while having no effect on crimes against my neighbors; criminals who choose me as a victim end up wasting their time, but criminals who choose you as a victim are as successful as ever. In that case, I have ample incentive to arm myself, and there is no reason to encourage me with a subsidy.
Hypothesis 3 says that when I buy a $100 gun, I protect myself from, say, $150 worth of property loss, while inflicting, say, $75 worth of property loss on my neighbors–because half the criminals who try unsuccessfully to rob me go on to rob someone else instead. In that case–again, according to the usual cost-benefit criterion–my gun is a bad thing; it costs $100 and only reduces total crime by $75. That’s an argument for discouraging gun ownership through taxation.
I do not know which of these hypotheses is closest to the truth and am not aware of any research that settles that question. Therefore I do not know whether gun ownership should be subsidized, taxed, or neither.
What’s remarkable about the Lojack research is that it does do a careful job of distinguishing among the analogues of Hypotheses 1, 2, and 3. That takes a lot of hard work and ingenuity. It will take harder work and more ingenuity before we know whether Niziol has jumped to the right or the wrong conclusion.
I found “So Are the Neanderthals Still Jews?” by Charles Paul Freund to be inappropriate for a publication from Microsoft. While it may be that Freund was attempting satire in his review of anti-Semitic origins over the last 2,000 years, it is just a stonestep away from believing that Freund himself believes many of the things he chronicles. More importantly, his writing style lends credence to these blatantly racist and anti-Semitic writings. What purpose or higher reasoning can Microsoft use to justify such writing?
–Adam Goldstein, M.D.Chapel Hill, N.C.
Funny, You Don’t Look Neanderthal
I just finished reading “So Are the Neanderthals Still Jews?” by Charles Paul Freund, and found it to be in very poor taste. I will assume for argument’s sake that the author is not blatantly anti-Semitic, but is only trying to outline the theories put forward over the centuries which account for the survival of the Jewish people in the face of hundreds of years of persecution. This type of article, even when well meant, just further fuels the fires of anti-Semitism and is counter-productive to the ongoing development of peace and civilization on Earth. Your decision to publish such an article dismays me. I would urge you to remove this article from the Net and avoid this type of journalism in the future.
Charles Paul Freund replies: Adam Goldstein thinks my style lends credence to Jews being space aliens, Neanderthals, horned devils, etc., while David Koppy says my story impedes Earth’s peace and civilization. Thanks anyway, but exposure (the story) and scorn (the style) are two available antidotes to the heritage of hatred and dehumanization I described, and which is arguably a bigger problem than my story. The article’s unfathomable purpose was, to quote it, “a lesson in how the most inane ideas can have the most appalling consequences.”
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