-: Welcome, once again, as MIT Professor Paul Samuelson
discusses the current economic scene.
This series is produced by
Instructional Dynamics Incorporated.
Professor Samuelson, what is the outlook
for the summit meetings that President Ford
will be attending soon?
-: I don't think there's much point in my
trying to guess what will happen at the summit meeting,
because a certain air of cynicism
has been exhibited towards almost everybody
about this meeting.
Giscard, the French Chief of State,
wanted to have a summit meeting.
It would be, perhaps, churlish of the Chief of State
of the United States, to refuse to sit down
with the other leaders of the world.
Usually, one can predict in advance
what might be accomplished by a meeting of heads of state.
If a war just ended, there's a need for a peace treaty
or you're setting up the United Nations,
however, it seems to me very dubious that anything
substantial can be accomplished at the summit meeting.
If that's the way I feel in advance of the meeting,
I think that there's very little useful that can be said.
Why don't we leave the summit meeting for a postmortem.
Perhaps I'll be surprised, maybe pleasantly surprised,
by more progress than I had thought.
I don't believe that it will be possible to decide
that we'll go back on the old gold standard,
or that the great debate between flexible exchange rates
and pegged exchange rates will be resolved, nor even
an effective rule of conduct which decides
on how much dirty floating and how much clean floating,
that is how much government intervention
will be the rules of the game.
Nor do I think that the general problem
of international liquidity, which used to be regarded
as a problem of too little international liquidity,
and which now is regarded in many circles
as a problem of too much international liquidity,
I don't think that that problem can be solved
at a weekend meeting.
Let me, therefore, turn to certain miscellaneous
considerations that will be of interest to anyone
who wants to follow the course of economics
at the modern period.
Very briefly, we got about a week ago,
some rather disappointing news; it was a one-two punch.
The unemployment rate went from 8.3% up to 8.6%.
That was fairly universally regarded as bad news.
At the same time, the wholesale price index
came in on a seasonally corrected basis,
not having dropped in the usual way
that it drops in October, and registered
a rate which if you annualize it,
was certainly in the two-digit range.
Most disturbing of all, to many observers,
was the fact that industrial wholesale prices,
not just sensitive raw material staples,
industrial wholesale prices were very much up.
This has kind of put a damper on the high spirits
of many people who had been basking in the 11%
annualized rate of growth of the American economy
in the third quarter.
They also had been basking in the sunshine
of what they regard as easier money, namely,
a tendency for the Federal Reserve
to want to encourage interest rates to come down.
Reflecting itself in a lowering of target
federal funds rates, and in successive cuts
of the prime rate at which the big banks
lend to their best customers.
That went from the general vicinity of 8%
down to the general vicinity of 7%,
and the last heard from,
was still, if anything, heading down.
I say this is what's called easy money
because, perhaps, 70% of the world
thinks of this as easy money, falling interest rates,
but since it's prime cause has been the failure
of the money supply to grow at the targeted rate
of between five and 7 1/2%, the other 30% of the world,
which defines easiness and tightness of money solely
in terms of the monetary aggregates,
they're cursing the Federal Reserve as, at this time,
being engaged in very tight money.
Well, I don't think that as far as motivation is concerned,
the Federal Reserve has particularly turned tight
in its thinking in recent weeks.
It's rather that there has been
a somewhat unexplained drop in the demand for money.
Nobody quite understands this, and we don't even understand
how much of a shift in the demand for money
is gonna be called for by the figures
when we have the revised figures in.
But let me paint the story of the picture
of what it is that seems to need to be explained.
You had very rapid growth in real GNP, that's called 11%.
Maybe that'll be revised a little bit downward
as they revise the inventory decumulation figures,
perhaps towards more decumulation.
Prices have risen by the GNP deflator at about 5%.
That gives you something like 16 plus percent of money GNP
rate of growth.
In the face of this, the quarter to quarter,
that second quarter to third quarter money supply,
grew at only 7%.
The difference between 7% and 16% is eight or 9%,
at which as an annual rate of growth of the velocity
of circulation of money, seems a bit excessive,
unless if it were accompanied by a great stiffening
of interest rates.
However, we know that although interest rates
had risen earlier and there are some lagged effects,
the interest rates have not, in this period,
been rising very much, and so there is a puzzle.
The puzzle one might hope to explain
by what's happening to foreign central banks
flush with Arab money,
whether they are buying treasury bills.
But that seems to be the reverse of the truth,
if I can judge from last week's
testimony by Arthur Burns
before the Senate Banking Committee, the Proxmire committee.
We don't seem to be able to explain matters there.
The way the treasury handles its cash balance
can probably explain part of the problem, granted.
I think maybe part of the problem
might be explained by the fact that so much
of the growth rate imputed
to the money GNP is in the form of inventories.
That could be just things which require
no transactions at all, just the building up of those,
and that might explain some of the behavior.
It may be that
a partial clue to the problem may come from
the New York crisis.
The New York crisis, which may result in default,
has scared people.
It's shifted a lot of people towards short-term securities,
and the safest short-term securities,
namely, treasury bills.
This shift of liquidity preference towards safety,
towards the shorter securities, would be expected
to put downward pressure on interest rates.
It might be part of that shift in the demand for money
that we've been talking about.
People, well, it's a little hard to believe it,
put that way, namely, that people are so scared
that they're holding less money,
and holding more treasury bills.
It would explain the decline in interest rates,
but I don't think it quite explains
the behavior of the velocity of circulation of money.
There is a puzzle there.
Well, just as everybody was feeling very good though,
because people in the marketplace,
even when they are not themselves monetarists,
I think there are some kooks in the marketplace
who may be monetarists, and they think that the
Federal Reserve has, in its schizoid behavior,
a strong monetarist leaning a good deal of the time,
they've just been rubbing their hands in glee
because if the money supply has been growing very slowly,
then they know it's got to grow faster in the future,
and this means that downward pressure
in the very short run will be put upon interest rates.
And many of them have convinced themselves
from very pleasant experience,
that whenever interest rates fall,
the stock market's likely to go up.
They already have some profits in the bond market
if they are not in the New York municipal market.
Well, it's tough to spoil this euphoria by having
a new concern that maybe inflation is back,
and maybe the recovery is not doing so well.
Let me very briefly give some reactions.
I don't feel that my knowledge has changed very much
by having unemployment come out reported as 8.6%
instead of 8.3%.
The 8.3% always looked a little bit low,
given the usual regression equations of past experience.
We had dropped from 9.2% in just last May
in the unemployment, and the drop had been a bit faster
than one would have expected knowing that unemployment
is a lagging series, so maybe the 8.3% was a little lower
than the truth really
should have asked for,
and maybe the 8.6% is a little bit higher.
You can't make too much of month-to-month behavior.
What we know is that the march downward to 7% unemployment
to 6 1/2% unemployment to 6%,
to wherever you think the next ultimate goal should be,
we've known that that's going to be a long,
slow, stretched out march, and that it won't be until
really quite late in this decade
that we'll begin to get there.
I would say from the standpoint of government policy,
moving into the election period of next year,
the fact that the reported number of unemployment
is still very high should be regarded as an expansionary
factor rather than as a contractionary factor.
If the unemployment rate had dropped from 8.3% to 7.9%,
people would say, aha, a lot of that unemployment
was false, was artificial.
We're eating into the unemployment too fast.
We're gonna create a recurrence of demand-pull inflation.
You'd better start being very conservative on fiscal policy
and very conservative on monetary policy;
that is very contractionary, non-expansionary.
Well, this is the reverse of that.
On the Wholesale Price Index,
I think one has to reserve judgment.
The 5% number reported in the third quarter
was much too low.
The chain index, as I have mentioned earlier, was above 7%.
The cost of living, the Consumers Price Index so-called,
has been rising at 8%.
I don't think that the baseline rate of inflation
in the American economy on a smooth basis
over the remaining months of this year
ought to be regarded as anything like 5% or below.
We may find ourselves there,
but I think that this baseline rate
has the smell of being more like six to 8% at least,
and that's compatible with a month or two of bad news,
even in the two-digit price inflation,
but it's something worth watching.
My suggestion is that we wait to see whether
New York gets through its next crisis
and the one after that before we start making
any agonizing reappraisals about what's likely
to happen in the strength of the recovery.
Let me, therefore, use my time today
to comment on a question that I'm always being asked
by subscribers and by people who read my various writings.
The question that is directed toward me is:
Do you still have the view that security analysts cannot
deliver to their clients a performance worth paying for,
that is any better than the clients themselves can do
by broad diversification which in its broadest aspect
would involve just buying the Standard & Poor's Index?
And my answer to that is,
all the experience that's been coming in in recent years,
has been in the direction of reaffirming in my mind
that view, rather than undermining it.
There have been odd periods during the performance euphoria
of the 1960s, when it looked as if, crudely,
the money managers were doing a bit better
than the comprehensive averages.
Part of that was an illusion, maybe all of it,
because they were just being more risk taking.
And when the market's going up, one of twin brothers
who borrows money and goes into the market on leverage,
even if he has no superior security selection ability
to his twin, is going to look better on paper.
Well, of course, these money managers by and large
did not borrow and leverage,
so I can't pooh-pooh their good performance on that basis.
But if you have twin brothers and both of them
are under restraint and not being allowed to borrow,
but one of them wants to be more leveraged than militant
in what he thinks is an up market and which proves
to be an up market, then all he has to do, really,
is buy more volatile securities.
And more volatile securities go up more in an up market,
and they go down more in a down market,
but he would look in the up part of the market
as if he is better.
Well, we correct for that by a crude,
it's by no means a perfect correction,
but it's remarkable how good and useful
the crude correction is by calculating the beta
of the securities which the money manager
has put his money into.
The beta is the regression slope showing
how those securities in the past, the recent, relevant past,
have moved dollar for dollar with the overall market,
as measured, say, by the Standard & Poor's Index.
If you find a fellow has done well in an up market,
but he's got a big beta, then you divide through
by that big beta, and then it turns out
that he's just rejoined the human race
and hasn't done exceptionally well.
In fact, he may have done worse than just the index,
because that sort of money manager is almost certainly
having a turnover rate in a securities
of anywhere from 30% a year up to over 100%.
That means that if you had a 100% turnover rate,
that on the average, whatever security was in the portfolio
last year isn't gonna be there today,
unless it's there for the second or third time
as you've been churning your portfolio.
While churning portfolios makes for brokerage commissions,
even in this age of negotiated commissions,
but it's a dead-weight loss taken right out of the
total yield over a period of time of any fund.
And nobody should ever do, engage in buy and sell
transactions, unless he has reasoned confidence
that he's going to make more than the cost
of those commissions.
The hidden cost, by the way, has to be added on
to the commissions.
Every time you buy and sell in any magnitude,
you actually push the price a little bit against yourself
both ways, and since you're initiating the transactions,
you have to pay through the nose for those.
It's very hard to calculate what that is,
but experts in the field can make a calculation.
Perhaps it's this churning that explains why the analysts
do worse on the average than the overall averages.
I have to put to rest, once again,
it comes up again and again, people say yes,
but you can't buy the averages.
Well, that is untrue.
It's certainly the case that one dentist
cannot himself buy the comprehensive averages.
There's been a proposal that the Dow Jones Averages
be put as a unit on the Chicago Options Board.
I don't know how that proposal is faring.
I think it would point up
what I think is obvious to anyone,
namely, that most of the people
who indulge in transactions on the buy side
in the Chicago Option market, are not
hedgers protecting themselves and playing safe.
They're people with strong hopes
about how the market's gonna go up,
and with limited liquidity and for a price,
the sellers, through the good
agency of the market, the seller or writers of the options
provide them with that.
Plus you have to modify and qualify my statement
for that part of the purchases which are matched
by sales and which simply represents spreads in that market.
Well, my reason for bringing this up today
is an article in The Wall Street Journal
of some few days ago with a headline, On the Average.
More pension funds try to tie the market
instead of beating it.
These are the headlines.
They seek to match the S&P 500
because money managers often fall short of index.
You could say almost always fall short of the index.
And this is very hard on the ego
of the security analyst profession
and the portfolio decision makers.
It's also, in the end, gonna be very hard
on their pocketbooks.
It means, if it's correct, that you need a lot less people
in the brokerage community to engage in these
pointless turnover buy and sell transactions,
and it means that there's no reason
why you should be paying out
to somebody a living doing security analysis
in beating the average when you can't beat the averages.
What's brought this up, what's made it newsworthy,
is that AT&T, with some really tremendous pension funds,
has thrown in the sponge on the belief
that they can buy money management
which will improve performance over the indexes,
and so they're now using the one or two or three
agencies which are available to anybody of any size
to match the indices.
What are those agencies that are available
to anyone of any size?
I mean any corporation with a pension fund
and really anyone with
a million dollars, and for that matter,
it won't be very long before somebody with $10,000,
I dare say, will be able to invest
on a no-load, no-management fee basis
in something like this, because it's the kind of idea
whose time has come.
Well, first you have the Wells Fargo Bank
in San Francisco, which has been experimenting
for some period of time in this and doing very well
in matching the index.
The Wells Fargo Bank actually tried to set up
a stagecoach fund which would have done this
on a fee basis, very small fee basis, for pension funds
but I guess that didn't get off the ground,
but they still, as a fiduciary,
do this, and that's one name to remember
if you have an interest in this matter.
Secondly, I'm just going in terms of chronological time,
the Batterymarch Financial Management Incorporation
of Boston offers this service,
and I think has something like 40 million dollars now
in this kind of indexed fund.
Batterymarch, I think, is named after
the Batterymarch Street in Boston.
Finally, there's a bank in Chicago,
the American National Bank of Chicago,
which has been offering this service.
There are some differences as described
in this Wall Street Journal article,
and has been discovered by professors of finance
who've looked into the matter.
Wells Fargo, by and large, goes out and buys all the stocks
in the Standard & Poor's 500.
That means that they're holding a lotta little stocks
along with the big stocks.
You've gotta be pretty big to do that,
and there are a few problems.
They don't buy them all,
because a fiduciary might get sued
if it held certain stocks that the courts
would hold to be risky,
so those always have to be excluded.
American National Bank and Batterymarch,
they just try to do a sampling and just match very closely
to the Standard & Poor 500.
I haven't really time to develop this,
but it's a mistake, in my judgment,
to try to match perfectly,
the S&P 500.
It's not a mortal sin to try to do that.
It's just a little venial sin; it's a little blunder.
There's nothing perfect about the S&P 500.
It's only the single most comprehensive index
easily available, that comes very close to, say,
matching 85% of the American equities.
But it's not 100%.
Moreover, if it matches, say, 80% of some defined
universe of American equities,
then if you count in closer-held corporations,
it's slipping down from 80% to 60% over-the-counter
and so forth, towards 50%.
If it's good to hold all of the American market,
then in this one world that we have,
why isn't it in principle good to hold
all world securities, or at least the universe
of publicly traded world securities,
and then the S&P 500 begins to slip down towards 40%.
Well, if it's the best wheel in town,
why don't you use it for making your bets
until a better one comes along?
I think the answer as to why there's a danger
in matching it too closely is the following.
The S&P Index itself is a changing index.
An example mentioned in this article,
W.T. Grant and Company, big chain,
is in some kind of trouble.
Some of these banks have already eliminated that stock
from the S&P 500.
I don't know that the S&P officials have yet removed it
because it's in bankruptcy,
but it's a good bet that it might be removed.
Well, if you're trying to match the shibboleth
of the S&P 500, then your instructions are,
you hold it until it's out of the S&P.
The morning it comes over the broad tape
that it's no longer in the S&P, you've gotta get rid of it.
Well, suppose a lot of people are doing this,
and you're beginning to get not 40 million dollars,
not 20 billion dollars, but you're beginning to get
hundreds of billions of dollars
just trying to match the S&P Index.
That morning, when W.T. Grant goes out of the S&P 500,
is gonna be a dreadful morning to put in
sell orders at the market.
Similarly, when a security is added,
suddenly all the index followers
will begin to add that security.
So I would say that in setting up your charter,
you'll have to give yourself a rule of reason.
Don't stick just to the shibboleth,
but to what is the letter, the spirit,
behind the letter of the rule
of trying to buy the whole market.
One caveat before I finish.
A reason for matching the S&P 500
is that if you hang your shingle out,
and say you're running an index fund,
it's something which people can understand.
It's something you can promise to do,
and which they can count upon your doing.
And, so, I wouldn't want to say flat-footedly,
that you should on the basis of what I said,
agree not to match it slavishly,
but I think you ought to weigh, very carefully,
the possible disadvantage as these index funds
become more popular, and just like the money market funds,
they're going to become more popular.
You wanna weigh what the disadvantages will be
against the advantages of non-ambiguity
and of clarity in contracts.
-: If you have any comments or questions
for Professor Samuelson, address them to
Instructional Dynamics Incorporated,
450 East Ohio Street, Chicago, Illinois, 60611.