Political Frame, Whither Balanced Growth?

"The federal budget is the main single instrument of national economic policy. Its use is fundamental, toward promoting economic performance in accord with our needs and capabilities. Nobody denies this in principle..."

Said Leon Keyserling 35 years ago as he looked in frustration at the onset of the largest post-war recession prior to our 2008 Great Recession, the Reagan-Volcker Double Dip recession of 1979-1982. The Full Employment and Balanced Growth Act of 1978 had been passed by large majorities in both houses of Congress to deal with the problem. The Act was promptly and nearly completely ignored by first Jimmy Carter and then Ronald Reagan.

It was in this context that Keyserling produced one of his best works, "Liberal" and "Conservative" National Economic Policies and their Consequences, 1919-1979, subtitled: "A Study to Help Implement Promptly the Humphrey-Hawkins Act."

Leon Keyserling was one of the most successful economists in American history in terms of getting significant legislation passed, influencing public policy over a long term, and seeing results in the performance of GDP, inflation, employment, growth and national well-being. He had a hand in the Wagner Act of the New Deal (1935), also known as the National Labor Relations Act. He claimed to have modeled the Full Employment Act of 1946, which was probably the single most important piece of economics legislation in the country's history. And he participated in and influenced greatly the Humphrey-Hawkins Act. Keyserling was a member of the Council of Economic Advisers, then chair, under Harry Truman, and helped immensely in the transition from war to peace and managing the economy into a period of prosperity.

"Balanced growth" was Keyserling's vision of how successful economics and public policy operated, as a partnership between labor (consumers), business (and investors), and the government (public sector). The problem Keyserling saw in 1979 was overcapacity, resulting in a reduction in investment and recession. The condition of overcapacity was a function not only of overbuilding, but of under-consumption and a deficiency in government outlays. "Balanced" growth was a coordinated expansion in each of these three components. Investment was necessary, but could not run ahead of consumption, or the profits would not ratify the investment, prompting cut-backs and recession. Sufficient federal outlays were necessary to provide the foundation for investment and consumption and to address the nation's overarching priorities.

Keyserling saw over-investment as a problem virtually throughout the "conservative" period beginning with Richard Nixon in 1969. The federal budget, both its spending and its taxing sides, promoted ever more investment, more capacity. "Belt-tightening" was prescribed for spending -- wonderful if you're a household, but seriously negligent and lazy if you're a family farm or a government with responsibilities. There was no aggressive effort to expand employment or incomes, quite the opposite. National priorities, such as energy independence, were left to half-hearted measures. Not surprisingly, this was the era that spawned the great divergence of incomes, the inequality that has now become corrosive and destabilizing to the society.

We listen to Keyserling in 1979 and we think, "We would be lucky to have these problems."

Compared with the attainable goals under appropriate changes in national economic policies and programs, the likely and very disturbing results of the projection of current national policies ... are: An average annual real economic growth rate of only 3.0 percent from 1979 to 1980, and the same average from 1979 to 1983; a productivity growth rate averaging only 1.8 percent throughout; an inflation rate of 9.0 percent in 1980 and 7.5 percent in 1983; real growth in federal outlays of only 2.5 percent during the first year and averaging only 2.2 percent during the period as a whole; and an unemployment rate of 6.8 percent for 1979 and averaging 6.5 percent for the whole period.
...

GDP 1979-1983

The President's [Carter's] goal for real economic growth is 3.3 percent from 1978 to 1979, and this has already turned out to be unrealistic on the high side. The goal is only 2.2 percent for 1980. Both of these goals are egregiously below our needs and capabilities at almost any time. Viewing the goals for these two years, the President's 3.8 percent average annual growth rate for 1978-1983 is utterly unattainable. It would require a real economic growth rate during 1980-1983 which is pie in the sky in terms of the programs and policies which he sets forth. And it is pure pie in the sky, under these goals, to expect to come anywhere near the goal of 4.0 percent unemployment in 1983, which the president also sets. The President projects a productivity growth rate averaging only 1.5 percent annually for the period as a whole. This is a surrender to the declining growth rate which has resulted from repeated economic stagnations and recessions, and it is not at all consistent with our revealed capabilities during good economic performance years, nor with the requirements for full production.

The President's goals for major components of GNP also do violence to the requirements for economic balance or for an acceptable rate of real economic growth. By way of example, at the start of 1979, the President projected for that year real economic growth rates of only 1.7 - 2.25 percent for consumer expenditures, and only 0.75 - 1.25 percent for Federal purchases of goods and services. His projection of 4.0 - 4.5 percent for nonresidential fixed investment is far out of balance with the other projections, and unattainable in terms of them. The President also projected for 1979 a real rate of increase in Federal purchases of 0.75 - 1.25 percent. This is also very low, and out of balance w9ith an non-supportive of some of the other goals.

The President commits himself to a "lean and austere" Federal Budget, with outlays rising at an average annual rate of 1.4 percent during fiscal 1979 - 1983, and generally declining from year to year. In ratio to GNP, this would represent a decline from 21.55 percent in fiscal 1979 to 20 percent or lower in fiscal 1983. That might be acceptable in a rapidly expanding economy; it would be intolerable in a repressed and slowly growing economy. Such Federal Budget trends in actuality would portend great losses for the economy and great hardship for large portions of the people.

All in all, to put it mildly the President has committed himself to the contrived development of the recession which is now under way, although in early 1979 his Economic Advisers denied that a recession was just around the corner."

...

In any event, the goals are dismal in terms of our needs and capabilities, or in terms of fulfilling the mandate of the Humphrey-Hawkins Act.

Indeed, the experience of the economy was substantially worse than Keyserling envisioned in 1979. GDP shrank by 0.3 percent in 1980, recovered to 2.8 percent in 1981 and shrank again, this time by 1.9 percent in 1982. The average for the period 1979 to 1983 was 1.3 percent. Unemployment skyrocketed under Reagan, 10.4 in 1981, 11.7 percent in 1982 and still growing at 12.2 percent in 1983. Meanwhile the deficits of $28 billion in Carter's austere year of 1979 ballooned to $60 billion in 1980 and then ever higher, being $195.4 billion in 1983.

Keyserling's book "Liberal" and "Conservative" National Economic Policies and their Consequences, 1919-1979 draws the end of the "liberal" regime in 1969, with the last four years of this period 1966-69 being decidedly more mixed than the period up to 1966. In 1979, he had not yet experienced Reagan, Supply Side, the Laffer Curve, triple digit budget deficits, massive budget deficits, double digit unemployment (except for two years under Nixon and Ford), the stagnation of wages, and the rest. Nor had he experienced the rise of the financial sector and the Ponzi finance that was to mark the 1990's and 2000's.

In Keyserling's world the overcapacity and under-consumption of private and public goods would certainly lead to serious economic consequences. Others looked at the correspondence of investment and growth and determined that stimulating investment would bring the economy out by itself.  Keyserling saw the only road as balanced growth, beginning with consumption, jobs and government outlays.  Debt was incurred to finance investment in productive physical assets: factories, machinery, housing. His recessions were imbalances of overcapacity and inadequate consumer or government demand.

Although Hyman Minsky had already teased out the principles of the Financial Instability Hypothesis and the structures of hedge, speculative and Ponzi financing, the role debt could play in extending demand while it destabilized the economy was not obvious in the 1970s. The growth of debt over the next thirty years, public and private, sponsored much of the demand that has kept the economy afloat. And when debt and debt service became too large, the economy stopped. That is where we are now.

The Fed and others believe the answer is more debt and more and riskier investment, but Keyserling would have objected in flamboyant terms. there is plenty of investment, far too much, promoted by years of tax concessions to business and inadequate support to labor and government outlays.

Demand Side sees government outlays and debt restructuring in the private sector as being the two pillars of any recovery. The government spending needs to come in the form of needed infrastructure investment, physical and social, and green jobs. The debt restructuring needs to be substantial, not only to revive consumer spending, but to return some form of market discipline to the financial sector.

Human and Social Capital, plus the "Retirement Co-op" proposal

This week's folder is labeled Human and Social Capital. We're going to get into some forecasting problems, and then to a specific scheme to solve a looming problem for many people, the boomers, in retirement financing, but first some notes.

It's funny how people get more respect when you consider them alongside machines or land or natural resources, and that is what happens when we put capital alongside "human" or "social." We begin to see that the society does better when people are better educated and in better health, irrespective of the increase in well-being to those people themselves.

There is an educational level -- skill level, if you must -- and a level of health that creates an intrinsic value that can be tapped. When we allow our educational systems to deteriorate -- often as a result of misguided schemes to hold teachers "accountable" -- or our health systems to run to high cost and low benefit -- often for the benefit of mega-corporations wearing free market costumes -- we are letting our infrastructure and capital decay just as surely as when we let the roadways turn to potholes or the sewer systems break.

Notice the difference between human capital and social capital. The educational and health care systems are parallel to physical capital, as well, and when we allow these, or police, or courts, or parks and libraries, or any of the rest of the utilities-type social services ... transportation ... to deteriorate, it is no different than a company allowing its production facilities to fall apart. Yet, corporations who would never let their machines rust or their roofs leak demand that the public sector do just that in the name of fiscal responsibility.

So when we consider the forecast for the medium and long-term futures, we need to take account of the crumbling human and social capital. But there are other issues.

One of them is the tendency to place more emphasis on the read-outs on the economic indicator dials -- GDP, investment, inflation, the rest -- than on the obvious condition of the infrastructure and what that portends for the future. Or for that matter, on the obvious condition of the population, its finances, health, security, and so on. One of the issues in this metrics vs. real condition that has gotten good attention recently is income disparity.

Which society is healthier, the one where the average income is $40,000 or the one where it is $50,000? Not enough information. In a society of 25 people, if 24 are getting $10,000 per year and one is getting a million, it is not clear that this is better than when all 25 are getting $40,000.

So, combine the two problems, the ignorance of social and human capital in the assessment of national well-being and the problem that the metrics often miss the mark, and you have a recipe for bad policy. Here we come again to health care, but also to retirement. One side says, cut the funding for social insurance, increase the contributions, raise the retirement age. But this doesn't fix the problems of growing older or being sick, it just shuffles the accounts and pushes people into private insurance. This is a more costly alternative, not as efficient, but it is good for GDP, or at least that part of GDP associated with the providers. In fact, as a public good, we need to universalize health care to drive the costs down. Doesn't do a thing for GDP. But we also need to make retirement efficient.

That brings us to today's special post, delivered partly for a want of time, since this is in the can from another project, but partly to offer a way out of the current and prospective dead-end for many baby boomers entering retirement. The investments many have made, the 401(k)s and individual retirement plans, have shrunk sadly under the Fed's easy money for the banks and corporations policy. A million dollars which returned $70,000 per year now returns half that. The house we were going to sell for a fat profit is now not worth enough for the down payment on the next one.

So, we've put up the Retirement Co-op Scheme. You can find the whole post below. But if you want to comment, please go to Retirement Co-op (http://retirementco-op.blogspot.com/) It is the first cut at this. Hopefully the concept comes through. There are a lot of details and aspects not directly addressed.

It offers retirees a way of securing their future in a very insurance-like way, entering a community before they need to join one physically, converting their energy, talent and property into the services they need while retaining equity and maximum estate value.


Basics

Issue:

People are entering retirement without adequate resources to fund traditional schemes. Drastic drops in the returns on savings and investment over recent years make the individual retirement scheme less and less viable. The process of retirement, from early, active stages to later, more restricted and dependent stages is clouded by uncertainty. Many retirees are capable, talented and interested in community. Many are determined to remain in their homes, in "independence" that may become simply isolation.

Question:

Is there a way to organize resources, particularly the property and energy and talents of retiring people in an efficient way that will provide adequacy and certainty to their physical and financial futures?

Proposal:

A non-profit corporation which (1) assembles a group of retirees with common or complementary interests, (2) converts time, talent, energy and property resources to shares in the corporation, and (3) uses these shares as a kind of currency to maintain the facilities and provide the services for their retirement.

Discussion:

Let us illustrate with two examples:

(1) A widow who owns her home and wants to remain in it as long as possible.

This person would buy the "plan" by transferring her house to the non-profit corporation (hereafter, "the Co-op") in return for shares. [She would retain residual rights to the property and the prerogative to remain there as long as possible, as well as the option to "buy back" her house for the original payment.] She would use the shares to procure services through the Co-op for meal services, home health care, grounds maintenance, personal services, etc. The widow would never be required to move. If she wanted to exit the plan, she would need only to reimburse the Co-op in the amount of shares used. This last option would be available only to the point she stayed in the home. If she moved to a group home or other Co-op facility, the home would not be recoverable in this manner.

(2) Person or couple with no property

This person would buy the Co-op "plan" with cash or services. The payments could be lump sum or streaming, and could come in the form of cash or services provided to other Co-op members. In between these two examples lie any number of combinations.

Service providers:

Three key classes of service providers make this program work:

(1) The retirees themselves who provide services in exchange for shares in their own plans.

Cooking, grounds keeping, health care, transportation, personal services, cleaning, entertainment, education, management are all services that are needed by some which could be provided by other Co-op members. The transfer of shares between the two is a key part of keeping costs down and eligibility up.

(2) The motivated group home manager.

Absolutely essential to a successful group facility is the manager. This person needs to be well rewarded as well as well oriented in terms of personal values. He must be enrolled in the plan himself, so as to give a personal stake in success. His remuneration might well come in the form of property. That is, he might occupy Co-op owned facilities before retirement as well as after. This should be a desirable and lucrative position.

(3) Non-member providers.

People hired to provide services who are not members may also receive remuneration in one of three ways: wages, housing services (living arrangements in Co-op owned facilities), or shares.

Plans:

The plans would be lifelong insurance and provide a transition from more to less independence, and fewer to more services. Actuarial determinations would be made to determine the level of plan buy-in. Different plans might be offered depending on facilities and services provided. Everything from complete stay-in-your-home support to modest quarters in a group home. In between would be apartment-style, clustered living, or other arrangements. The transition from one living arrangement to the next would be voluntary, with limitations and restrictions known well in advance. Services available would depend on the buy-in and accumulation of shares through services provided by members.

Note here: It is not necessary for the buy-in to cover the entire projected lifespan and needs of the individual. As with private individuals, a certain wealth and income level enables Medicaid support. An individual who enrolls in the Co-op plan who exhausts his or her shares, would continue in the co-op supported by Medicaid. Similarly, health care would be coordinated with Medicare. Nobody would ever lose their access to services and facilities after being enrolled.

Management:

The co-op concept reduces costs, provides certainty and control to members, and converts retiree's resources into the services they will need. It uses shares in the nonprofit as a kind of currency to make this conversion efficient. The concept is simple, but the execution will be complicated.

The accounting for what is needed, by whom, who receives payments in what form, what types of facilities are required, will be a matter that needs close attention. It must be clear to all current and potential members that their property is safe, their shares convertible in some form and their futures not at risk. The legal structure must be air tight to assure, for example, residual rights as above to the widow, and to make sure shares are directly backed by claims on real property.

As a nonprofit, the Co-op would be run by a board of directors elected by member-shareholders. The board would hire managers who would oversee operations. managers would be required to be co-op members. A strict auditing regime would be required for both finances and operations. Members' choices would determine what facilities were obtained, what services provided, and when. These choices would be updated regularly.

Summary:

The intent is to provide an efficient mechanism to transfer property, talent and energy to a retirement program that is transparent and complete. The mechanism is the non-profit corporation, the Co-op, and the shares of the Co-op which act as a kind of currency. Co-op plans are basically retirement insurance and rely on coordination with public sector insurances, such as Medicare, Social Security and Medicaid.

Addenda:

The Co-op, again, would be a kind of insurance, as well as a retirement plan.

Property would be valued in terms of shares for its functionality to Co-op needs, not by its market value. Thus an expensive house, say in an up-scale neighborhood, may have the same value to the Co-op as a more modest or appropriately designed house elsewhere with a much lower market price. The potential member who is a homeowner may not want to covert that property to shares in line with Co-op appraisal, but rather to sell and either buy in via cash, or to buy another property that is more in line with Co-op valuations.

There is no particular need for Co-op facilities to be geographically concentrated, except as indicated to keep providers of services from having to travel too far from one home or facility to another.

Because of the complexity of execution, there is probably a critical mass of some number over 15 members and some need for grant funding to identify the legal constraints and to backstop a pilot project.

Again, coordination of social insurance benefits with Co-op services and facilities is an important element that keeps costs down and eligibility up.

A health assessment would be required upon admission, not so much to restrict access as to tailor plans. It would not be efficient, for example, to maintain somebody in their home who for severe health issues needs more intense monitoring and services.

The two simplest models that inform this proposal are: (1) the individual homeowner with a mother-in-law apartment, who "rents" the apartment to a person in exchange for services, and (2) the group home with a dedicated manager/RN.


Next Steps:

(1) Vetting by you. Your comments are very valuable. Submit them in the comments section at Retirement Co-op or e-mail us at demandside@live.com.

(2) Obtaining grant funding for a pilot project. Again suggestions are useful. We anticipate submitting this to the AARP for suggestions.

Commodities

This segment of reMacro is reserved for Commodities, Resources and the Commons. We're going to begin with a look at commodities markets, as they are a serious problem and an ignored risk.

Commodities have become an investment vehicle. Speculation has divorced the market price from the physical supply-demand price. Futures markets that were once 70 percent hedging and 30 percent speculation are now the reverse.Once the futures markets were ways to hedge price exposure. Farmers and other producers of commodities could lock in a price that made sense and operate accordingly. Users of commodities could lock in a price that made sense in their production schemes. Price surprises could be avoided.

That has changed. Commodities are no longer products or intermediate goods whose prices need to be hedged. They have become an asset class, and futures markets have become their stock markets. That is not quite accurate. With the advent of exchange traded funds -- ETFs -- commodities are now traded like stocks. Not for their intrinsic value, but for their value as chips in the casino.

It is fair to say that speculation has a long history and is needed to keep markets liquid. Speculation is by definition an attempt to profit by movements in prices. John Maynard Keynes is said to have been good at it. Farmers themselves have tried it by simply withholding sale, as in the period directly after World War II. But with the advent of cash settlement, where you no longer have to take physical delivery of your commodity if you hold the futures contract to completion, and then with the advent of the ETF, speculation has moved to a new level.

The series of charts below demonstrates the scale of the commodities distortion. Dare we call it a bubble? The pattern is evident across all classes of commodities except gold. [Gold has been called a currency, and certainly it displays the characteristic of steady appreciation against the dollar.] Supply and demand are plainly overwhelmed by the great swings in prices. (Chart Source:  Seeking Alpha.)

Major Commodities Indexes

Oil

Food

Coal

Copper

Gold

Prominent investor Jim Rogers has fingered tight supply and more importantly the easy money policy of central banks as bullish for "physical assets," as he calls commodities. We do not see the tight supply, but we do see the printing of money. Rogers' thesis is that this appreciates the value of physical assets in the same manner as with gold. We see it as providing chips in the casino, and there is no reason the bets should pay off just because they are larger.


Distorted commodities prices, particularly food prices, have real and tragic consequences. Desperation and social disruption across the globe heightens when food is priced out of reach of people. The current crisis in Egypt is sharpened by this effect. (Egypt is also a laboratory of another aspect of commodity distortions, which is the preference given to U.S. industrial cotton farms in contrast to the cotton producers in Egypt, which reduces incomes and standards of living there. This will be taken up in a future Commodities-Resources-Commons segment.)


The Influence of Commodity ETFs on the Commodity Markets

By Chuck Kowalski, About.com Guide

Commodity ETFs and ETNs have become a new and easy way for investors to trade commodities and include them as part of their long-term investment portfolio. However, commodity ETFs have somewhat changed the dynamics of the markets, as some believe this wave of new funds into the markets has increased volatility, ultimately leading to exaggerated moves in commodity prices.

How Commodity ETFs Work

Commodity ETFs are funds that invest in commodities. They typically invest in futures contracts on an unleveraged basis. Money flows into and out of the ETFs similar to the way mutual funds invest in stocks. When people invest money into the funds, the fund manager has to buy a designated amount of commodities – or futures contracts. Oppositely, when a person redeems funds in the ETF, the fund manager has to sell a proportional amount of futures contracts.

There is an obvious flow of money coming into and out of these funds each day. The net result is what you want to follow. You’ll often find that investors tend to put more money into the commodity ETFs that are moving higher. They also have a tendency to avoid the markets that aren’t hot.
Overall Commodity Investments

It is important to note that commodity ETFs typically are not leveraged like futures contracts. Some funds are leveraged 2x or 3x, but not to the degree of futures contracts. In theory, this would drop the likelihood that commodity ETFs lead to over speculation and exaggerated price swings. After all, it is still a large capital outlay and it takes a great deal of money to move markets. However, there are still some underlying concerns with commodity ETFs that might eventually cause greater problems.

The commodity ETFs that invest in the actual commodity, like SPDR Gold Shares (GLD), are supposed to buy actual gold. The fund is currently worth about $72 billion. That means the fund should have bought and is currently holding $72 billion of gold in storage. In reality, that is probably not the case and some experts in the investment world believe this is cause for concern.

It is unlikely that every owner of the SPDR Gold Shares would want to redeem their investment in gold at the same time. If you could picture a stampede of people wanting their $72 billion worth of gold, that is what it would be. What would happen if the fund couldn’t make good on this redemption? Certainly they would pay in cash, but that really isn’t the point.

The issue of commodity ETFs influencing the markets might become clearer if you realize that investors can continue to buy an asset where there is really no claim on it. What if there was only $100 billion worth of a commodity in the world, yet a commodity ETF was holding $200 billion worth of claims on those commodities. Is that how things should work?

A good case could be made that the fund is oversubscribed and they should only be allowed to accept investment dollars in a commodity that they can actually attain for their investors. That sounds good on the surface, but what happens when you have too many dollars chasing too few goods? Yes, the price rises and some times substantially. You would get the same result in price with or without a commodity ETF. An argument could be made that prices would actually be higher if investors could only purchase the readily available supplies.

Commodity ETFs have opened the door to a new crowd of people to invest in commodities and there is actually more money invested in commodities today. Many investors and money managers won’t invest in futures contracts, but now they have a new mechanism to participate in commodities. Commodity ETFs aren’t necessarily to blame for the volatility in the markets. They might be the vehicle that brings extra money to the markets, but you still have the same investor mentality. The only difference now is that there are more investors and more money – that is what causes the wider swings in the market.


Are ETFs To Blame For Over-Speculation, Record-Correlations, And A Potential Crash?

Seeking Alpha
October 19, 2011
ETFs are huge enablers for soaring stock and commodity prices. And like their mutual fund predecessors, ETFs may have encouraged mass over-speculation that will ultimately result in a stock market crash.

ETF investing continues to be a top choice for diversification, targeted exposure, and specific strategies; but they have caused such mass speculation and have inflated prices to such an extent, that their intended benefits may actually be void and nullified by the tremendous risks and unintended consequences they have posed. ETFs have increased speculation, massively inflated stock and commodity prices, and may be responsible for the unprecedented and hugely-risky correlations across all stocks, sectors, and markets.

ETF Overview

Exchange Traded Funds (ETFs) are a revolutionary financial innovation, and provide many benefits for both individuals and institutions. Bought and sold much like stocks, ETFs are listed on exchanges and allow investors to trade them throughout the day. Like mutual funds, ETFs aim at providing diversification and exposure to a wider range of individual stocks or assets. Unlike mutual funds, however, ETFs can be traded all day, since their prices are instantaneously adjusted. Moreover, ETFs are cheaper and easier to invest in than mutual funds.

ETF Uses

ETFs represent a portfolio of individual stocks, and provide an enormous number of uses – from tracking broad stock indices (like the S&P 500 (SPY) or Russell 2000 (IWM), for example), to investing in specific themes or sectors (like technology (XLK), financials (XLF), housing (XHB)), to providing exposure to emerging markets and individual countries (emerging markets (EEM), China (FXI), Brazil (EWZ), etc.), to currency investment (US Dollar (UUP)), Euro (FXE)), to volatility (VXX), to commodities (Oil (OIL), Gold (GLD), Natural Gas (GAZ)), to bonds (TLT, TBT), and even to actively-managed trading strategies. In other words, ETFs are exceptional tools for individuals and institutions to invest in commodities, sectors, countries, bonds, currencies, strategies, and just about any investment theme imaginable. ETFs provide a way for the average person to invest in a wide basket of stocks which he otherwise would not be able to.

ETFs offer many uses for portfolio strategy and asset allocation:

They also provide a slew of reasons why investors should use them as part of their investment approach:

ETF Industry

With so many innovative uses and benefits, it is no surprise ETFs have grown at such a rapid and perhaps unprecedented pace. By May 2011, there were 2,747 ETFs offered by 142 ETF providers and traded on 49 exchanges – adding up to $1.446 Trillion in assets! There were also plans to launch an additional 1,022 ETFs. With such a huge number of ETFs being traded, there is no doubt that ETFs have revolutionized stock market trading – the question now, however, is “how have ETFs affected markets?”

Massive ETF Growth

Since their introduction, ETFs have grown tremendously – from $0.8 billion in 1993 to nearly $1.5 trillion by May 2011:

ETFs’ popularity has soared largely because institutions have embraced them:

ETFs have also made it much easier and more accessible for individuals and institutions to invest in commodities:

Prior to ETFs, investment in commodities such as oil, gold, grains, and others was limited to commodity traders, futures, or buying the physical commodities themselves. ETFs have provided a means for the common investor to buy these commodities from the comfort of his or her home, without any expertise or knowledge of the underlying asset. To make matters worse, the availability of these ETFs and the constant touting by the institutions that sell them, has greatly increased speculation in commodities and tremendously inflated prices. It is easy to understand why we’ve seen such massive rises in commodity prices over the past few years – investors have poured billions of dollars into commodity ETFs in order to profit from the shortage they expect, as China and emerging markets demand more and more commodities and raw materials for their growing economies. The major problem, however, is that it has become extremely hard to track exactly how much of this commodity price surge is due to real demand – as opposed to the inflated demand that ETFs have caused. In other words, commodity prices could be severely out of whack with reality and way beyond where they should be.

ETFs may have offered tremendous benefits when they were introduced, and still continue to offer investors a way to pick specific sectors, themes, individual commodities, etc; but we are at a point where ETFs may have created such investor frenzy and over-investment, that current prices for stocks and commodities may be highly overextended – and set for a sharp pullback.

Mutual Funds vs. ETFs

ETFs have essentially made mutual funds obsolete. For decades, mutual funds were the number one way for investors to diversify and gain exposure to specific strategies and professional money managers. The introduction of the ETF, however, has made it easier, cheaper, and more effective to invest. Mutual funds have therefore seen large outflows over the past decade, as investors who were disillusioned by terrible mutual fund performance have pulled out their money. Investors simply have no good reason to keep their money in mutual funds when so many funds actually underperform and fail to beat the market while still charging high management fees. ETFs are cheaper, easier to buy and sell, and allow investors to bet on whatever they choose.

Mutual Funds, The Technology Bubble, and The Rise of ETFs

In the technology bubble era, stocks rose to extreme levels because investors were piling into technology stocks and, most importantly, mutual funds. Mutual funds were seeing huge inflows of new investors, and the money that came into these “diversified money managers” was then being invested into the stock market – sending stock prices even higher.

Eventually, after millions of investors piled their money into these mutual funds and the stock market in general, the technology bubble collapsed, and the stock market fell, and mutual funds lost their investors billions of dollars. Average investors, professionals, people with retirement accounts like 401ks or IRAs, and others lost a large chunk of their investment value.

Mutual funds are essentially an investment fund led by one or more portfolio managers. These managers accept investments, trying to invest the funds appropriately in order to make their investors profit. Most funds, however, charge a management fee just for investing. Even if the fund does not gain for the year, the manager may still get paid for managing the investors’ money. The investor is actually worse off in the mutual fund than if he owned a stock of the broader market. In other words, the fund manager did worse than the overall market, when he was actually hired by the investor to beat the market.

It is no surprise then, that mutual funds lost a lot of their appeal when the tech bubble burst and when NASDAQ and stock markets fell from 2000 to 2002. A new financial instrument was about to launch into mass popularity – the ETF. Since so many mutual fund managers couldn’t beat the market, why should investors keep their money invested there? If investors just bet on the overall market they could’ve beat the mutual fund’s returns. Yet there were few if any ways for investors to invest in the broad markets; investors would have to buy a very wide selection of stocks that represented the whole market, and track each of those positions to closely monitor the portfolio allocations. The average, and even the professional, trader simply don’t have the means to buy so many stocks and monitor them closely. Yet diversified exposure to the overall market was still available mainly through mutual funds.

The innovation of ETFs, however, largely cuts out the middle man (portfolio manager), lowers fees, and allows investors to invest in broad themes and overall stock indices that track markets. In other words, if the mutual funds were failing to beat the market, why not just bet on the market? ETFs were invented to very closely track the overall markets or sectors by buying a proportional share of stocks to mirror an index or sector. Investors now had an investment vehicle that was pretty much automated, cutting out the costly middle man and eliminating poor investment choices. Instead, investors could now just “buy the market” and expect the 8% return that the market averaged per year, going back 60 or more years.

Irrational Exuberance in ETFs?

ETFs are undoubtedly an amazing innovation in investing, but may have also helped create over-speculation and unwarranted price increases in the underlying stocks and commodities. By offering an easy, cost-effective, and highly-intriguing way of investing, ETFs have created the illusion that investing is less risky than it really is. ETFs have also massively boosted stock and commodity prices, as investors who were once not able to invest in certain stocks or commodities now bid up the prices of the underlying stocks and commodities by buying ETFs.


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