Monthly Archives: October 2013

Blog Post of the Year?

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John Cochrane’s post on Nobel Laureate Robert Shiller is certainly a contender. It’s long, and you should read the whole thing. Of many possible excerpts, I choose:

No matter where you look, stock, bonds, foreign exchange, and real estate, high prices mean low subsequent returns, and low prices (relative to “fundamentals” like earnings, dividends, rents, etc) mean high subsequent returns.

These are the facts, which are not in debate. And they are a stunning reversal of how people thought the world worked in the 1970s. Constant discount rate models are flat out wrong…

To Fama, it is a business cycle related risk premium. He (with Ken French again) notices that low prices and high expected returns come in bad macroeconomic times and vice-versa. December 2008 was a recent time of low price/dividend ratios. Is it not plausible that the average investor, like our endowments, said, “sure, I know stocks are cheap, and the long-run return is a bit higher now than it was. But they are about to foreclose on the house, reposess the car, take away the dog, and I might lose my job. I can’t take any more risk right now.” Conversely, in the boom, when people “reach for yield”, is it not plausible that people say “yeah, stocks aren’t paying a lot more than bonds. But what else can I do with the money? My business is going well. I can take the risk now.”

To Shiller, no. The variation in risk premiums is too big, according to him, to be explained by variation in risk premiums across the business cycle. He sees irrational optimism and pessimism in investor’s heads. Shiller’s followers somehow think the government is more rational than investors and can and should stabilize these bubbles. Noblesse oblige.

By the way, Cochrane’s post on Lars Hansen is also top notch.

Pinpoint the Scandal

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The Sunlight Foundation reports,

All but one of of the 47 contractors who won contracts to carry out work on the Affordable Care Act worked for the government prior to its passage. Many–like the Rand Corporation and the MITRE Corporation–have done so for decades. And some, like Northrop Grumman and General Dynamics, are among the biggest wielders of influence in Washington. Some 17 ACA contract winners reported spending more than $128 million on lobbying in 2011 and 2012, while 29 had employees or political action committees or both that contributed $32 million to federal candidates and parties in the same period. Of that amount, President Barack Obama collected $3.9 million.

I don’t hold it against the contractors that they had prior government experience. I don’t hold it against them that they lobby or contribute to campaigns.

To me, the scandal is that there are 47 different organizations involved in building the site. I cannot imagine that any sane project executive would want it that way. I am just guessing, but it seems more likely to me that this many contractors were imposed on the project executive because there was a requirement to “spread the work out” to keep all these companies in the politicians’ pockets.

In any case, if you are trying to fix something that was assembled by 47 different organizations….good luck with that. Megan McArdle considers the possibility that it won’t get fixed in time.

Private Securitization and the Housing Bubble

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Adam J. Levitin and Susan M. Wachter write,

We argue that the bubble was, in fact, primarily a supply-side phenomenon, meaning that it was caused by excessive supply of housing finance. The supply glut was not due to monetary policy or government housing finance. The supply glut was not due to monetary policy or government affordable-housing policy, although the former did play a role in the development of the bubble. Instead, the supply glut was the result of a fundamental shift in the structure of the mortgage-finance market from regulated to unregulated securitization.

Pointer from Reihan Salam.

The implication is that if government regulates securitization, things will be fine. Some problems I have with this analysis:

1. They do not examine how the market for “unregulated” securitization was in fact bolstered by capital market regulations. Take away the regulatory advantage for AAA-rated and AA-rated securities, and I do not think that the securitization market is able to take off. Remember that capital requirements for banks were so perverse that holding a tranche in a pool backed by sub-prime mortgages required more less capital than originating and holding a low-risk mortgage.

2. The “regulated” sector, namely Freddie and Fannie, lowered its standards at exactly the wrong time, in 2005 through 2007. Several private players, including AIG, either exited the market or tightened standards before the bubble burst.

3. The problem with private securities is not that they lack standardization. It is that the whole securitization model is flawed. It introduces more costs than benefits into the mortgage finance system. That fact has been obscured by all of the support that government has given to securitization, including the “too big to fail” status of Freddie and Fannie and the perverse capital requirements noted in (1) above.

Wither 90 percent of employment?

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Some analysts at the Gartner group are buying into Average is Over.

From 2020 to 2030, “you are going to see the first human-free enterprise — nobody is involved in it, it’s all software, communicating and negotiating with one another,” said Diane Morello, a Gartner analyst, who has looked at how smart machines will reshape employment.

The upshot?

On an extreme end of the scale, he [Gartner’s Kenneth Brandt] put the impact of smart machines at 90% unemployment, which is either catastrophic or leads to a utopia, where basic needs are met and people are free from drudge work.

Money Illusion in Wage Behavior: How Important?

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Simon Wren-Lewis writes,

My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages. There is overwhelming empirical evidence for this phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer Smith at Warwick). The behavioural reasons for this are explored in detail in this book by Truman Bewley, which Bryan Caplan discusses here. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioural economics.

Read his whole post. The paragraph I quoted includes links that I did not transfer here. Pointer from Mark Thoma.

Some comments:

1. Just because something can be shown to exist at the micro level does not mean that it is important at the macro level. (This is in some ways equivalent to the point that just because you have what you think makes a neat microfoundation does not mean that it helps you with macro.)

2. In particular, if worker A at firm X suffers from money illusion, that does not imply that macroeconomic behavior will look like that worker and firm. There is plenty of exit and entry among firms as well as turnover in the labor force.

3. Indeed, I happen to agree with Robert Solow that what makes the DSGE framework so unpromising is that it typically insists on modeling a single consumer/worker/capitalist as representative of the entire economy. Obviously, you tend to forget about entry and exit and labor force turnover when you do that.

4. When one looks at macroeconomic data for evidence of money illusion, the results seem to me to be decidedly mixed.

a. Matt Rognlie writes,

A large output gap is extraordinarily effective at bringing inflation down from, say, 8% to 2%, but far less effective at bringing about a drop from 2% to -2%.

If that is true, then it looks like a point in favor of money illusion. To believe that it is true, you have to believe in the original Phillips Curve. That’s easy to do if your macroeconomic thinking was shaped by the 1960’s. Maybe it’s easy to do if your thinking was shaped by the last five years, although in that case you have only observed one region of the Phillips Curve. Looking at other time periods raises doubts.

b. If you put your chips on nominal wage stickiness to explain recessions, then I do not see how you avoid predicting a countercyclical share of labor income in GDP. That prediction is strongly violated by a number of downturns, including the current one.

c. Also, if you put your chips on nominal wage stickiness, youth unemployment should be relatively low in a recession. People who are just entering the job market are not comparing current job offers to previous salaries.

d. If there is money illusion, probably there are other illusions that allow employers to adjust at the margin without being able to reduce wages. As an employer, I can put more work on your desk. I can reduce bonus payouts. I can require a longer vesting period for stock options or pension benefits. I can reduce the match on your 401(K). I can increase what you have to contribute to health insurance. There seem to be enough margins available that sticky nominal wages should not matter.

5. On balance, I think that the case for wage stickiness as a crucial macroeconomic phenomenon is quite flimsy, notwithstanding the strong case for nominal wage stickiness that can be made by looking at micro behavior.

Brad DeLong Makes an Omission

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He writes,

So what do economists have to say when they speak as public intellectuals in the public square? As I see it, economists have five things to teach at the “micro” level–of how individuals act, and of their well-being as they try to make their way in the world. These are: the deep roots of markets in human psychology and society, the extroardinary [sic] power of markets as decentralized mechanisms for getting large groups of humans to work broadly together rather than at cross-purposes, the ways in which markets can powerfully reinforce and amplify the harm done by domination and oppression, the manifold other ways in which the market can go wrong because it is somewhat paradoxically so effective, and how the market needs the state to underpin and manage it on the “micro” level.

Pointer from Mark Thoma.

The phrase “the ways in which markets can powerfully reinforce and amplify the harm done by domination and oppression” locates Brad on the three-axis model, doesn’t it? You can read his post and see whether his examples prove his point. I tend to think not, but I do not want to focus my post on this issue.

What is absolutely missing in Brad’s list is any mention of public choice. Thus, we are left to take the enchanted view of the state as the cure for all of the market’s problems. Is he saying that economists are not qualified to speak about the flaws in government processes? Or is he saying that even though we know something about incentive problems and institutional weaknesses of government, we should shut up about it?

If Brad were to employ this gambit in a debate on economic philosophy, I think he would be dead out of the opening, as a chess player would put it.

The 2014 Nobel Laureates Fama, Hansen, and Shiller

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What they have in common is the “second moment.” In statistics, the first moment of a distribution is the mean, a measure of central tendency. The second moment is the variance, or spread. Politically, their views have a high second moment. If they are asked policy questions during interviews, the differences should be wide.

Shiller is known for looking at “variance bounds” for asset prices. Previously, economists had tested the efficient market hypothesis by looking at mean returns on stocks or bonds. Shiller suggested comparing the variance of stock prices with the variance of discounted dividends. Thus, the second moment. He found that the variance of stock prices was much higher than that of discounted dividends, and this led him to view stock markets as inefficient. This in turn made him a major figure in behavioral finance.

Fama was the original advocate for efficient markets. However, he was an empiricist. He verified an important implication of Shiller’s work: if stock prices vary too much, stock returns should exhibit long-run “mean reversion.” Basically, when the ratio of stock prices to a smoothed path of dividends is high, you should sell. Conversely, when the ratio is low, you should buy. Mean reversion also says something about the properties of the second moment.

Finally, Hansen is the developer of the “generalized method-of-moments” estimator. This is a technique that is most useful if you have a theory that has implications for more than one moment of the distribution. For example, Shiller’s work shows that the efficient markets hypothesis has implications for both the first and second moment (mean and variance) of stock market returns.

Although Tyler and Alex are posting about this Nobel, I think that John Cochrane is likely to offer the best coverage. As of now, Cochrane has written two posts about Fama.

In one post, Cochrane writes,

“efficient markets” became the organizing principle for 30 years of empirical work in financial economics. That empirical work taught us much about the world, and in turn affected the world deeply.

In another post, Cochrane quotes himself

empirical finance is no longer really devoted to “debating efficient markets,” any more than modern biology debates evolution. We have moved on to other things. I think of most current research as exploring the amazing variety and subtle economics of risk premiums – focusing on the “joint hypothesis” rather than the “informational efficiency” part of Gene’s 1970 essay.

Cochrane’s point that efficient market theory is to finance what evolution is to ecology is worth pondering. I do not think that all economists would agree. Would Shiller?

Some personal notes about Shiller, who I encountered a few times early in my career.

1. His variance-bounds idea was simultaneously discovered by Stephen LeRoy and Dick Porter of the Fed. The reference for their work is 1981, “The Present-value Relation: Tests Based on Implied Variance Bound,”’ Econometrica, Vol. 49, May, pp. 555-574. Some of the initial follow-up work on the topic cited LeRoy and Porter along with Shiller, but over time their contribution has been largely forgotten.

2. When Shiller’s Journal of Political Economy paper appeared (eventually his American Economic Review paper became more famous), I sent in a criticism. I argued that his variance bound was based on actual, realized dividends (or short-term interest rates, because I think that the JPE paper was on long-term bond prices) and that in fact ex ante forecasted dividends did not have such a bound. Remember, this was about 1980, and his test was showing inefficiency of bond prices because short-term interest rates in the 1970s were far, far higher than would have been implied by long-term bond prices in the late 1960s. I thought that was a swindle.

He had the JPE reject my criticism on the grounds that all I was doing was arguing that the distribution of dividends (or short-term interest rates) is unstable, and that if you use a long enough data series, that takes care of such instability. I did not agree with his view, and I still don’t, but there was nothing I could do about it.

3. When I was at Freddie Mac, we wanted to use the Case-Shiller-Weiss repeat-sales house price index as a check against fraudulent appraisals. (The index measures house price inflation in an area by looking at the prices recorded when the same house is sold in two different years.) I contacted Shiller, who referred me to Weiss. Weiss was arrogant and unpleasant during negotiations, and we gave up and decided to create our own index using the same methodology and our loan database. Weiss was so difficult, that we actually had an easier time co-operating with Fannie on pooling our data, even though they had much more data at the time because they bought more loans than we did. Eventually, our regulator took over the process of maintaining our repeat-sales price index.

4. Here is my review of Shiller’s book on the sub-prime crisis. Here is my review of Animal Spirits, which Shiller co-wrote with George Akerlof.

Finally, note that Russ Roberts had podcasts with Fama on finance and Shiller on housing.

Wither the World’s Manufacturing Employment?

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Dani Rodrik writes,

Consider China. In view of its status as the world’s manufacturing powerhouse, it is surprising to discover that manufacturing’s share of employment is not only low, but seems to have been declining for some time. While Chinese statistics are problematic, it appears that manufacturing employment peaked at around 15% in the mid-1990’s, generally remaining below that level since.

Pointer from Tyler Cowen.

Rodrik’s main point is that newly-developing countries, like China and Brazil, seem to have maxed out on their manufacturing employment without reaching the levels of income achieved by earlier industrializers, such as South Korea. He is concerned that this means poor growth prospects in the newer developing countries.

When the US, Britain, Germany, and Sweden began to deindustrialize, their per capita incomes had reached $9,000-11,000 (at 1990 prices). In developing countries, by contrast, manufacturing has begun to shrink while per capita incomes have been a fraction of that level: Brazil’s deindustrialization began at $5,000, China’s at $3,000, and India’s at $2,000.

By the way, the title of my post is not a typo.

To think about this, start with the idea that employment increases in sectors where demand grows faster than productivity, and employment declines in sectors where productivity grows faster than demand. That is not a very deep theory–it is arithmetic.

In rich countries, the share of goods in consumption has been declining for decades. The best hope for manufacturing growth in the newer developing countries is that their own consumers will want to accumulate physical stuff, the way we did in the middle decades of the twentieth century.

However, households in China today are not going to want what households in the U.S. wanted fifty years ago. Analog television? Stereos? Landline phones? Cars that don’t last more than a few years?

Maybe no country today has to go through a phase in which 1/4 of its labor force works in manufacturing. Middle-class households around the world can get the stuff they want without devoting so much labor to that sector.

It may be that the cost of the manufactured goods that a middle-class household wants nowadays is so low that Brazil, China, and India are already middle class in that respect. Our own middle-class incomes are much higher, but we fritter that away on cost-ineffective health care and education.

I think that this is an important point about the nature of inequality, both in the U.S. and in the world. A higher proportion of people can afford food. A higher proportion of people can afford useful goods, ranging from refrigerators to cell phones. However, a lower proportion of people can afford elite schools and unsubsidizedinsulation from having to pay directly for health care.

This is not your grandfather’s inequality. It may be better or worse, but it is different.

Consumer Spending and the Stimulus

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Jonathan A. Parker, et al, find a strong effect.

on average households spent about 12-30% of their stimulus payments, depending on the specification, on non-durable consumption goods and services (as defined in the CE survey) during the three-month period in which the payments were received. This response is statistically and economically significant. Although our findings do not depend on any particular theoretical model, the response is inconsistent with both Ricardian equivalence, which implies no spending response, and with the canonical life-cycle/permanent income hypothesis (LCPIH), which implies that households should consume at most the annuitized value of a transitory increase in income like that induced by the one-time stimulus payments. We also find a significant effect on the purchase of durable goods and related services, primarily the purchase of vehicles, bringing the average response of total consumption expenditures to about 50-90% of the payments during the three-month period of receipt.

Their approach uses cross-section analysis, with differences across households in the timing of receipt of stimulus payments as the identification strategy.

IMF Official Joins the Daft

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The WSJ blog reports,

A senior official at the International Monetary Fund said Wednesday that it will be difficult for the Bank of Japan to meet its 2% inflation goal within its two-year time horizon, noting that inflation expectations aren’t growing significantly.

Those of us who are daft™ believe that inflation is only a monetary phenomenon if the monetary authorities do some really spectacular helicopter drops. Ordinary buying and selling of securities will not do it. To be fair, the official, Naoyuki Shinohara, seems to think that central bank purchases of stocks or real estate investment trusts could do the trick, so he may not be completely daft™.