Monthly Archives: April 2014

Short-termism

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While on a Sunday stroll, I encountered Jerry Muller, author of The Mind and the Market, among other works. He asked me what I thought about “short-termism.” Mostly, I think that it is a difficult concept to pin down.

I guess my working definition would be that short-termism is a bias among executives to forego long-term opportunities in order to achieve short-term profit objectives.

But how would you measure it? What observations would confirm it?

For example, I might argue that, at today’s low long-term interest rates, a nuclear power plant looks like a high net-present-value investment for a utility company. Does their failure to invest in nuclear power plants reflect short-termism? Obviously, it is more complicated than that. There are regulatory barriers, site licensing barriers, and there is economic risk–suppose that ten years from now solar power becomes so inexpensive that the price of electricity no longer provides a decent return on the up-front investment? Not to mention the risk that the plant will have something wrong, or that the nuclear waste will be a problem, or some other risk.

The point is, it is very hard to separate pure time preference from risk when it comes to real-world investments.

Some other thoughts:

1. For the economy as a whole, most pundits think that the big long-term investment opportunities are in energy, computers/communications/robotics, nanotechnology, and biotechnology. My impression is that biotech is perhaps being held back by regulatory issues. But otherwise, I get the sense that investment is pretty active. Google certainly is making some long-term investments.

2. Sometimes, the financial crisis is blamed on short-termism. But there is very little evidence that the banks knew that they were making short-term profits that were going to turn sour in the long term. Instead, it seems that they believed that things were fine, both short term and long term.

3. If you were going to advise a firm to sacrifice some short-term profits in order to undertake long-term investments, which firm would that be? What investment should it make? Can you be confident that it is short-termism rather than concern about risk that is inhibiting the investment?

I’d Connect These Data Points

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1. From Atif Mian and Amir Sufi.

We are now five full years from the end of the recession (if you buy NBER dating). And housing starts are still below any level we’ve seen since the early 1990s!

Pointer from Mark Thoma.

2. Shaila Dawan writes,

Nationally, half of all renters are now spending more than 30 percent of their income on housing, according to a comprehensive Harvard study, up from 38 percent of renters in 2000. In December, Housing Secretary Shaun Donovan declared “the worst rental affordability crisis that this country has ever known.”

Pointer from Tyler Cowen.

By the way, I saw this coming, and so I made a big investment last year in several companies that own and manage apartments. The performance of these investments was terrible, particularly when compared with the overall market. Go figure.

John Cochrane vs. Financial Intermediation

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He writes,

demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For [money-market?] funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable.

I suppose Murray Rothbard would have liked this.

My own aphorism about financial intermediation is that the nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets, which the financial sector accommodates by doing the opposite. If that aphorism is correct, then Cochrane’s vision involves getting rid of financial intermediation.

I suspect that the optimal amount of financial intermediation is not zero. However, I suspect that it is not as much as we get in a world in which there is deposit insurance, too-big-to-fail guarantees, and tax advantages of leverage. Here, Cochrane’s tactical approach is interesting.

Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.

The way I put it is that you cannot make financial institutions too regulated to fail. So instead of trying to make financial institutions harder to break, try to make them easier to fix. This means taking away the incentives to adopt unstable financial structures. Cochrane would go further and penalize unstable financial structures using taxes.

Meanwhile, Peter Wallison warns that the command-and-control approach to regulation has a logic of ever-widening jurisdiction.

Yuval Levin on Scientism and Skepticism

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He writes,

But understanding human limitations does not mean we can overcome them. It only means we can’t pretend they don’t exist. It should point us toward humility, not hubris. And in politics and policy, understanding the limitation that Klein highlights should point us away from technocratic overconfidence and toward an idea of a government that enables society to address its problems through incremental, local, trial-and-error learning processes rather than centrally managed wholesale transformations of large systems.

I suggest reading the whole thing. I could have picked about any paragraph at random to excerpt.

Greg on Greg

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Meaning Cochran on Clark.

If moxie is genetic, most economists must be wrong about human capital formation. Having fewer kids and spending more money on their education has only a modest effect: this must be the case, given slow long-run social mobility. It seems that social status is transmitted within families largely independently of the resources available to parents.

Pointer from Jason Collins.

Nick Rowe on Secular Stagnation

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He writes,

What is it with you townies? Have you never looked out of the window, when you fly (do you ever drive?) from one city to another, and wondered about all that stuff you see out there? It’s called “land”. It grows food, that you eat. And that land is valuable stuff, and there’s a lot of it, and it can last a very long time, and it pays rent (or owner-equivalent rent). And if the rent on that land is strictly positive (which it is), and if the price of that land is finite (which it is), then the rate of interest you get by dividing that annual rent on land by the price of land is going to be strictly positive. And that’s a real rate of interest, because land is real stuff, and what it produces is real stuff too.

So when you go to a helluva lot of trouble to build a model with a negative equilibrium real rate of interest, and it’s a very fancy complicated model, but it totally ignores land, I really wonder where you are coming from. Actually I don’t wonder. I know where you are coming from. You are coming from the town, or the big city, where you can easily forget about land. But even then: you know that stuff your house or condo is built on? That’s called “land” too.

Brad DeLong on Piketty

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Brad writes,

We have a world in which some eminent economists (Larry Summers) say r1 is too low, and other eminent economists (Thomas Piketty) say r2 is too high…

The difference between r1 and r2 is the risk premium. In a well-functioning market economy with well-functioning financial markets, there are powerful reasons to believe that this risk premium should be small: less than 1%-point per year. The fact the risk premium appears to me to be 7%-points per year today is a powerful evidence of the profound dysfunctionality of our financial markets, and of their failure to do their proper catallactic job. But that is a separate and largely independent discussion: that is a dysfunction of our modern market economy which is different from either the dysfunction feared by Summers or the dysfunction freaked by Piketty. For the moment, simply note that it is perfectly possible for all three of these major dysfunctions to occur together.

Pointer from Mark Thoma. Read the whole thing. The risk-premium solution was also suggested here in a comment by Matt Rognlie.

So far, the left-wing journalistic verdict on Piketty is rapture. Economists, even those inclined to agree with Piketty’s conclusions, seem somewhat unsatisfied with with his treatment of capital and interest.

College Sports Spending

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Tamar Lewin reports,

Even as their spending on instruction, research and public service declined or stayed flat, most colleges and universities rapidly increased their spending on sports, according to a report being released Monday by the American Association of University Professors.

She reports that colleges contest this report.

“This comes from the American Association of University Professors, which has a vested interest in finding that too little money is going to faculty and too much to sports and administration,” Mr. Hartle [senior vice president of the American Council on Education] said. “If you just look at the percentage increases, without the base they’re working from, it’s hard to tell what it means.”

Pointer from Tyler Cowen.

Even if the AAUP is talking its book, I think that they may be right. College spending on facilities in general, and athletic facilities in particular, is out of control. Consider this:

Our athletic facilities are among the best in Division III. In 2006, we acquired the former headquarters and practice facility of the Baltimore Ravens. The grounds are now home to Mustang Stadium, a 3,500-seat facility for the football, men’s and women’s soccer, field hockey and men’s and women’s lacrosse teams, and Owings Mills Gymnasium, a 38,000 square foot complex for the men’s and women’s basketball, and men’s and women’s volleyball teams. Caves Sports and Wellness Center is the primary training facility for more than 800 Mustang student-athletes.

That is from Stevenson University, a very low-tier institution located in a suburb northwest of Baltimore.

In general, this is one of my pet peeves. I also could cite Brandeis University–even though it was practically broke due to the Madoff scheme, it proceeded with a totally unnecessary rebuilding of its admissions office. Or I could cite Swarthmore college–I would love to get a measure of the square footage of facilities per student. I am sure that it is ridiculous. It was huge when I went there, and since then the facilities appear to me to have increased by more than the number of students.

Wealth, Income, and Stock Prices

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As I start to read Piketty, the following train of thought occurred to me.

How would I explain fluctuations in the ratio of wealth to income? In particular, why did that ratio fall in the 1930s and why has it risen in recent decades?

My first thought is to look at stock prices, and at the P/E ratio. As the P/E ratio goes up, the ratio of stock market wealth to earnings goes up.

What drives the P/E ratio? The standard explanation would use some version of the discounted earnings model. That is, the P/E ratio will be high when the discount rate is low and/or expected future earnings are high. Over the past century, stock prices have trended upward because of one or both of these factors. That is, investors have been willing to discount earnings at lower rates or they have raised their expectations for earnings.

Call the discount rate r and the expected growth rate of earnings g. In short, the discounted earnings model says that the P/E ratio will be high when r is low and/or g is high.

Yet Piketty sees the rise in the ratio of wealth to income as caused by the opposite configuration. That is, he thinks it has taken place because r is high and g is low.

Of course, his r is “return to capital,” not the discount rate. And his g is the growth rate of total income, not corporate earnings. But I wonder how one sorts this all out, and how one goes about choosing between the finance-theoretic explanation of changes in the ratio of wealth to income and the Piketty-Marxist explanation.

UPDATE: James Galbraith writes,

when asset values collapsed during the Great Depression, it mainly wasn’t physical capital that disintegrated, only its market value. During the Second World War, destruction played a larger role. The problem is that while physical and price changes are obviously different, Piketty treats them as if there were aspects of the same thing.