Monthly Archives: July 2017

Scarcity of financial intermediation?

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Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas write,

For the last few decades, with minor cyclical interruptions, the supply of safe assets has not kept up with global demand. The reason is straightforward: the collective growth rate of the advanced economies that produce safe assets has been lower than the world’s growth rate, which has been driven disproportionately by the high growth rate of high-saving emerging economies such as China. If demand for safe assets is proportional to global output, this shortage of safe assets is here to stay.

The signature of this growing shortage is a steady increase in the price of safe assets, necessary to restore equilibrium in this market. Equivalently, global safe interest rates must decline, as has been the case since the 1980s. Simultaneously, we observed a surge in cross-border purchases of safe assets by safe asset demanders—many of them located in emerging economies—from safe asset producers, mostly the United States.

I get their point, but I do not like the idea of talking about the quantity of safe assets as the problem. Remember my view of finance: people want to issue risky, long-term liabilities and hold riskless, short-term assets. Financial intermediaries accommodate this by doing the opposite. Hence these thoughts:

1. What my framework suggests is that if there are too few riskless, short-term assets, then there must also be too few risky, long-term liabilities. That is, there is a general shortage of financial intermediation.

2. There does not appear to be a general shortage of financial intermediation. Relative to the economy, the financial sector has been growing, not shrinking.

3. In the “safe assets” framework, government helps to solve the problem of safe-asset scarcity by printing more money and issuing more short-term debt. In my framework, more government liabilities are not helpful. Government’s short-term, riskless liabilities are not backed by long-term risky assets.* So government is not increasing the amount of financial intermediation. Government instead is crowding out financial intermediation.

*You could say that the government’s risky, long-term assets are future tax revenues. But it is not the case that governments are raising money in order to invest in projects that will lead to increased future tax revenues. They are mostly making transfer
payments.

4. In fact, a lot of financial activity is associated with funding the government. So it could be that what I think of financial intermediation has declined even though financial activity has increased.

5. In other words, perhaps the financial sector is growing but not increasing its holding of risky, long-term assets. If so, this could be due to many things, but I think that the political assault on banks (regulations, “settlements” with prosecutors) comes to the top of my mind. Politicians bash the financial sector as being unproductive even as they increase the intensity of their utilization of the financial sector to channel money toward political ends.

6. The interest rate on safe assets is not a good measure of where interest rates are relative to some Wicksellian natural rate. In other words, don’t worry about the interest rate on safe assets being too low. Worry about the interest rate on a typical risky, long-term asset being too high relative to its natural rate. But changes in any given market interest rate on long-term, risky assets get confounded with changes in expected inflation and in risk perception.

Amazon arithmetic in a bubble, continued

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A commenter writes,

AWS (the Amazon “cloud”), is wildly profitable (20%+ margins), and while only 10% of their revenue currently, is growing much (over 2x) faster than the rest of the business.

He offers these figures for the second quarter:

Amazon Web Services $4.1 billion revenue, $0.9 billion profit, revenue growth rate of 50 percent per year.

Amazon excluding AWS $33.5 billion revenue, $1.5 billion loss, revenue growth rate of 22 percent per year.

So let me play with these numbers a bit, to try to get to $12.5 billion in profit, which I think is needed to justify the current stock valuation. We have four numbers to play with: AWS revenue, AWS margin, ex-AWS revenue, and ex-AWS margin.

1. Start with a combination of AWS margin of 20 percent, ex-AWS margin of 0. Then we need AWS revenue to be at $62.5 billion, compared to $4.1 currently. That might not happen for . . .ever.

2. Start with a combination of AWS margin of 20 percent and ex-AWS margin of 4 percent. At current revenues, that gives them $.9 billion and $1.34 billion, respectively, for $2.24 billion. That means that they have to grow revenue in each sector by a factor of 5 to get to $12.5 billion in profit. Even if AWS maintains a 50 percent growth rate, it would take 4 years to go up by a factor of 5. And it would take ex-AWS a lot longer. All while supposedly goosing their profit margins in retail to 4 percent.

Another commenter notes that Dean Baker thinks the way I do about Amazon.

Other commenters have said that profits are understated, because Amazon has plenty of “free cash flow” that it is currently spending to try to enhance its capabilities. OK, but Amazon’s revenues are not understated. They had $38 billion in quarterly revenue. How much of that could possibly be profit, under the most generous accounting?

I’ve got $100 that says the market cap of Amazon is lower on July 31, 2020 than it is today.

What I’m Reading

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Culture and Power: The Sociology of Pierre Bourdieu, by David Swartz. An excerpt:

Bourdieu in fact speaks of three different types of field strategies: conservation, succession, and subversion. Conservation strategies tend to be pursued by those who hold dominant positions and enjoy seniority in the field. Strategies of succession are attempts to gain access to dominant positions in a field and are generally pursued by new entrants. Finally, strategies of subversion are pursued by those who expect to gain little from the dominant groups. These strategies take the form of a more or less radical rupture with the dominant group by challenging its legitimacy to define the standards of the field.

For Austrian economists, Pete Boettke likes a succession strategy. I prefer a subversion strategy.

Yes, but can it help you predict?

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From acommenter:

I’d ask why self-interest needs to be manifested in overtly economic terms.

If you define self-interest broadly enough, then the statement “people pursue their self-interest” becomes irrefutable. And if you cannot refute it, then it is just an empty tautology.

I would much prefer to work with refutable claims than with empty tautologies.

So I continue to treat public choice theory as saying that people pursue economic gain in the political process. With that definition, public choice theory is often wrong, but at least it can be usefully right.

Arithmetic in a bubble, once again

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Mark J. Perry writes,

Amazon and Facebook were in the news this week for “joining an exclusive club open to only the richest companies in the world: both crossed the half-a-trillion mark.” Those two companies join Apple ($785 billion as of today), Alphabet/Google ($652 billion), and Microsoft ($564 billion) in the exclusive club of companies whose market capitalization tops $500 billion. To put the size of that market cap into perspective, consider that the entire Mexican stock exchange has a current market valuation of $438 billion, Thailand’s publicly traded stocks are worth $468 billion and the Russian stock exchange has a market cap of $554 billion! Together, the five US companies in the “$500 billion” club have a combined value of nearly $3 trillion… To put that into perspective, just those five US companies, as a separate country or stock exchange, would be the eight largest stock market in the world (see table above), and 40% larger than No. 9 Canada’s entire stock market and almost 50% (and $1 trillion) larger than the German stock exchange!

Some arithmetic:

Amazon just reported quarterly earnings of $200 million. At that rate, it would take 2500 quarters to earn $500 billion. That is 625. Years.

Call me impatient, but I do not care to wait 625 years to earn back my investment. I would rather see the money paid back a bit sooner. Like maybe 10 years.

If you want a $500 billion investment paid back in 10 years, then you need quarterly earnings of $12.5 billion. What does Amazon have to do to achieve that?

Their earnings are their sales times their profit margin. Investopedia writes,

Each year, the S&P 500 releases industry specific returns on equity and net margins, and each year the retail industry is among the least profitable. This is especially true for web-only retailers, which often see net margins as low as 2.50 to 3.50%.

So if we assume that Amazon is capable of achieving a 4 percent profit margin, we are being generous. At that profit margin, to get $12.5 billion in quarterly earnings, you would need $312.5 billion in sales. Actual sales last quarter were $38 billion.

Unless I have made some errors (check to see that I haven’t messed up by a factor of 10 somewhere), this arithmetic says that Amazon needs to be 8 times as big as it is, with a generous profit margin, in order to make me want to own the stock.

In July of 1999, I wrote Arithmetic in a Bubble. My first blog was an extended exploration of the topic. Maybe it is time for that blog to make a comeback.

Clark Medal trends

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Concerning the John Bates Clark award, Beatrice Cherrier and Andrej Svorenčík write,

From the citations of the medalists from the late 2000s onward, one get the impression that all economics has indeed become applied

Pointer from Tyler Cowen.

I agree with the authors’ view of the trends. In my essay, I pointed out that in the 1970s, what I refer to as the “peak math” era, the Clark medalists had published heavily in the most mathematical journals of the time, Econometrica and the Journal of Economic Theory. The more recent winners appear very little in those journals.

Money, interest, and the economy

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John Cochrane writes,

Investment responds to the stock market, and the stock market moves because risk premiums move, not because interest rates move.

He goes on to suggest that if monetary policy can effect the economy, it must work through the channel of affecting the risk premium. That seems dangerous. To me, it also seems far-fetched. I view this as helping to reinforce the Fischer Black/Arnold Kling ultra-heterodox view that central banks are not macroeconomically significant.

The theory that central banks are irrelevant can withstand the supposed counter-example of hyperinflation. We view hyperinflation as a fiscal phenomenon. The government cannot tax and borrow enough to match spending, so it pays its bills by printing (ultimately worthless) paper.

Cochrane links to an essay by Dan Thornton, in which Thornton argues that the evidence is weak that the interest rate affects spending.

“So why do policymakers believe that monetary policy works through the interest rate channel and that monetary policy is powerful?” Well, there was one important event that brought economists and policymakers to this conclusion. Specifically, the Fed under Chairman Paul Volcker brought an end to the Great Inflation of the 1970s and early 1980s.

Indeed, this is the great counter-example to my view the central banks are irrelevant. I have to argue that the Great Inflation and the Volcker Disinflation were not the monetary-policy phenomena that they are widely viewed as being.

My best alternative hypothesis concerning the Great Inflation is that the breakdown of the sort-of gold standard of Bretton Woods and the use of “incomes policies,” most notably the Nixon wage-price controls, caused a change in pricing norms away from stability and toward upward ratcheting. The actions of the oil cartel in the 1970s can be viewed as both a response to the breakdown of the Bretton Woods system and as a causal factor in itself that affected pricing norms throughout the economy.

My best alternative hypothesis concerning the Volcker disinflation is that it was not Volcker that produced the shift to a regime with less inflationary pricing norms. Perhaps deregulation, particularly in transportation, played a role. The collapse of the oil cartel, a collapse which decontrol of the U.S. oil market probably helped to foster, was a factor also.

Incidentally, I am not as convinced as Thornton that housing construction and consumer durables are insensitive to interest rates. Those sectors certainly are highly cyclical, with Ed Leamer showing that they are almost always implicated in recessions. For much of the post-war period, the institutional environment, including key financial regulations, ensured that any rise in long-term nominal interest rates caused credit for housing to dry up. But the regime of the 1960s, with strong restrictions against interstate banking and with deposit interest ceilings, was dismantled by 1990.

The new regime appeared to be nearly recession-proof until 2008. Then what happened? I think that we will be arguing forever about what exactly caused the recession to be so deep as well as what role, if any, monetary and fiscal policy played in the recovery.

How economic model-building is unique

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Consider two rationales for building models:

(a) Build a model in order to clarify the signal by filtering out the noise in a complex causal system. This is a knowledge-seeking endeavor.

(b) Build a model in order to be able to say, “In setting X, I can show how you get outcome Y.” This is just playing a game.

An example of playing a game is Akerlof’s Lemons model. In effect, it says, “In a setting where sellers know the quality of the product and buyers do not, sellers of high-quality products will have to settle for low prices, if they choose to sell at all.”

Some remarks:

1. I am pretty sure that economists are unique in their attachment to model-building as a game. My sense is that in other disciplines, including those that study human behavior and those that use non-mathematical models, researchers are more likely to be building models in order to try to separate the signal from the noise in a complex causal system.

2. Countless papers begin by describing a setting as having two factors of production, capital and labor, before adding further wrinkles to the setting. From the knowledge-seeking perspective, I fear that this is a dubious strategy. The two-factor model gets rid of a lot of signal and introduces a lot of noise. But for playing the game (and getting published) it works well.

3. Economists who work in business (think of Hal Varian at Google) do not have the luxury of playing games. If they want to use models to help the firm, they need to build them with the goal of separating signal from noise.

Applied TLP

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Megan McArdle writes,

Trump has coalesced around himself the people who are most interested in order, leaving the people who are focused on freedom and coercion somewhat unmoored. There’s a place for that conservative thought: Crime is the ultimate barbarian force, attacking the gentle roots of our civilized order. It’s easy to see why people conclude that if criminals are bad, then things which attack criminals must be good.

But the Founding Fathers were not unaware that bad people would sometimes get away if prosecutors had a high burden of proof to meet. They were not unaware that some of those people would go on to do further bad things. What they understood, and Sessions apparently does not, is that there are even worse things than crime, and one of them is a government that is allowed to steal our liberty like a thief in the night.

She is referring to civil asset forfeiture, which only a hardcore civilization-vs.-barbarism type could love. That is, you really, really have to believe that the police represent civilization and that when they confiscate the assets of suspects it is a blow against barbarism.

Sales of homes to foreign buyers

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CNN Money reports,

The National Association of Realtors released a report Tuesday that said foreign buyers and recent immigrants spent an estimated $153 billion on American properties in the year ending March 2017. That was a 49% increase over the previous year and the highest level since record-keeping began in 2009.

The purchases accounted for 10% of the total value of existing home sales in the U.S. The report did not include new homes.

Pointer from Scott Sumner, who writes,

the sale of homes to foreigners does represent a US export, and creates lots of goods jobs for American blue collar workers. (Note that it doesn’t really matter whether they buy new or existing homes; the net effect on the housing market is the same.)

When a house is built, that counts as GDP. But when an existing house is sold, that is not new production, so it does not count as GDP.

Suppose an existing house gets sold by an American family to a someone in China or Canada, who leaves it vacant. Next, a new house gets built to house the American family that still needs to live somewhere. The new house gets counted as GDP. It seems to me that if you counted the sale of the existing house as an export, then that would be double-counting. So I am not with Sumner here.

I am more interested in the statistics in the article. Let us suppose that these foreign owners are not choosing between renting and buying in the U.S. They are buyers only, with no thought of renting. Let me guess that these Chinese and Canadians are just a bit more likely to be buying houses in San Francisco or Manhattan than in rural Ohio. Then this might help to explain why price/rent ratios are so divergent within the U.S.

Note, however, that the foreign owners might still be interested in renting out the properties they buy. In that case, the ratio of price to rent should still matter to them.