Defining a Bubble

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Justin Fox writes,

So maybe we should tweak the second sentence of Brunnermaier’s definition, to something like: Bubbles arise if the price far exceeds the asset’s fundamental value, to the point that no plausible future income scenario can justify the price. A little clunky, and of course “plausible” is a judgment call. But it does get at the idea that we shouldn’t be calling every last rise in P/E ratios a bubble.

Pointer from Mark Thoma.

I would tweak this definition back in Shiller’s direction. I think you have to know why people are buying the asset in order to know whether it is a bubble. If investors who are buying the asset have estimates of the discounted present value of the income from that asset that imply a negative real return, then it is a bubble.

To simplify, assume no aggregate inflation. That gets out of the way any difference between real income and nominal income or between real returns and nominal returns.

Suppose that I buy an asset that yields an income stream–rents, dividends, or what have you. Suppose that we discount this income stream at the risk-free rate, and the resulting real return is negative. Why, then, am I buying the asset?

1. Perhaps it has a “negative beta,” so it has tremendous diversification value. Let’s rule that one out.

2. I get utility out of owning the asset. This might apply to jewelry or paintings. Or I could get “extra utility” out of owning my house that is over and above what I save by not having to pay rent. Let’s ignore those cases, also.

3. I expect to be able to sell the asset at a higher price to someone else.

When (3) is the only way to get a positive return from holding the asset, then we have a bubble.

The difference between my definition and Fox’s is that his definition requires that we have an objective definition of “plausible.” Mine requires learning from investors what their estimates are for future income from the asset.

So with something like stocks, you have to know whether the people buying are projecting higher future earnings than what you think are plausible (in which case, no bubble) or whether they are projecting earnings that imply negative rates of return (in which case, bubble).

What 5 Policies Would Help Millenials?

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Dylan Mathews makes an attempt at answering. The question is probably stupid, because the answers do not seem so smart. I think that the biggest problems for millenials are the high fixed cost of hiring workers and the big generational imbalance embedded in government budgets. However, millenials are likely to benefit at some point from very rapid technological progress.

Some policies that might help:

1. Decouple health insurance from employment.

2. Legalize catastrophic health insurance coverage, as opposed to mandating comprehensive coverage. In other words, undo Obamacare.

3. Eliminate the corporate income tax, taxes on saving and employer payroll taxes. Millenials are going to need all the saving and all the work they can get. What that leaves you with is a consumption tax.

4. We also have to cut spending. Carefully means-test Social Security, Medicare, and get rid of the millionaires on Medicaid. Get rid of all Federal grant programs except for those from the NIH and NSF. No export-import bank, no energy subsidies, no education grants, etc.

5. No agriculture subsidies, no housing subsidies of any kind.

Hey, I didn’t say that any of this was going to be feasible politically.

DSGE and the Market Test

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Noah Smith writes,

In other words, DSGE models (not just “Freshwater” models, I mean the whole kit & caboodle) have failed a key test of usefulness. Their main selling point – satisfying the Lucas critique – should make them very valuable to industry. But industry shuns them.

Pointer from Mark Thoma.

A few years ago, I happened to run into Olivier Blanchard. I offered my complaint that folks like Stan Fischer and himself had made macroeconomics narrow and stilted. “We’ve passed the market test,” he replied. But the “market test” to which he referred is limited to academic macro. It is a supplier-controlled cartel, not a consumer market.

Social Reasoning, Continued

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I’ve been stalking Mathew Lieberman on line, looking at videos and interviews and such. Also, a commenter found this journal article. I suppose I ought to just read his book, but I find his style somewhat annoying, so I hesitate. Anyway, here is an NPR interview.

if I’m being rejected from a group, how do I need to change my behavior or what I say or think in order to not be excluded or rejected from that group? It teaches me lessons about how to behave differently in the future. And because we can imagine the future, we can also use that preemptively. We can feel social pain at the threat of being excluded from a relationship or a group.

I do think that this is a very powerful motivator. Go back to Adam Smith. People want to feel high self-regard. But your self-regard depends on how you are regarded by others. Ideally, your tribe wants to nurture and protect you, because they love you and admire you. Worst case, your tribe wants to shun and expel you.

Some thoughts on what I might call the “tribal membership motivator.”

1. It is amazingly powerful. How else to explain fans of college sports or professional sports?

2. Do we need it for social glue? If we lacked this instinct, would we be unable to follow rules? If you only followed social norms when you made a rational calculation about the costs of getting caught cheating vs. the benefits of getting away with it, we probably end up in a world of Prisoners’ Dilemma games in which everyone constantly defects.

3. But the social brain also makes us vulnerable to exploitation. Examples would include men recruited to fight for warlords, individuals pledging loyalty to crime bosses, citizens manipulated by politicians, workers manipulated by bosses, and customers manipulates by salespeople.

4. Lieberman argues that the social brain is important in primates because of the long period in which infants are helpless. We need to be able to form strong connections with parents, or else we would not survive. Note how this circles back to the way in which many institutions try to tap into this primal attraction to parents by stepping into the role of substitute parent: religious organizations, schools, governments, and business hierarchies all exploit this to some degree.

5. Even if markets are effective in some objective sense, they do not provide people with a sense of familial protection and tribal belonging. Perhaps what libertarians need to do is build up the non-governmental substitutes for familial protection and tribal belonging in order to take some of the oxygen away from government. Of course, the other tribe, those evil bastids, is doing the opposite.

State and Local Health Obligations

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From a new working paper by Bryan Lutz and Louise Sheiner.

A major factor weighing down the long-term finances of state and local governments is the obligation to fund retiree benefits. While state and local government pension obligations have been analyzed in great detail, much less attention has been paid to the costs of the other major retiree benefit provided by these governments: retiree health insurance. The first portion of the paper uses the information contained in the annual actuarial reports for public retiree health plans to reverse engineer the cash flows underlying the liabilities given in the report. Obtaining the cash flows allows us to construct liability estimates which are consistent across governments in terms of the discount rate, actuarial method and assumptions concerning medical cost inflation and mortality…Relative to pension obligations discounted at the same rate, we find that unfunded retiree health care liabilities are 1/2 the size of unfunded pension obligations.

Perhaps the most interesting aspect of the paper is the amount of effort it took on their part to find the data to do the calculations. Similarly, one of the biggest challenges for Reinhart and Rogoff is to find data on government debt outstanding. There are strong incentives for politicians to avoid transparent accounting, and not much in the way of countervailing power.

Why I Quit Macroeconomics

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We construct a microfounded, dynamic version of the IS-LM-Phillips curve model by adding two elements to the money-in-the-utility-function model of Sidrauski (1967). First, real wealth enters the utility function. The resulting Euler equation describes consumption as a decreasing function of the interest rate in steady state–the IS curve. The demand for real money balances describes consumption as an increasing function of the interest rate in steady state–the LM curve. The intersection of the IS and LM curves defines the aggregate demand (AD) curve. Second, matching frictions in the labor market create unemployment. The aggregate supply (AS) curve describes output sold for a given market tightness. Tightness adjusts to equalize AD and AS curve for any price process. With a rigid price process, this steady-state equilibrium captures Keynesian intuitions. Demand and supply shocks affect tightness, unemployment, consumption, and output. Monetary policy affects aggregate demand and can be used for stabilization. Monetary policy is ineffective in a liquidity trap with zero nominal interest rate. In contrast, with a flexible price process, aggregate demand and monetary policy are irrelevant when the nominal interest rate is positive. In a liquidity trap, monetary policy is useful if it can increase inflation. We discuss equilibrium dynamics under a Phillips curve describing the slow adjustment of prices to their flexible level in the long run.

That is the abstract of a new paper by Pascal Michaillat and Emmanuel Saez. It was while I was in graduate school that this sort of mathematical self-abuse took over the field.

Wesley Mouch’s Assistant

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CBS reports,

Lesley Stahl: Let me interrupt you. You were the government. How many of the loans were you involved in?

Steven Koonin: Difficult to know the exact number. But I would say in the order of 30.

Lesley Stahl: Did you make mistakes?

Steven Koonin: I think I didn’t do as good a job as I could’ve. In retrospect, I would’ve done things a bit differently.

Lesley Stahl: Part of this was supposed to be creating new jobs. Everything I’ve read there were not many jobs created.

Steven Koonin: That’s correct.

Lesley Stahl: So what went wrong there?

Steven Koonin: I didn’t say it would create jobs. Other people did.

Honestly, I did not know what to excerpt. Read the whole thing. Wesley Mouch was, of course, Steven Chu, the Energy Secretary in President Obams’s first term.

DY2VTSC

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Larry Summers writes.

[we need] policies that restore a situation where reasonable growth and reasonable interest rates can coincide. To start, this means ending the disastrous trends toward ever less government spending and employment each year

The CBO wrote,

By 2038, CBO projects, federal spending would increase to 26 percent of GDP under the assumptions of the extended baseline*, compared with 22 percent in 2012 and an average of 20½ percent over the past 40 years.

Did you two visit the same country?

*The “extended baseline” is an unrealistic scenario, which includes spending cuts that are embedded in current law but unlikely to be retained by Congress. The more realistic “alternative fiscal scenario” projects even higher spending relative to GDP.

Macro Experiments are not Controlled

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Alex Tabarrok writes,

I happen to agree with Krugman that one test is not decisive. The economy is very complex and we don’t have controlled macro-experiments so lots of things are going on at the same time.

Read the whole thing, especially if you do not know the austerity-test controversy to which Alex is referring. And if you want more, you can read Mark Thoma or Scott Sumner either at EconLog or at MoneyIllusion.

My comments.

1. Don’t throw all your eggs at Paul Krugman. Save some for Mark Zandi, of Macroeconomic Advisers Moody’s, who also forecast dire consequences from the sequester.

2. You don’t have to believe the fiscal austerity was a non-event. You can believe that the economy was about to expand rapidly, and trimming the budget deficit held it back. Although, as Alex points out, telling this story makes it a little harder to say that we were in a liquidity trap/secular stagnation. Anyway, believing that austerity held back a boom is just the mirror image of believing that the stimulus worked, and the only reason that unemployment ended up higher than what was predicted without the stimulus is that the economy was in a deeper hole than we thought. The “deeper hole” theory is now the conventional wisdom among Stan Fischer’s 72 Ph.D advisees and their descendants. That is the beauty of macro. Even something that is defined ahead of time as a “test” is not a controlled experiment.

3. Even if you believe that fiscal austerity was a non-event, you do not have to believe that it was “monetary offset” that made it so. I would suggest that the process of business creation and business destruction did its thing without regard to fiscal and monetary policy.

4. Try to explain why nominal interest rates went up. If austerity matters, then interest rates should come down. If monetary offset works the way it does in old-fashioned textbook models, then interest rates should come down even more.

5. In Scott Sumner’s floofy world where the Fed directly controls NGDP expectations, you would expect nominal interest rates to go up with monetary offset. But I am still trying to come up with even a thought experiment that would refute market monetarism. If 2013 had been a down year, it would just have shown that the Fed failed to maintain NGDP expectations. This is uncharitable, but I think of market monetarism as a theory that can only be confirmed, never rejected.*

Is there anyone I haven’t offended yet?

*To be less uncharitable, let Scott speak for himself.

In my view the now famous Krugman “test” of market monetarism is an indication of the pathetic state of modern macro. We are still in the Stone Age. Future generations will look back on us and shake their heads. What were they thinking? Why didn’t they simply create a NGDP futures market? They’ll look back on us the way modern chemists look back on alchemists. It’s almost like people don’t want to know the truth, they don’t want answers to these questions, as then the mystical power of macroeconomists with their structural models would be exposed as a sham. Remember when the Christian church produced bibles and sermons in a language that only the priesthood could understand? That’s macroeconomics circa 2013.