Category Archives: Mark Thoma is Indispensable

A Time to Buy Put Options?

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I note this, from Tobias Adrian and Michael Fleming:

we present a table listing attributes of the fifteen largest bond market selloffs since 1961. The three selloffs highlighted in this post—1994, 2003, and 2013—are ranked fifth, ninth, and thirteenth, respectively, and are highlighted in blue. Beyond reporting figures behind the earlier discussion, the table shows the change in the ten-year, zero-coupon yield and in the spread between the ten-year and three-month yields between the start of each selloff and the maximum selloff date. Of note, the recent episode and 2003 are instances in which the yield spread moved almost as much as the ten-year yield itself (that is, the three-month yield rose little), explaining the importance of the term premium in those cases.

Pointer from Mark Thoma.

and this, from John Mauldin.

The Shiller P/E is now 24.4, about the same level as August 1929, higher than December 1972, higher than August 1987, but less extreme than the level of 43 that was reached in March 2000 (a level that has been followed by more than 13 years of market returns within a fraction of a percent of the return on Treasury bills – and even then only by revisiting significantly overvalued levels today). The Shiller P/E is presently moderately below the level of 27 at the October 2007 market peak. It’s worth noting that the 2000-2001 recession is already out of the Shiller calculation. Moreover, looking closely at the data, the implied profit margin embedded in today’s Shiller P/E is 6.3%, compared with a historical average of only about 5.3%. At normal profit margins, the current Shiller P/E would be 29.

Shoot First, Negotiate Later

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No, this is not another post on the Zimmerman case. It is my reaction to an article by Mary C. Dalythese patterns are consistent with the reluctance of employers to adjust wages immediately in reaction to changing economic conditions. In particular, employers hesitate to reduce wages and workers are reluctant to accept wage cuts, even during recessions. This behavior, known as downward nominal wage rigidity, played a role in past recessions, but was especially apparent during the Great Recession. Wage rigidity kept nominal wage growth positive throughout the recession. This led to a significant buildup of pent-up wage cuts, that is, wage cuts that employers wanted, but were unable to make. As the economy recovers, pent-up wage cuts will probably continue to slow wage growth long after the unemployment rate has returned to more normal levels.

Pointer from Mark Thoma.

If no one told you what the data looked like, which would be more plausible?

a) Employers at first are reluctant to let go of employees, and they instead react to a drop in demand by immediately slowing wage growth. If the recession persists, they fire people.

b) Employers at first are reluctant to slow wage growth, so they fire people. If the recession persists, they slow wage growth.

I’m sorry, but (a) seems way more plausible to me than (b). We live in a world where there are a lot of fixed costs of hiring and firing. Yet the authors want to argue that in the short run, the easiest margin of adjustment is to fire people, and then in the long run you hire them back at lower wages.

Now this is a bit better:

As the recovery takes hold, businesses gradually reduce wage growth. At the same time, inflation typically erodes the real wages of workers, relieving some of the pent-up demand of employers for wage cuts. This gradual process can continue long after the unemployment gap begins to narrow. At the same time, slower wage growth also means businesses are able to hire more workers, which stimulates the demand for labor and pushes the unemployment rate down further.

Emphasis added. Still, I hate the phrase “pent-up demand for wage cuts.” It makes it sound as if “gee, if we could just get workers to accept a little lower wage, I could keep all of them.” That is a world in which there are an awful lot of $20 bills lying on the sidewalk.

Instead, I prefer to think of a dynamic economy and ask “what keeps entrepreneurs from finding ways to make use of available resources (unemployed workers)?” To me, that makes a recession more comprehensible, although less treatable.

How to Interpret Asset Market Prices?

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Jeremy Stein says (in my words) “Don’t try.” His words are

fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well–and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics.

If true (and I believe it is), this is a very important statement. It implies that events are in the saddle and ride the Fed. Not the other way around.

Pointer from “G.I.” of The Economist blog, via Mark Thoma.

Aggregate Supply and Demand

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A lot of economics bloggers have been discussing the merits and flaws of the paradigm of aggregate supply and demand. Mark Thoma linked to a couple of the more recent examples.

I think that, viewed on its own terms, AS-AD is confusing (or confused). That is, mainstream economists do not know what to put on the vertical axis. If you put the price level on the vertical axis, you get a nice textbook model, but no connection to the real world, where economists talk in terms of inflation rather than the price level. On the other hand, if you put inflation on the vertical axis, that does not work very well, either, as I explain in this 8-minute video. (Comments, other than about my handwriting, are welcome.)

I developed PSST as an alternative to AS-AD. PSST does not appear to explain nearly as much as AS-AD. That may look like a feature in AS-AD, but on closer inspection it is a bug. The explanatory “power” of AS-AD is a delusion.

1. The AS-AD paradigm is invoked to explain changes in the combination of inflation and unemployment. If one goes up while the other goes down, we call this an aggregate demand shift. If both move in the same direction, we call this an aggregate supply shift. Thus, we can explain anything. But there is a lot of hand-waving involved. The stories we tell about AD and AS are always post hoc, just-so stories.

2. In the 1970s, we had a huge rise in the combination of inflation and unemployment. What caused this? The rise in the price of imported oil is often cited, but it cannot possibly account for the large acceleration in inflation. At most, it would cause a temporary increase in inflation, followed by a decrease. Many (most?) macroeconomists attribute the 1970s disaster to a “rise in inflation expectations.” Prices rose because they were expected to rise. Through habit and repetition, we have come to accept this story. But how intellectually satisfying is that?

3. Turning to events since 2008, the typical macroeconomist describes the rise in unemployment as the result of a “demand shock.” However, they do not all agree on what the shock was. Scott Sumner says that it was a contraction by the Fed. Others say that it was the wealth effect of a decline in house prices. Others say that it was a credit crunch. Others say that it was the effect of inflation dropping too close to zero. All of these are just-so stories.

From April of 2003 through April of 2008, the rate of growth of the CPI averaged 3.2 percent. From April of 2008 through April of 2013, it averaged 1.6 percent. If in 2007 you had asked macroeconomists to predict the consequences of a decline in the inflation rate of that magnitude, how many would have told you to expect unemployment to rise above 7 percent? None of them would have foreseen it. My guess is that many of the macroeconomists would have regarded a drop in inflation of 1.6 percentage points as close to a non-event for unemployment. (Note to Scott Sumner: yes, the decline in nominal GDP growth was much bigger than the decline in inflation. But that only restates the mystery–it doesn’t solve it.)

The terms “aggregate demand” and “aggregate supply” are highly loaded. That is, they lead economists to imagine something analogous to supply and demand in microeconomics. But the analogy is mostly misleading, and economists who invoke AS and AD are the ones who are most misled.

Connecting Household Balance Sheets to PSST

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Interesting comment found by Glenn Reynolds. From Jeffrey Levin:

If you dig around and research start-ups you will find that the majority of start-ups are funded by second mortgages or HELOC draws. Due to the housing crash, that equity is just not there for the vast majority of people looking to start up a new business. Its one of the large reasons why commercial credit expansion has been so moribund. Without getting off the ground from seconds or HELOC’s all those startups that would have made it past year 1 and then been able to obtain standard commercial business loan never got off the ground and thus never graduated to commercial loan financing. You have to walk first before you can run. Startups don’t start in the commercial loan department (at least most of them don’t).

Recalculation means discovering new patterns of sustainable specialization and trade. Doing so requires entrepreneurial trial and error. As Levin points out, the stereotypical 20-year-old in a garage is actually atypical. Most entrepreneurs are like I was, forty years old and risking accumulated wealth. If my wealth had suddenly been halved in 1993, I doubt that I would have started a business in 1994.

And whose wealth got crushed by the housing crash? According to a paper by Edward Wolff, as cited in the WSJ blog:

The big drop in home prices between 2007 and 2010 meant a 59% loss in home equity for people under 35, compared with just 26% for people generally. That meant a massive loss of wealth, or “net worth” — what people own minus what they owe. People ages 35-44 saw a 49% fall in home equity.

Thanks to Mark Thoma for the pointer.

Against Home Borrowership

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Dean Baker writes,

If homebuyers knew that they had to put down 20 percent to get a lower cost mortgage, then they would be more likely to have a 20 percent down payment than in a context where this was not a requirement

Pointer from Mark Thoma.

I wish Baker had been there to help me at the hearing yesterday. The Congresspeople were chanting at least three scary mantras.

1. We need more home ownership.

2. We need to make sure that people who can’t make a big down payment can purchase homes.

3. We need to preserve the thirty-year fixed-rate mortgage that is pre-payable at any time.

I could not address any of these.* Instead, I tried to focus on debunking the idea that government needs to revive the mortgage securities market in order to “provide sufficient private capital” for mortgages. The other witnesses, and pretty much every Congressperson, were against me.

I am afraid that the housing lobby is alive and well, and very few economists share Dean Baker’s willingness to take it on.

*I tried a little bit, and more in my written testimony, to address (3), and in particular to explain that the interest-rate risk on the thirty-year mortgage is likely to be borne by taxpayers. Any institution that takes on a large portfolio of thirty-year mortgages has to, in addition to issuing long-term debt, purchase derivatives to hedge the prepayment option. Who will be on the other side of such transactions, writing these out-of-the-money options? My concern is that buried in the housing finance system somewhere will be the equivalent of AIG financial products. That is, an institution with way too much risk in its book, which regulators will discover only when it is too late.

This is Too Much

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Jared Bernstein writes,

had R&R gone through the peer-review process, I’m fairly confident that a) the spreadsheet error would NOT have been found, but b) the paper would have been sent back to them for failing to provide even a cursory analysis of the possibility of reverse causality (slower growth leading to higher debt/GDP ratios vs. the R&R claim of the opposite). Re “a,” peer reviewers do not routinely replicate findings, though they should when possible (more work these days is with proprietary data sets which cannot legally be shared).

Pointer from Mark Thoma.

I have not been commenting on the Reinhart and Rogoff fracas. My view of empirical macroeconomics is that there are hardly any reliable findings, so I always brushed aside the notion that there is some adverse growth impact of having a debt to GDP ratio of 90 percent. But some people took it seriously. And now the left is howling that all of the austerity policies in the world are due to Reinhart and Rogoff, and they should be burned at the stake, or something.

But speaking of unreliable findings in empirical macroeconomics, this is the same Jared Bernstein who co-authored a memo for President Obama saying that the multiplier is 1.54, as if we know what it is with that precision (I do not think we know with any precision that it even has a positive sign.) He has about as much right to complain about Reinhart and Rogoff as a crack-head has to complain about somebody who got drunk once.

And do read F. F. Wiley. (pointer from Tyler Cowen)

Personal Saving and Public Policy

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1. Ezra Klein writes,

This is the other, perhaps more pressing, Social Security crisis: It’s not generous enough to counteract the sorry state of retirement savings nationwide. In a report for the New American Foundation, Michael Lind, Steven Hill, Robert Hiltonsmith and Joshua Freedman survey this data and conclude that the ongoing debate over how to cut Social Security is all wrong: We need to make Social Security much more generous.

They would keep today’s income-based Social Security program, but add a “Part B,” which would be a flat payout to all retirees. When parts A and B are combined, all retirees would be guaranteed 60 percent of their average working wage in retirement, with low earners seeing closer to 100 percent replacement. Part B would be pricey, adding almost a trillion dollars to Social Security’s costs in 2037, and the authors don’t have a clear proposal, much less a politically realistic plan, for how to pay for it. But not paying for it doesn’t mean those costs disappear: It either means living standards for seniors will tumble, or families will strain as they try to support older relatives.

When I read this, it came across to me as a poor use of economic language. Instead, I would have pointed out that if Baby Boomers are not saving enough for retirement, and someone suggests using transfer payments to give them more resources, then in order to know whether or not this is a good idea one needs to know where the resources will come from. Take any year, say, 2018. If you increase Baby Boomers’ consumption in that year, then either you have to decrease the consumption of other people who are alive that year or you have to diminish the rate of capital accumulation. Those are the costs that do not disappear in using transfers to solve the problem of Baby Boomers’ consumption needs in retirement. Perhaps this sounds picky. But as an economist I think that, particularly when one is writing for a lay audience, it is appropriate to employ the principles of scarcity and trade-offs.

2. Richard H. Thaler writes,

Payroll savings plans are vital because they are essentially the only way that middle-class Americans reliably save for retirement. Your grandmother probably knew that the best way to save is to put money aside before you have a chance to spend it. That approach has always worked — and is a core idea embedded in these plans.

…The Obama administration has proposed a simple solution to this problem: the automatic I.R.A. This plan, originally proposed by scholars at the Brookings Institution, would require any employer that doesn’t offer its own plan to enroll workers automatically into individual retirement accounts, with the option to opt out. The burden on employers would be tiny, and the benefit to workers could be life-changing.

Pointer from Mark Thoma.

I liked Thaler’s piece better. He sees the problem as one of encouraging people to provide for their own future consumption by deferring current consumption. If his suggestions were adopted and they work as intended, then there will be more capital in 2018 than otherwise, which would result in more output. Therefore, Thaler’s solution is consistent with economic principles.

As an aside, Klein covers another topic in his column, which is the cost of health care. He writes,

A key fact — perhaps the key fact — about American health care is that the prices we pay for the health care we consume are far, far higher than in any other country.

He recommends putting people age 55-65 on Medicare and negotiating down the compensation of health care providers.

Maybe I was in an uncharitable mood, but I was disturbed by the tone of the quoted sentence. In Crisis of Abundance, I spent a chapter talking about various narratives that have been used to explain health care spending in the United States. On page 25 I wrote,

The most awkward fact for the narrative that attributes high health care spending solely to prices is the finding by John Wennberg and his colleagues…by looking directly at utilization figures, it is clear that when it comes to explaining spending differences across regions it is not prices. Patients in high-spending regions see more physicians and undergo more procedures than patients in low-spending regions.

After surveying a lot of literature, I concluded that the most important narrative for explaining American health care spending is that we use a lot of what I dubbed “premium medicine.” I offered evidence that health care in the United States uses more physical and human capital, meaning medical equipment and specialists, than health care in other countries.

Klein is entitled to disagree with me, of course. But I cringed when he pronounced the over-pricing narrative as if it were a “fact.” In fact, there are many economists who doubt that we can have a free lunch by paying providers less for their services.

3. Turning back to Baby Boomers’ retirement, Reihan Salam writes,

In recent months, opponents of reducing the growth of Social Security benefits have been making the case that Social Security benefits should actually increase, to reflect the inadequacy of private retirement savings. A month, I wrote about Josh Barro’s call for an expanded Social Security program and how it might be reconciled with Andrew Biggs’ center-right vision for Social Security reform. Basically, Barro is open to expanding the public commitment to retirement security through a number of strategies, including mandatory savings accounts….

while policy intellectuals are thinking hard about Social Security’s future — another good example is the work of Charles Blahous and Jason Fichtner on how to make the Social Security payroll tax more work-friendly and fertility-neutral — there has has yet to emerge a consensus among Republican lawmakers on Social Security reform, hence the fact that the House Republican budget proposal didn’t tackle the issue head on. My sense is that there is a way to draw on the work of Biggs (the larger architecture), Barro (his idea of a new class of government securities linked to wage growth or GDP growth merits consideration), and Blahous and Fichtner (thinking through how we can connect their work on fertility-neutrality to the Stein tax reform agenda) to craft an attractive retirement security agenda that would actually prove more generous, when all elements including the mandatory savings element are taken together, than the current system while also proving more fiscally sustainable. Fundamentally, this would be a “conservative” reform, as it would improve work incentives and emphasize pre-funding.

Read the whole thing. Salam is my favorite policy wonk.

Sentences to Ponder

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From Brad DeLong:

the twentieth century is unique in that its wars, purges, massacres, and executions have been largely the result of economic ideologies. Before the twentieth century people slaughtered each other for the other reasons. People slaughtered each other over theology: eternal paradise or damnation. People slaughtered each other over power: who gets to be top dog, and to command the material resources of society. But only in the twentieth century have people killed each other on a large scale in disputes over the economic organization of society.

Pointer from Mark Thoma.

I will be seeing Brad and Mark on April 11-12 at this event. It is not a public event, but I will have a bit of time off from the conference. If you are in the Kansas City area and want to try to arrange to meet at some point, leave a comment.

A Higher Education Data Point

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From Dean Baker.

My colleague John Schmitt and former colleague Heather Boushey looked at this issue a couple of years ago. They noted that there was a far larger dispersion in the wages of men with college degrees than was the case with women. In fact, there was a substantial overlap between the distribution of wages of men without college degrees and men with college degrees.

The ev-psych story is that men tend to have wider variance in general. They dominate both the best jobs and the worst jobs. College may not affect this.

Pointer from Mark Thoma.