What Else Would be True?

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Chris Dillow writes,

we should remember the Big Facts. For example, one the Big Facts in finance is that active equity fund managers rarely beat the market for very long, at least after fees. This, as much as Campbell Harvey’s statistical work reminds us to be wary of the hundreds of papers claiming to find factors that beat the market.

Pointer from Mark Thoma

This is a good example of asking, “What else would be true?” When you are inclined to believe that a study shows X, consider all of the implications of X. In the example above, Dillow is suggesting that if one finds that there is some factor that allows one to earn above-market returns, how do we reconcile that with the fact that we do not observe active fund managers earning above-market returns?

Recall that I raised a similar question about the purported finding that in the United States worker earnings have gone nowhere as productivity increased. This should greatly increase the demand for labor. It should greatly increase international competitiveness, turning us into an export powerhouse. Since I do not see either of those taking place, and since many economists have pointed to flaws in the construction of the comparison of earnings and productivity, I think this makes the purported finding highly suspect.

In contrast, consider the view that assortative mating has increased and plays an important role in inequality. I have not seen anyone say, “IF that were true, then we would expect to observe Y, and Y has not happened.”

I think that this is the way to evaluate interpretive frameworks in economics. Consider many possible implications of an interpretive framework. Relative to those implications, do we observe anomalies? When you have several anomalies, you may choose to overlook them or to explain them away, but you should at least treat the anomalies as caution flags. If instead you keep finding other phenomena that are consistent with the interpretive framework, then that should make you more comfortable with using that framework.

Income Causes Conscientiousness?

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The WaPo reports,

Not only did the extra income appear to lower the instance of behavioral and emotional disorders among the children, but, perhaps even more important, it also boosted two key personality traits that tend to go hand in hand with long-term positive life outcomes.

The first is conscientiousness. People who lack it tend to lie, break rules and have trouble paying attention. The second is agreeableness, which leads to a comfort around people and aptness for teamwork. And both are strongly correlated with various forms of later life success and happiness.

Look, I hope this is true. Just keep in mind that any study that found that instead money made no difference would never be written up and published.

The Puzzle of Low Real Interest Rates and Low Investment

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Antonio Fatas writes,

What the world is missing is investment demand. The real tragedy is that investment in physical capital has been weak at the time when financial conditions have been so favorable. Why is that? Jason Furman (and early the IMF) argues that the best explanation is that this the outcome of a a low growth environment that does not create the necessary demand to foster investment. And this starts sounding like a story of confidence and possibly self-fulfilling crises and multiple equibria. But that is another difficult topic in economics so we will leave that for a future post.

Pointer from Mark Thoma.

The puzzle in macroeconomic data is that the real interest rate is low and investment is low. There are a number of stories, none of them fully convincing.

In the Keynesian category, we have:

1. Low “animal spirits.” As far as I know, no one has actually propounded this.

2. Accelerator model. That is, when other forms of spending are high, investment is high. So when spending by households goes down, investment goes down. I put Furman (and most Keynesians) in this camp.

In the non-Keynesian category, we have:

3. Real interest rates are actually high, because prices are falling. This is perhaps more plausible if you think about sectoral price movements. If the price indexes go up because of college tuition and health insurance, then prices elsewhere may be falling.

4. Real interest rates are actually high for risky investment. Interest rates on government debt and on high-grade private bonds are a misleading indicator of the marginal cost of capital.

5. Crowding-out can occur at low interest rates. That is, if financial intermediaries are gorging on government debt, they may not seek out private-sector borrowers.

These explnations are not mutually exclusive.

Free Trade and Trade Treaties

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Noah Smith writes,

As for the Trans-Pacific Partnership — the most important trade deal in years — support from the economics profession has been muted. However, some of that might be because of the intellectual-property protections in the treaty, which many consider a trade restriction rather than a liberalization.

Pointer from Mark Thoma.

On the other hand, Greg Mankiw writes,

I would guess that TPP would also poll well among economists. FYI, here is CEA chair Jason Furman singing the praises of TPP, and here is an open letter from a sizeable group of past CEA chairs.

Apart from mood affiliation, economists should not feel compelled to support every trade agreement. In fact, there is no reason to presume that a trade agreement actually promotes free trade. One country can do its part to promote free trade without having to negotiate an agreement with anyone. Just eliminate trade barriers, regardless of what other countries do.

It is likely that every trade agreement includes at least some measures that are protectionist. Maybe you can say something good about an agreement “on net, relative to the status quo.” But in a better world, there would be no trade treaties–just free trade.

UPDATE: Jeff Frankel gives the upbeat view of the TPP.

Garett Jones is Endorsed

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‘Pseudoerasums’ writes,

Your “moral circle” is wider with intelligence and patience than without.

…To paraphrase Garett Jones…smart, patient people are more Coasian; they find a way to cooperate and build good institutions.

It is a very long essay, and all throughout I was thinking of Garett Jones, so it was nice to see him turn up at the end. Pointer from Tyler Cowen.

The substantive point is that you can expect good institutions when you have a population that is high in intelligence and patience. Although the author of the essay does not go this far, I would suggest a causal pyramid with population intelligence and patience at the bottom, institutions the layer on top of that, and economic outcomes and other indicators of human development on top of that.

See also the appendix to my recipe for good government piece.

Specialization and Trade

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Chelsea German writes,

Last week, I wrote about a man who spent 6 months of his life and $1,500 to make a sandwich entirely from scratch, without the benefits of market exchange. The story illustrates how exchange and trade enrich our lives.

After making his incredibly costly sandwich, the same man embarked on an even costlier endeavor: making a suit from scratch. He picked cotton from a field, spun the cotton into thread, wove the thread into cloth, sheared wool from a sheep, harvested hemp, raised silkworms for their silk, killed a deer and tanned its hide to make leather. This process cost him 10 months of work and $4,000.

Pointer from Don Boudreaux.

I just don’t think you capture the phenomenon of specialization and trade with textbook economic models. It is not two-by-two trade. It is far more complex than that. And don’t get my started on representative-agent models of the GDP factory.

Poor Replication in Economics

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Andrew C. Chang and Phillip Li write,

we replicate 29 of 59 papers (49%) with assistance from the authors. Because we are able to replicate less than half of the papers in our sample even with help from the authors, we assert that economics research is usually not replicable.

Pointer from Mark Thoma.

As an undergraduate at Swarthmore, I took Bernie Saffran’s econometrics course. The assignment was to find a paper, replicate the findings, and then try some alternative specifications. The paper I chose to replicate was a classic article by Marc Nerlove, using adaptive expectations. The data he used were from a Department of Agriculture publication. There was a copy of that publication at the University of Pennsylvania, so I went to their library and photocopied the relevant pages. I typed the data, put into the computer at Swarthmore–and got results that were nowhere close to Nerlove’s.

Steve Teles Defends Technocrats

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He wrote,

greater responsiveness only increases the opportunities for concentrated interests to exert influence over the agencies that are supposed to regulate them. Perhaps ironically, it may be the case that only those regulatory agencies that are able to escape domination by politicians will be able to effectively pursue the goals that those same elected officials wrote into law back when the public was paying attention. Effectiveness, in short, may demand a significant degree of bureaucratic autonomy, rather than democratic control.

…Carpenter’s key insight is that bureaucrats themselves have the power not only to shirk or subvert their principals, but in some cases to guide or even dominate them. The canvas on which he explains how this is possible is the history of one of America’s most powerful agencies, the Food and Drug Administration.

Teles is reviewing a book by David Carpenter, in which the author argues that the FDA’s power stems from its reputation. Because the FDA is highly regarded, it can maintain its independence from Congress.

Teles sees that as a good thing. His model of politics is that there are fleeting demands for regulation, to which Congress responds by establishing an agency. However, once the spotlight is off and the actual regulatory process is underway, the more politically responsive the agency, the more likely it is that the agency will be manipulated by special interests. It is better for the agency to polish its reputation and sustain independent power.

In this model, what is it that limits an agency’s power?

In theory, the loss of reputation leads to a loss of power. When has this happened? The Federal Emergency Management Agency (FEMA) has a terrible reputation, but it has at least as much responsibility as ever. Same with the Transportation Security Administration (TSA). The Environmental Protection Agency (EPA) recently spilled chemicals into the Colorado River, and as far as I can tell it suffered no consequences.

Still, I think that it is fair to say that technocrats focus on their reputations. Bad publicity does attract Congressional attention, and perhaps that makes an agency less aggressive than it otherwise might be.

But reputation-protection, rent-seeking, can be costly. A place like the Fed selects for chairmen who write self-serving memoirs. The question is whether the focus on reputation leads to better behavior or mere image-polishing.

In the private sector, there is the same tension. Reputation can be earned, or it can be manipulated through public relations. But one hopes that the competitive process will eventually expose the manipulators and reward the good performers.

Two Stars for Shaky Ground

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For the first time in many years, I wrote a review for Amazon. About Bethany McLean’s book on Freddie and Fannie, I say,

I was disappointed with this book, because I think that her earlier work, All the Devils are Here, co-authored by Joe Nocera, is probably the best journalistic account of the run-up to the financial crisis.

On “Shaky Ground,” here are my thoughts:

1. This book might have been titled “Sympathy for the Devils.” There is way too much sympathy expressed for the hedge funds that bought preferred stock in Freddie and Fannie. They were making a bet that the political process would come out a certain way, and they lost that bet, fair and square. End of story, as far as I am concerned. I should note that on several occasions representatives of the hedge funds have felt me out about doing some “research” or writing an article to support their position. I would not have done it for any amount of money. I am not accusing McLean of having succumbed to this, but I would not completely rule it out.

2. The other devil who gets a ton of sympathy is former Fannie Mae executive Tim Howard. McLean endorses all of his self-serving views, which include a claim that he did nothing wrong in Fannie’s giant accounting scandal. Also, his view is that had the Fannie management not been replaced, his team would have averted the crisis. Both claims may be true. In my opinion, Freddie and Fannie were better managed before both of their management teams fell in accounting scandals. But I think that more journalistic skepticism is in order. Regardless of who was in charge, there was pressure on Freddie and Fannie management to dive into high-risk lending, with shareholders seeing profits and regulators seeing a mission to expand home ownership opportunity.

3. She is no fan of Ed DeMarco, who was the only person in Washington working to gradually wind down the GSE’s, which is supposedly what everyone wanted. I think it is fair to say his approach was too unpopular with key players to be sustained. But he does not deserve to be dismissed by McLean with boo-words, like “free-market ideologue.”

4. She says that if you take it as given that the government is going to promote what the housing lobby wants, namely “home ownership” with little actual equity and a mortgage market dominated by the 30-year fixed-rate loan, then keeping Freddie and Fannie is better than the alternatives. If you accept the premise, then I agree. But there is a powerful case to be made against government caving into the housing lobby. The costs of this, including serial financial crises (the S&L crisis, the crisis of 2008) and misallocation of capital, are huge, and the social benefits are miniscule. (The private benefits can be enormous–just ask Tim Howard.) McLean does mention some of the evils of this housing-industrial complex, but her bottom line is, in effect “you can’t beat ’em, so don’t try.”

Overall, this is not a terrible book. But if you read it, you should keep in mind that she gives the most favorable treatment possible to Freddie, Fannie, the hedge fund investors, and to policy makers who attempt social engineering using housing finance. Although the book is not completely one-sided, she does not give alternative points of view as much respect as I think they deserve.

The Fed as a Bank

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A commenter asks,

1) Suppose the Fed increased interest on reserves from 0.25% to 8% tomorrow and simultaneously began a program to sell few trillion of the assets on it’s balance sheet and announced a new inflation target of 0%. What does the Book of Arnold predict will happen to inflation over the next two years?

2) Suppose the Fed cut the interest rate on reserves to -2%, announced a plan to buy an unlimited amount of financial assets until a market based forecast of NGDP 5 years from now reached $22.5T (5% year over year growth). What does the Book of Arnold predict will happen to NGDP over the next two years?

I think of the Fed as a bank. It makes profits in a weird way. It requires banks to hold reserves, and then it imposes a tax on those reserves by paying a below-market interest rate. Funded this way, it buys assets that earn a market rate of interest. (The Fed also profits from assets obtained with zero-interest-rate currency.)

So in the first exercise, the Fed’s cost of funds would rise from 0.25 percent to 8 percent. If this were to happen to any bank, it would soon be insolvent. For the Fed, this would mean having to go to Congress and beg for a large appropriation to cover its losses. That is such a weird and unlikely scenario that I do not think that any prediction can be made about NGDP.

In the second exercise, the higher tax on bank reserves would make their business less competitive, perhaps even unprofitable. We could see a big decline in bank balance sheets and an increase in shadow banking, or maybe just an increase in reserve-minimization tactics, like sweep accounts. Because reserves would plummet, the Fed’s liabilities would shrink, not rise. The only way that the Fed could expand its balance sheet would be by using currency to pay for its increase in assets.

I am not sure what the net effect would be on nominal GDP. Perhaps in the short run, you get bank failures and other forms of financial disruption, causing actual and forecast nominal GDP to decline.

The phrase “buy an unlimited amount of financial assets until…” makes me want to draw a cartoon with Janet Yellen telling investors “we will administer an unlimited amount of beatings until morale improves.” Again, I wonder how much the Fed could actually buy before running afoul of Congress.

Look, if you get rid of any constraints on the size and maneuverability of the Fed, then sure, they can do something to nominal GDP. And if you get rid of any constraints on the size and maneuverability of my body, then I could play in the NBA.