Sunday’s Washington Post

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It had two long pieces that angered me. Usually, I let these things go. It’s a waste of time trying to play Whack-a-Mole with those with whom you disagree. But I’ll waste my time this time.

1. Here is Barry Ritholtz.

Finance is filled with colorful phrases such as “Spoos,” “Vol,” “Monte Carlo simulation,” and “Gaussian Copula.” In these columns, I try to eschew the usual Wall Street jargon. But I have used the phrase “secular cycles” (most recently here), and a reader recently called me on it. To redress that error, this week I will discuss what a secular — vs. cyclical — market is, its significance and what it might mean to your portfolios.

What made me angry is that the Wall Street jargon to which he refers has some theoretical content to it. There may be erroneous assumptions baked in, and practitioners who know the jargon are capable of making really bad decisions.

But he is making it sound as though “secular market,” and in particular “secular bull market,” is a generally accepted scientific concept that can be used to predict future stock prices. I think that this article should have at the very beginning a huge disclaimer that says “I am about to present a concept that has absolutely zero rigorous research behind it.”

Every attempt to analyze the stock market must start with the efficient markets hypothesis. As far as I know, there is no alternative that is sufficiently robust to yield strong predictions of market movements that hold up for long periods out of sample.

Note that I am not saying that I can predict the market better than he can. I am not saying that there aren’t a zillion other stock market columnists serving baloney sandwiches every day. What I resent about this particular column is his sheer pretentiousness. He is passing off his baloney sandwich as if it were expert knowledge. That is what ticks me off.

2. We Need a National Food Policy, by Mark Bittman, Michael Pollan, Ricardo Salvador and Olivier De Schutter.

They do not say, and indeed they could not possibly say, that we now have a free market in food. Among other criticisms of current policy, they write,

in February the president signed yet another business-as-usual farm bill, which continues to encourage the dumping of cheap but unhealthy calories in the supermarket.

The problem is not that we lack a food policy. The problem is that these four authors would like to see a different food policy.

The article strikes me as a classic “moral will” story. That is, experts know the right policy. All we need is the moral will to execute it. There is no acknowledgment of either the socialist calculation problem (centralized experts may not have the information they need to actually make a better food policy than the market) or the public choice problem (government as an institution is ripe for capture by interest groups).

Of course, you could say that libertarians have our own “moral will” story. We think that people need the moral will to resist campaigns to put the national government in charge of everything.

Canadian Banking and U.S. Banking

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Timothy Taylor writes,

Clearly, the U.S. has a larger share of financial activity happening in the “other financial institutions” area, while Canada has a larger share of its financial activity happening explicitly in the banking sector. The Canadian economy is of course closely tied to the U.S economy. But the recession in Canada was milder than in the U.S., perhaps in part because Canada’s financial sector was less exposed to the issues of shadow banking.

Two interesting possibilities:

1. The Canadian shadow banking sector is underdeveloped. Canada is an ok place to get a mortgage or a commercial loan, but for more sophisticated financial transactions you have to go elsewhere.

2. The American shadow banking sector is overdeveloped. Our financial institutions are playing a game of hide-and-seek from the regulators, and shadow banking has emerged to enable banks to produce balance sheets that appear (to regulators) to be safer than they really are.

Of course, both of these could be true to some extent. I am more inclined to believe (2).

As an aside, I have no idea how one could measure the size of the shadow banking sector with any precision. I picture large books of derivatives, and do you look at gross or net exposure, current market value or potential value at risk, etc.?

The Single Point of Entry Solution

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Rebecca J. Simmons writes,

The critical element of the SPOE strategy is the recapitalization of the company’s material operating subsidiaries with the resources of the parent company. For the SPOE top-down approach to work effectively, there must be sufficient resources at the holding company level to absorb all the losses of the firm, including losses sustained by the operating subsidiaries.

SPOE is being touted as the solution to the too-big-to-fail problem. You have a gigantic bank holding company that gets in trouble. You (the FDIC) want to keep all the subsidiaries going, because you want depositors and counterparties not to panic. So you put the holding company into receivership, and only pay off shareholders and debtholders of the holding company after your are sure you have got money to do that.

I may not fully understand this. Here is what I think happens. The value of the subsidiaries as ongoing concerns is positive, say $100. However, if you subtract the value of the outstanding debt of the holding company, the value of the holding company is negative. With, say, $150 in outstanding debt, the holding company’s value is -$50. The receivership creates a new holding company, which will eventually be sold back to the public, but without the outstanding debt. When the new holding company is sold, the debtholders in the old company get first dibs on the proceeds, and if there is anything after that, the equity holders can get it. Again, I could be completely wrong about this, but that is my understanding.

Simmons continues,

The capitalization of the bridge financial company must be sufficient…not only to allow the operating subsidiaries to obtain needed capital from the bridge to continue operations but also to allow stakeholders and the broader public to view the entity as safe and viable as it transitions from failed firm to bridge financial company, and ultimately to emergence as a new firm.

The problem is that financial firms have multiple self-fulfilling states of equilibrium. There is a state in which everyone believes in you, so you pay low interest rates on your debt, and you are fine. There is a state in which counterparties do not believe in you, so your interest costs soar, and you are dead. One key question about SPOE is whether it can prevent a jump from the good equilibrium to the bad equilibrium.

Suppose that we had this strategy in place, with all of the legal means for implementation. I still believe that if JP Morgan Chase or Citigroup got into trouble, the Fed Chairman and the Treasury Secretary would be wetting their pants. In a crisis, the probability that they would go through with SPOE, rather than undertake an ad hoc bailout, is very low.

George Smith on Herbert Spencer, continued

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I recommend the series of essays by Smith, called From Optimism to Pessimism.

According to Spencer, most people are too ignorant to understand the detrimental long-term consequences of government intervention, so they will continue to embrace the superstition that a government can accomplish virtually anything, given the requisite political will and despite one failure after another. Experience counts for nothing here, because to understand the abstract nature of political institutions and their causal effects on social and economic interaction requires a level of conceptual ability that exceeds the intellectual powers of most people.

That quote is from Part 5 of the series. Another quote:

Spencer even criticized American democracy, because many Americans believed that “smart people” in government can do whatever they set out to do. Spencer, who was blunt if he was anything, was not reluctant to use words like “stupidity” when describing these and similar beliefs.

Chris Dillow on a Basic Income

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He writes,

A lowish basic income satisfies the right’s desire that there be only limited redistribution. But it would compel people to find low-paid and unpleasant work.

Pointer from Mark Thoma.

Dillow believes that a basic income should be high enough so that a person could turn down low-paid and unpleasant work. I am confident that I could not persuade him otherwise, but all I can say is that I disagree. The summers I spent in an electronics factory were much better for my morale than the summers that I spent idle. And if my daughters faced the choice of a future cleaning hotel rooms or a future living on welfare checks, I honestly would think of them as better off cleaning hotel rooms.

In fact, one of the arguments against a negative income tax is that there is some evidence that labor supply is highly inelastic, so that even with high implicit marginal tax rates poor people choose to work. That evidence would suggest that many people share my preferences about the dignity of having a job and earning one’s living.

If the studies are correct, then lowering the implicit marginal tax rate will induce only a small increase in labor supply. I happen to think that in the long-run, perhaps meaning the multi-generational long run, the labor supply elasticity is higher than the studies show. However, even if I am wrong about that, I would still prefer lowering the marginal tax rate on ethical grounds. Let government policy reinforce the work ethic, rather than exploit it.

Kevin Carey on Vocational Education for College Grads

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He writes,

The obvious next target for boot camps is the expanding market for professional master’s degrees. This is really a case of one for-profit business competing with another—master’s degrees are market-priced revenue generators for “nonprofit” colleges and are treated as such. If more employers send the signal that “college degrees are not the primary qualification,” there could be a great many more students who decide that $8,000 for three months of intensive work is a much better deal than $50,000 for a master’s degree of questionable quality.

The article describes a program in which young people obtain computer skills using very practical exercises. Read the whole thing.

Herbert Spencer on Exit and Voice

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In 1850 or 1851, he wrote,

If every man has equal freedom to do all that he wills, provided he infringes not the equal freedom of any other man, then he is free to drop connection with the state–to relinquish its protection, and to refuse to pay toward its support…

Let men learn that a legislature is not “our God upon earth,” though, by the authority they ascribe to it , and the things they expect from it, they would seem to think it is.

These are selections from chapter 19 of Social Statics, reprinted in a new volume of readings from the Adam Smith Society, edited by James R. Otteson. The title of the volume is What Adam Smith Knew: Moral Lessons on Capitalism from Its Greatest Champions and Fiercest Opponents. This looks like an excellent collection of readings for a course in social and political philosophy.

What strikes me about Spencer’s chapter is how clearly he makes the case that exit is more legitimate than voice.

I think that my counter to Spencer would be this:

1. In modern society, we must interact, both directly and indirectly, with many strangers.

2. If we had competitive government, in which each person could choose which set of rules to obey, the cost of interacting with strangers might increase. When you sell me food, how do I know that you submit to a quality-assurance regime that gives me confidence that you are not cheating or poisoning me? Today, I can assume that the simple fact that you live in the United States makes you automatically subject to its rules. With competitive government, I would need some sort of signal.

3. As we expand the list of interactions, the signaling costs may mount up.

I do not think that this signaling-cost story is sufficient to explain and to justify the existence of government. I do not think that government emerged because people got together and said, “Sigh. Yes, government is a really problematic institution, but without it we would have to waste a lot of resources on signaling that we are going to treat strangers decently.”

I do think that there is something to a Hansonian view that we tend to want to affiliate with high-status people, and that certainly includes people with power. And I think that this view accounts for a lot of the support that the state receives. Spencer strikes me as anticipating this view, or coming close to anticipating it, for he complains of

that sentiment of power-worship which still misleads us by magnifying the prerogatives of constitutional governments as it once did those monarchs.

George H. Smith gives a quite different Spencer. In a footnote, Smith writes,

he insists, in Social Statics (1850), that ethics, including the Law of Equal Freedom, applies only to the “ideal man,” i.e., to a future society populated by people with highly evolved moral sentiments.

Pointer from Alberto Mingardi, who himself has written a book on Spencer.

In another essay, Smith writes,

When this remarkable man moved from an early optimism (during the 1840s and 50s) to an extreme pessimism (beginning roughly in the 1880s) about the prospects for individual liberty, when he predicted the rise of militarism and total war in the twentieth century and the political centralization and regimentation that such militarism would bring in its wake, he let it be known that classical liberalism was dead for the foreseeable future. And he was right.

Political Donations vs. Industry Affliation

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Business Insider reports,

Lobbyists are, perhaps unsurprisingly considering their role in the political system, similarly split

Actually, you need to read the article. Pointer from Tyler Cowen. Some remarks.

1. Although both liberals and conservatives receive large donations from lobbyists, the donations of people in the media skew very heavily liberal. I am not sure that this is easy to explain. I would think that the market would produce a bulge in the media at both extremes, not at one.

2. I am not surprised that the auto, banking, pharmaceutical, and real estate industries donate heavily to both liberals and conservatives. When you have a close relationship with government, you need to hedge your bets.

Inflation Defies Fundamentals

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Jan Groen writes,

Another issue is how to find the right variables to predict future inflation. Economists often use the Phillips curve relationship, with inflation depending inversely on unemployment—that is, lower unemployment puts upward pressure on wages and, eventually, on inflation. But while an unemployment rate variable is common, it isn’t clear that this is the best gauge. Stock and Watson (1999) and Wright (2009) consider a broader range of possible “economic slack” variables and then use different ways to condense the information in these variables to predict future inflation. Generally, these approaches do as well as or better than autoregressive models. Atkeson and Ohanian (2001), however, conduct a similar exercise but focus on the post-1985 period, which—up to the advent of the Great Recession—was a period typified by remarkably low and stable inflation in the United States. Using the Chicago Fed National Activity Index (CFNAI), which summarizes information across many activity variables, they show that the resulting inflation forecasts are worse than when one just relies on current inflation to forecast future inflation.

Links omitted. Pointer from Mark Thoma.

Standard macro theory includes a “tight” model of inflation. You might have a Phillips Curve in which inflation depends on unemployment. Or you might prefer a monetarist formulation, in which inflation depends on money growth.

However, if you rely on these relationships in the real world, your predictions for inflation will be awful. Think of your forecast as a weighted average of

a) inflation tomorrow will be what it was yesterday; and
b) inflation tomorrow will be determined by measures of economic slack and/or money growth

If you put any significant weight on (b), you will be hosed.

My own inclination, which I think is close to that of the late Fischer Black, is to treat both money and the average level of prices as consensual hallucinations. As far as money goes, we accept currency and abstractions representing currency today because we expect that other people will accept them tomorrow. The prices that we charge today are based on prices that we expect to face tomorrow. These habits and beliefs are extremely sticky, and they are usually self-validating.

Let me put it this way:

the average behavior of prices is an emergent phenomenon, not a phenomenon that is controlled top-down through the manipulations of the central bank.

Read that several times, until you appreciate the heresy.

I do subscribe to a fiscal theory of hyperinflation. If the government runs deficits and loses the ability to fund those deficits with long-term borrowing, then it has to go on a money-printing frenzy that will destroy the emergent properties of money and prices.

Along those lines, I am curious as to what will happen in Japan. The fiscal and monetary authorities there would like to engineer a moderate level of inflation. What they seem to be doing strikes me as sufficient to generate hyperinflation. So far, a consensual hallucination of zero inflation seems to be holding.

I think that economists should be very modest and humble in claiming to understand inflation.

My Election Take

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1. There is little else to write about today.

2. It was a Seinfeld election. Mitch McConnell said that he did not want to tip his hand before the election by articulating an agenda. Does anyone think he has a hand to tip? The only reason he runs for the Senate is because he loves hanging out there.

3. Conventional wisdom is that, relatively speaking, Democrats have a structural advantage in Presidential elections, because those elections attract more turnout. In other words, they do much better among disengaged voters. One could spin this positively for the Democrats, saying that they get support from the weaker segments of society. One could spin this negatively and say that they rely on a segment of the electorate that is poorly informed and easily bamboozled, which I believe is the case. The counter to that would be that Republicans also rely on a segment of the electorate that is poorly informed and easily bamboozled, which I also believe is the case. I really do not understand why people think that democracy is so great. Its chief advantage is that it provides for peaceful transitions of power. I continue to believe that markets, imperfect as they often are, produce better outcomes than voting.

4. One problem with the Democratic “brand” at the moment is that it is associated with incompetence. How will they remedy that in 2016? Would nominating Cuomo do the trick?

5. Another problem is that in the ethnic/gender wars, the Democrats came off as more strident than the Republicans in 2014. They may have reached the point where their tactics are alienating more voters (many white males and also some white females) than they are attracting. Of course, such tactics may be better suited to a Presidential election with more turnout.