Category Archives: financial markets

Matt Rognlie Proposes a Solution

Posted on by

In the comments on this post, he suggests a possible way to reconcile secular stagnation with a high return on capital.

One way to reconcile the two is to say that Piketty’s return on capital includes the equity premium (and other premia for privately held businesses, etc.), whereas the secular stagnation idea of a perpetual ZLB deals with only the riskfree rate.

Some remarks:

1. Fischer Black said that finance is about time and risk. The risk-free rate is the price of time. The equity premium might be a proxy for the price of risk.

2. In Keynesian terms, perhaps one can think of a low risk-free rate as reflecting the desire to hoard and a high risk premium as reflecting low animal spirits.

3. As Matt notes, this approach to reconciling secular stagnation with a high return on capital implies that those earning the high returns are being rewarded for taking risks in an economy in which such risk-taking is scarce. Picketty seems to be pretty confident that high earners will not change their behavior much in response to higher taxes. Perhaps this might be true of labor supply. But can one rule out a significant dampening effect on risk-taking?

Read Matt’s entire comment. As he points out, the secular stagnation story is difficult to reconcile with some fairly basic calculations concerning capital and investment.

Shiller-Bashing

Posted on by

Scott Sumner writes,

I distinctly recall that Robert Shiller did not recommend that people buy stocks in 2009. That made me wonder when Robert Shiller did say it was a good time to buy stocks.

Barry Ritholtz writes,

By one metric — Yale professor Robert Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE ratio — stocks are especially pricey. This has become the bears’ favorite valuation measure. But beware of cherry-picking any particular metric that rationalizes your position. Indeed, over the past 20 years, the CAPE measure has pegged U.S. equities as “overvalued” 85 percent of the time.

But for me, the most interesting Shiller-bashing is in the book I am reading by Duncan Watts, Everything is Obvious. He reproduces a chart created by David Pennock and Dan Reeves, using option prices to derive the probability distribution of future stock prices. The chart shows clearly that the uncertainty about future stock prices is much higher than the variation of past stock prices. That is exactly the criticism that I made of Shiller’s famous “variance bounds” estimates when he first published his work on that topic, and which he told the journal editor to reject. I still think that I was right. I should note that Watts does not make the Shiller connection in his book. However, I think that Watts gives us plenty of reason to be cautious about making statements like “Shiller called the housing bubble.”

I wish that more economists were aware of Watts.

Nerd Baseball

Posted on by

Just about every year, one of my high school students asks me to be a faculty sponsor for a team that will participate in a stock market contest. I always refuse. My problem is that the strategy for winning the contest is the opposite of what I would recommend for a real-world investor.

A real-world investor should try to more or less match the market. But if you want to win the contest, you have to do much better than the average investor, which means you need a strategy that makes outrageous bets. I think if you entered me in the contest, I would put all of my money on out-of-the-money put and call options on the S&P 500. In the real world, you figure to lose all your money that way. But in a contest, if the market has either a good run or a bad run, you will win the contest. I am not saying that my strategy is absolutely the best for the contest, but I think it makes sense.

Anyway, speaking of such contests, this it the time of year for fantasy baseball. My thoughts below the fold. Continue reading →

Housing and Austrian Economics

Posted on by

Megan McArdle writes,

Now, I thought we all agreed that in 2008, prices were too high, and there was a big bubble. What are we to think of even higher prices in 2014, when the economy has been staggering along on life support for six years?

I can tell a story about these cities in which they’re somehow special and the money will just keep rolling in. But I can also tell a story in which people are paying more than they should for houses in my neighborhood on the assumption that today’s $750,000 house will be tomorrow’s $1.5 million retirement fund, even though incomes in DC can’t really support an entire city’s worth of seven-figure homes. I might even tell a story where today’s ultra-low interest rates give several cities full of smart upper-middle-class professionals a badly contagious case of money illusion.

Low interest rates do seem to boost the prices of some assets.

The Danger of Bond Bubbles

Posted on by

Gillian Tett writes,

In recent years an astonishing amount of money has quietly flooded into fixed income funds, which buy corporate bonds, emerging markets bonds and mortgage debt. And as the US looks more likely to raise interest rates, creating potential losses for bondholders, the flows could reverse – creating destabilising shocks for regulators and investors alike.

Read the whole thing. Pointer from Phil Izzo. My thoughts:

1. The last time I talked about a “bond bubble” was in 2003. Subsequently, I wrote that only a bursting of the bond bubble could undermine high house prices. I was wrong about that one.

2. Larry Summers would explain the “bond bubble” as secular stagnation. In his view, there is low demand for capital. As you know, I have little regard for this thesis.

3. Perhaps I feel burned by the way that the housing bubble burst on its own, but I would not focus on a bursting of the bond bubble as the key risk today. I find myself sympathetic to Seth Klarman on the stock market (Klarman is cited by Tett, and if you search diligently you can find copies of his investor letter posted on the web). I am skeptical of contemporary market arithmetic.

4. Klarman blames the Fed for low interest rates, and so do many people of my ideological stripe. My view is that if the markets wanted high interest rates, they could have them, notwithstanding the Fed’s efforts. Perhaps we now live in a world in which the primary threat to saving comes from political risk. In that world, savers are not looking for the assets with the best financial characteristics. Instead, they are hoping to invest where they will not lose their capital to taxation and confiscation. This might explain why a lot of foreigners still prefer to invest in low-yielding U.S. assets.

But the bottom line is that today’s financial markets have me puzzled.

The Financial Crisis and Wealth Transfer

Posted on by

Amir Sufi writes (with Atif Mian).

The strong house price rebound in high foreclosure-rate cities likely reflects these markets bouncing back after excessive price declines. But these foreclosed properties are not being bought by traditional owner-occupiers that plan on living in the home. Instead, they have been bought by investors in large numbers.

This is from a new blog spotted by Tyler Cowen, and both of the first two posts are worth reading in their entirety.

The picture that I get is of a pre-crisis economy in which middle- and lower-middle-income households thought they were doing well in the housing market. Then their house prices collapsed. Vulture investors swooped in to buy. Meanwhile, the government bailed out big banks and the stock market boomed. Some folks will credit the Fed for the latter. I don’t, but that is a bit beside the point here.

Net this all out–the sucker bets on housing by the non-rich, followed by big gains by wealthier folks in stocks and in foreclosed houses, and you get a picture of a huge regressive wealth transfer engineered in Washington. Carried out primarily by those who profess to be outraged by inequality.

Freddie and Fannie Shareholders vs. Government

Posted on by

Richard Epstein cries “Fraud.”

The initial bailout terms were contained in a Senior Preferred Stock Purchase Agreement (SPSPA). Under its terms, each corporation had to issue a new class of senior preferred stock to the United States, which bore interest at 10 percent per annum. That sum increased to 12 percent if Fannie and Freddie chose to conserve cash instead of paying dividends. For the next two or so years, as conditions in the housing market improved, the arrangement proceeded more or less as planned. The entire legal landscape, however, was radically changed in August 2012, when the Third Amendment to the 2008 SPSPA was passed. It called for a “net worth sweep” under which FHFA and Treasury entered into a deal that magically converted all the net receipts of Fannie and Freddie as “dividends” to be paid to the government.

Peter Wallison says it’s not so sad.

The original shareholders of Fannie and Freddie, as noted above, should have been wiped out by a receivership. The Treasury’s mistake in keeping shareholders’ rights “alive” was a windfall for this group. The shareholders that bought in after Fannie and Freddie were placed in the conservatorship were largely hedge funds, speculating on later developments. Speculation is certainly good, and is vital to price discovery, but in this case the hedge funds probably realized not only that Fannie and Freddie—because they continued to dominate the housing market—would eventually become profitable but also that they could probably push Congress to do what Entine recommends: allow these profitable companies to exit the conservatorship and resume their role as profit-making enterprises. That would have made a fortune for the hedge funds. Indeed, the Treasury’s move to extract all the profits from Fannie and Freddie was probably developed to prevent the success of this strategy. The Treasury was worried that it might succeed.

I’m with Wallison. If you bought Freddie or Fannie stock any time after 2008, you were not investing in fundamentally sound private businesses. You were buying a political lottery ticket. If the politicians had decided to perform financial CPR on Freddie and Fannie and then re-privatize them, you would have made a fortune. Given that they decided otherwise, you lost a pittance. Don’t sue because your lottery ticket lost. Don’t pay Richard Epstein to plead your case in public. Just tear up your worthless lottery ticket and shut up.

My Review of Calomiris and Haber

Posted on by

Is here. An excerpt:

The authors posit a contrast between what they call liberal democracy and populist democracy. Liberal institutions are designed to limit the power of what James Madison called factions, in part by making the government relatively unresponsive to public clamor. Populist institutions are designed to increase the power of those who can command electoral majorities.

A central claim of the authors is that banking crises are more likely in heavily populist countries than in countries that are less populist. They cite Canada as an example of the latter. For instance, in Canada, Senators still obtain office by appointment, rather than by direct election.

Podcast with Calomiris and Haber

Posted on by

Russ Roberts did the interview live.

I was in the audience, and I stammered out this question”

I’m trying to figure sort of what makes Canada’s banks stable, and the thing that comes to mind is charter value, that the–you only have 5 of them, and they are profitable, and so they don’t want to lose their charter, and so maybe that stabilizes things. First, I wonder if you agree with that. And secondly, if you do, what are the forces that keep that from happening in the United States? I think you mentioned the populist sentiment–people don’t want banks to be profitable. The government wanted to use banks for redistribution purposes. Should we be trying to head toward a system where banks have valuable charters and if so, how could we head that way?

I did not think that they answered the question well. When I was at Freddie Mac, the CEO, Leland Brendsel, was very clear on the fact that the company had a valuable charter that it needed to protect, and this included not taking excessive risk. That changed after I left. In part, it was a new CEO. In part, it was a political environment in which Congress was even more convinced than the private sector that there was no such thing as a loan application that you should turn down.

A lot of the banking deregulation in the 1980s and 1990s was designed to make banking more competitive. The quasi-monopoly power of “unit banks,” which Calomiris and Haber have such contempt for, was ended. But the result was to weaken the value of bank charters, which may have induced banks to take more risk. Gary Gorton made this point a few years ago.

In any event, if I had it to do over again, the question I would ask is, “What explains Switzerland?” Because a lot of their thesis is that banks emerge in order to feed government demand for borrowing to fight wars. Switzerland famously has a significant banking sector, but I don’t see it as having arisen to help finance Swiss imperialism.

John Cochrane’s Bank Reform

Posted on by

He proposes,

For every dollar of short-term debt, pay the government (say) 10 cents. I don’t know the exact number either, but a wrong tax rate does a lot less damage than a wrong quanti[t]ative restriction.

Instead of telling banks what their ratio of debt to equity should be, let them choose that ratio, based on a tax that offsets the implicit subsidy to debt that comes from bailouts. Makes sense.