Category Archives: markets

Olivier Blanchard and Joseph E.Gagnon: This Time is Different

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They write,

the deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets? A central aspect of the crisis has been the decrease in the interest rate on bonds, short and long. According to the yield curve, interest rates are expected to remain quite low for the foreseeable future. The expected return on stocks may be lower than it used to be, but so is the expected return on bonds.

Pointer from Mark Thoma.

Their point is that when interest rates are low, you can justify exceeding historical norms for the price-earnings ratio on stocks. I made a similar point about the price-earnings ratio for real estate relative to interest rates during the housing bubble.

Bureaucratic Rump-Covering

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Timothy Taylor points to a report by a new bureaucracy, the Office of Financial Research. Taylor writes,

The report emphasizes three main risks facing the US economy: 1) credit risks for US nonfinancial businesses and emerging markets; 2) the behaviors encouraged by the ongoing environment of low interest rates; and 3) situations in which financial markets are not resilient, as manifested in shortages of liquidity, run and fire-sale risks, and other areas.

There is a difference between actionable intelligence and bureaucratic CYA. If somebody says, “we are seeing a lot of chatter laately among these four terror cells. We had better watch these individuals closely,” that is actionable. If somebody says, “there is a risk that in the current climate terrorists will attempt a major attack,” that is not actionable, it is just CYA.

Reading Taylor’s post, I doubt that there is anything actionable in the OFR report. If the OFR had existed in 2006, we would have been told that the high level of house prices posed a potential risk. Which everyone already knew. They just did not have actionable intelligence about the state of the portfolios of key players, like Merrill Lynch, Citigroup, and Freddie and Fannie.

Dealers vs. Brokers in Housing

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Tyler Cowen points to a WSJ story about a start-up that will buy your house and flip it, so that you don’t have to spend time selling it.

In securities markets, we differntiate between brokers and dealers. A broker brings together buyers and sellers. A dealer buys from sellers, holds securities in inventory, and sells to buyers out of this inventory.

One challenge with trying to be a housing dealer is that it adds another transaction in a market where transaction costs are artificially high. Some jurisdictions have transfer taxes. You might have to pay for an extra title search. Another home inspection. Etc. Also, while a security still accrues interest while it is in inventory, an unoccupied house does not generate rent.

Regulation and Financial Complexity

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CFTC Commissioner J. Christopher Giancarlo said,

At the heart of the 2008 financial crisis was the inability of regulators to assess and quantify the counterparty credit risk of large banks and swap dealers. The legislative solution was to establish swap data repositories (SDRs) under the Dodd-Frank Act. Although much hard work and effort has gone into establishing SDRs and supplying them with swaps data, seven years after the financial crisis the SDRs still cannot provide regulators with an accurate picture of bank counterparty credit risk in global markets. That is because international regulators have not yet harmonized global reporting protocols and data fields across international jurisdictions. Certain provisions of Dodd-Frank actually hinder such harmonization, despite widespread bipartisan legislative support for their correction over the past two Congresses.

Pointer from Timothy Taylor. Read the whole speech, which is wide-ranging and thought-provoking. Among other topics, Giancarlo discusses the significance of blockchain and the outsized role of the Fed in key securities markets due to its enlarged balance sheet.

My view is that the financial market is a complex, adaptive system, and attempts to reduce systemic risk will backfire. Several years ago, I focused on the discrepancy between knowledge and power. Regulators seek more and more power, and at times they get it. But what they really lack, and will never possess, is the information needed to understand market processes well enough to be able to predict the ultimate effect of regulation on behavior. That information is dispersed, so that no one individual or regulatory body can obtain it.

The Midas Paradox So Far

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That is Scott Sumner’s magnum opus on the Great Depression. I am part way through it. The importance of the book cannot be overstated. Here, I want to mention two problems I am having.

1. The structure of the book. It is difficult to get through. He constantly interrupts his own interpretive narrative to discuss other economists’ narratives. I would have rather seen the discussions of other narratives cordoned off into appendices.

2. Sumner wants to rely on stock market movements as indicators of the effect of monetary policy on the economy. I am never a fan of trying to interpret the stock market, and this time period seems particularly problematic. Robert Shiller’s famous argument against the efficient markets hypothesis is the “excess volatility” that he found in stock prices. The period that Sumner is describing has volatility that goes far beyond even what caused Shiller to reject market efficiency. Reading Sumner’s narrative, there seem to be a lot of days where the market goes up or down by 4 percent, 5 percent, or more. In today’s terms, that would mean the Dow often gaining or losing 700 to 850 points in a day. I am inclined to dismiss 90 percent of these movements as irrational (I would do the same for short-term movements in the market now). I understand that Sumner is looking for indications that the economy is responding to monetary policy, as opposed to some other factor, but I find it more persuasive when he cites medium-term trends in commodity prices than when he cites short-term stock price behavior.

I Admit I Do Not Understand a Negative Bond Interest Rate

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The FT reports,

The Swiss 10-year yield fell (meaning prices rose) 0.02 percentage points this morning, touching minus 0.41 per cent, breaking the previous record low of minus 0.39 per cent it hit last week.

Pointer from Tyler Cowen.

Why would I not rather hold Swiss currency than Swiss bonds? Currency would seem to be just as safe, and it does not earn a negative interest rate. Some possibilities:

1. There is a “convenience yield” from holding bonds. If you want to store a lot of wealth, currency is bulky and more easily stolen. So very wealthy individuals and large institutions are willing to hold bonds, even though they yield less than currency.

2. There is a bond bubble. That is, everyone knows that eventually bond prices have to fall (meaning that the interest rate rises), but momentum traders are willing to bet that in the near term bond prices will rise (meaning that rates will fall further). They think that when they buy bonds they will make a short-term profit by selling to the next sucker.

Neither of these stories is persuasive to me, but if I were forced to choose, I would pick (2).

Since writing the above, I came across Scott Sumner’s useful thoughts. He writes,

I recall reading that the SNB was informally discouraging currency use, by telling banks not to pay out large sums of currency to depositors. (Unfortunately I forgot where I read that.) Of course the US government has been trying to criminalize the use of significant sums of currency.

I still think it’s a bond bubble. I personally believe that the odds are that we will see positive interest rates a few years from now, and the people buying medium- and long-term bonds today will get burned.

Can Crowdfunding Work?

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Robert Shiller is worried about crowdfunding.

But the SEC could do more than just avow its belief in “uncensored and transparent crowd discussions.” It should require that the intermediary sponsoring a platform install a surveillance system to guard against interference and shills offering phony comments.

Pointer from Mark Thoma.

My thoughts:

Amateur investing in start-ups is per se a really bad idea. I did it a few times as an “angel investor” and got screwed. Founders made promises to me about how they would handle finances, and they quickly broke those promises. And once, when the start-up managed to do well, the founder obtained follow-up funding that amounted to legal blackmail against those of us who were early investors, so we got nothing. I came out of that experience convinced that unless you have top-notch lawyers working with you, investing in start-ups is a no-win game. As a small investor, you would need to score a home run just to cover your legal bills.

I see two possibilities for crowdfunding.

1. Suppose that people are only asked to invest in companies where they want to buy the company’s offering. Then, it seems like an interesting way for start-ups to do early market testing.

2. Suppose that the crowdfunding platforms provide some of the legal protection that venture capitalists and other high rollers are able to give themselves against subsequent misbehavior by founders or follow-on financiers.

If one of these, or preferably both, are in place, then I think that crowdfunding could last. Otherwise, I expect it to produce very negative average long-term returns and die a natural death.

Houses and Land

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Kevin Erdmann writes,

The real long term natural rate right now is about 2.5%. If you have tons of cash or you can run the gauntlet and get a mortgage, or if you are an institituional investor going through the difficult organizational process of buying up billions of dollars of rental homes, you get the preferred rate of 4% real returns.

Pointer from Tyler Cowen. Erdmann thinks that we have not built enough houses, so rents will be rising, so owning rental property is a great investment. My comments:

1. I would have thought so, too. I put a lot of money in REITs. It has not done well. I also invested a lot of money in firms that own/manage a lot of apartments. It did not do well. Maybe all that says is that I played in a segment of the market that is efficient, when the point is to try to exploit the inefficient segment.

2. If I understand his thinking, there are not enough buyers to bid house prices to their fair market value. So you can own an apartment building at a high rent/price ratio. But it seems to me that, at least in some markets, the price/rent ratio has gone up rather than down in the past few years.

3. I am not sure that I trust my intuition about housing markets. My friends and relatives tend to be located in Blue cities where regulation restricts supply. I do not have a good feel for less-regulated markets.

Wray on Minsky

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My review of the book says,

While L. Randall Wray also praises Minsky for his anticipation of the financial crisis of 2008, he provides a much more nuanced and complete picture of Minsky’s analytical framework than I had encountered previously. While I am not completely converted, I came away from the book with considerably more understanding of Minsky’s views and a greater respect for them.

I still consider this one of the best books of the year.

Good Turner, Bad Turner

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In Between Debt and the Devil, Adair Turner writes (p. 61),

Textbook descriptions of banks usually assume that they lend money to businesses to finance new capital investment…But in most modern banking systems most credit does not finance new capital investment. Instead, it funds the purchase of assets that already exist and above all, existing real estate.

…Different categories of credit perform different economic functions and have different consequences. Only when credit is used to finance useful new capital investment does it generate the additional income flows required to make the debt certainly sustainable. Contrary to the pre-crisis orthodoxy that the quantity of credit created and its allocation between different uses should be left to free market forces, banks left to themselves will produce too much of the wrong sort of debt.

What is good about the book is that he invites us to examine how credit is created and where it goes. As he points out, standard macro models have totally ignored this issue.

What is bad about the book is embedded in the last sentence quoted above. We are left to assume that the huge allocation of credit toward housing was the operation of “free market forces.” I do not know about other countries, but for the United States this is totally false. The government was very much involved in channeling credit, and it channeled as much as it could toward housing finance.

Still, I think that what is good about the book makes it worth reading. I plan to say more when I have finished it.