Category Archives: markets

Oops, Maybe You Should Not Annuitize

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Felix Reichling and Kent Smetters write (gated–ungated version here),

But the presence of stochastic mortality probabilities also introduces a correlated risk. After a negative shock to health that reduces a household’s life expectancy, the present value of the annuity stream falls. At the same time, a negative health shock produces potential losses, including lost wage income not replaced by disability insurance, out-of-pocket medical costs, and uninsured nursing care expenses, that may increase a household’s marginal utility. Since the value of non-annuitized wealth is not affected by one’s health state, the optimal level of annuitization falls below 100 percent.

I once wrote,

An annuity is risk-reducing if the only risk you face is additional longevity. In fact, other risks may be more serious. You could easily find yourself needing to take out a loan if your savings are tied up in an annuity and your spouse requires a home health aide.

Economists have been preaching for 50 years that the low usage of annuities illustrates a market failure. In fact, what it may illustrate is that economists who relied on a mathematical model left out some important considerations. We need a term for this. I propose model failure.

How Bad is Financialization?

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Noah Smith writes,

For a long time, and especially since the financial crisis, many people have suspected that financialization is bad for an economy. There is something unsettling about watching the financial sector become a bigger and bigger part of what people do for a living. After all, finance is all about allocation of resources — pushing asset prices toward their correct value so businesses can know what projects to invest in. But when a huge percent of a country’s effort and capital are put into finance, there are less and less resources to reallocate. We can’t all get rich trading houses and bonds back and forth.

Pointer from Mark Thoma.

1. Economists have no idea how to measure the value created by the financial sector. Ask any economist the following question: how should we define/measure the output of a commercial bank? You will hear the sound of crickets–even among economists who purport to study economies of scale in banking! An even more difficult question is how to measure the output of an investment bank.

2. Mathematical economics, notably the Arrow-Debreu general equilibrium model, implies that the value produced by the financial sector is exactly zero. Note Smith’s phrase “pushing asset prices toward their correct value.” This strikes me as a very truncated view of the role of financial institutions, but even so it is ruled out by Arrow-Debreu, in which prices are determined by a set of equations without any agent in the economy doing any “pushing.”

What should we conclude from (1) and (2)? One possibility is that the value of the financial sector is close to zero. The other possibility is that the cult of mathematical modeling has left economists unable to describe the role of financial institutions in the economy. My money is on this latter possibility.

Economists’ analysis of the financial sector is close to 100 percent mood affiliation. You will find many economists who are convinced that the failure of Lehman Brothers had major economic effects. You will not find a carefully worked-out verbal description of this, much less a mathematical model.

Note that I do not cheer for large banks or for mortgage securitization. My thinking on the financial sector is spelled out more in the Book of Arnold.

Here, the point I am trying to make is that not having a grasp on what financial institutions do should be an indictment of economists, not of the financial sector.

Eugene Fama on Fed Impotence

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He writes,

Section II uses autoregressions with error correction terms to document that the day-to-day
variation in rates for maturities of a month or more has little or nothing to do with the Fed’s target rate.
This is consistent with a Fed that has little control of rates, but we shall see that it is also consistent with a
powerful Fed whose predictable actions with respect to TF are built in advance into interest rates.

Thanks to John Cochrane for the pointer. Note that TF is the Fed funds rate. My remarks:

1. I do not trust any time series regressions.

2. I think it is interesting that a framework in which the Fed has no influence is observationally close to a framework in which the Fed controls interest rates but market participants anticipate the Fed’s actions very well.

3. We may be in an environment today in which long-term rates over-react to short-term changes in the Fed funds rate.

4. Still, I take the view that the Fed is not big enough in the financial markets to have much durable influence on market interest rates.

A Fiery Analogy

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Robert Shiller writes,

The reluctance to acknowledge the need for immediate intervention in a financial crisis is based on a school of economics that fails to account for the irrational exuberance that I have explored elsewhere, and that ignores the aggressive marketing and other realities of digital-age markets examined in Phishing for Phools. But adhering to an approach that overlooks these factors is akin to doing away with fire departments, on the grounds that without them people would be more careful – and so there would then be no fires.

Pointer from Mark Thoma.

There is a school of thought (I am not a member) that would instead compare the Fed to the 10-year-old boy who starts a fire and then claims to be a hero because he then calls the fire department to come in to save it. Similarly, this school would argue, the Fed’s expansionary policies caused the housing bubble, and now the Fed earns praise for saving the economy from the resulting crisis.

Indeed, in recent interviews, Shiller has warned that stock prices are too high and we could see a crash. He would say that this is because markets are irrational. As far as I know, he is not calling on the Fed to raise interest rates in order to try to stop what he might call another financial epidemic. Again, I am not of the school of thought that thinks that the Fed is responsible for the stock market boom. But I think that Shiller ought to engage with those who are of that school of thought.

Incidentally, I received a review copy of Phishing for Phools, by Shiller and fellow Nobel Laureate George Akerlof. My views of the financial crisis are informed by my knowledge of institutional characteristics and history of housing finance. Their views are not. I find that this is the case with many economists who have written on the crisis, but their book left me especially frustrated. UPDATE: Alex Tabarrok also reviewed the book negatively.

The Econometrician and the Entrepreneur

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Don Boudreaux writes,

The market itself is a vast and on-going laboratory of experiments – experiments that are relevant, real, and revealing. These experiments are valuable not least because they are made under real-world circumstances and by people with strong personal incentives to discover and comprehend the ‘truth’ better than their rival experimenters. . .

While I sincerely believe that much useful information can be gathered by academics doing empirical studies (both quantitative and non-quantitative), it is an unwarranted conceit of academics to suppose themselves and their empirical studies to be the only, or even the chief, source of empirical knowledge of social reality.

The notion that markets generate and process information must be very non-intuitive. It strikes me as under-appreciated by many people, including economists. Of course, markets lack perfect information–otherwise there would be no flawed products, no business failures, and no financial crises. But I am not arguing that the market process has generated perfect information. I am simply suggesting that it is hard for someone–even someone armed with a lot of data and a computer–to be more informed than the market.

Double Liability for Bank Shareholders

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Howard Bodenhorn writes,

Beginning in the 1810s, several states imposed double liability on chartered commercial
banks. . .

Relying on cross-sectional data Macey and Miller (1992) and Grossman (2001) find that double liability actually increased measured bank leverage, an apparently counterintuitive result they attribute to double liability serving to reassure creditors that they would be made whole in the event of bank failure. To the extent that double liability served as an implicit, off-balance-sheet increase in the bank’s capital account, the increase in measured leverage overstates creditor risk and explains the counterintuitive result.

Remarks:

1. Double liability for shareholders is not as strong as a proposal that I have made, which is that bank managers serve prison terms in the event of bank failure.

2. I think that double liability works well only if the bank’s ownership is highly concentrated. In that case, I assume that the shareholders would be able to exert strong influence on the bank’s practices.

3. There are two forms of leverage: financial leverage, which is the ratio of debt to equity; and operating leverage, which is the risk of the firm’s assets. Assuming that bank creditors were rational, they must have believed that the double-liability firms were employing less operating leverage than their peers.

Against Identical Expectations

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Noah Smith writes,

rational expectations might really be wrong. People might make systematic errors, thinking that booms or busts will last forever. If that’s the case, then it will require the economics profession to abandon one of its strongest orthodoxies. But the payoff could be big if the profession devises models that successfully explain phenomena like bubbles and crashes.

Pointer from Mark Thoma.

Smith cites (preliminary?) research by Jesse Bricker, Jacob Krimmel and Claudia Sahm, who

looked at data from the Survey of Consumer Finances, from before and after the housing crash in 2008. They found that more optimistic ZIP codes — that is, places where people had unrealistically high expectations for their own incomes — were more likely to overpay for houses in the bubble run-up before 2008. These overoptimistic people also took on more debt, and they were more likely to increase borrowing in response to rising house prices.

I have not found a write-up of this work. UPDATE: slides here. But my thoughts:

1. “Rational expectations” is one of an entire class of expectations models that I reject. I call this class “identical expectations,” because it assumes that every individual has the same model of the market and the same information, thus arriving at the same set of expectations. I find this both unrealistic and, as Frydman and Goldberg have pointed out, un-Hayekian, because it assumes away any sort of local knowledge.

2. If we are going to attempt a simple model of expectations, then I would suggest one in which there are two types of traders–momentum traders and contrarian traders. Momentum traders live by the maxim “the trend is your friend.” When prices have risen recently, they expect them to continue to rise. Contrarian traders live by the maxim, “if something cannot go on forever, it will stop.” When prices have risen recently to the point where they are above historical norms relative to fundamental measures of value, contrarian traders expect them to fall.

Momentum traders never see bubbles. Contrarian traders see bubbles everywhere.

Economists tend to be contrarian traders. Robert Shiller is the leading exemplar of this. Not all economists share his views, of course, but hardly any economist would confess to being a momentum trader.

Still, I think that there are times and situations where momentum trading dominates. Both Shiller and John Cochrane see momentum trading as something that can persist for a while in housing markets, because of the high costs facing traders who would try to take advantage of even well-founded contrarian views.

Update: Smith recommends a paper by Hong and Stein.

Financial Advice for Bryan Caplan

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He says that he maintains as much housing debt as possible, in order to take advantage of the mortgage interest deduction.

My advice to him is to sell his stock portfolio, pay off his housing debt, and take long positions in stock index futures.*

*In practice, the prospect of incurring capital gains taxes might make this a bad move.

Here is my thinking.

1. If you maintain housing debt that you could pay off, you have to put the money to work somehow. The question is whether you can earn more on your money than the after-tax interest rate. If you invest in risk-free securities, the answer is obviously “no.” Borrowing at 3 percent to invest in a money-market fund is a losing proposition, tax deduction or no tax deduction.

2. There might be some bond that you can buy that earns more than the after-tax mortgage interest rate, but that bond is going to have some risk attached to it. And you will have to pay taxes on the interest from that bond.

3. That leaves stocks. If you maintain housing debt in order to own stocks, then you are saying that you are happy to have a leveraged position in stocks, because you think that the expected return on stocks is higher than your borrowing rate. In Pikettyian terms, you believe that g is greater than r.

Fine. But if that is true, then I am pretty sure that the most efficient way to take your position would be by holding a position in stock index futures, rather than by taking out a mortgage loan to invest in stocks.

If you don’t like paying taxes, I understand that. As much as I disparage non-profits, I give large amounts to non-profits because I prefer that to paying taxes. But from a purely financial perspective, I think that maintaining mortgage debt that you could afford to pay off strikes me as a losing proposition. You unnecessarily enrich the mortgage lender at your expense.

A Gentleman’s Bet on the Fed

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I would bet that five years from now the size of the Fed balance sheet will be at least 85 percent of what it is now. I would make the same bet for ten years from now, but it is easier to hold me accountable in five years. Unlike Bryan Caplan, I prefer non-money bets.

My view is that “monetary policy” is just a ruse. If you want to understand government’s role in financial markets, focus on credit allocation. From that perspective, I do not think that the Fed will want to reallocate credit away from government debt and mortgage securities any time soon. . .or, in fact, any time.

Bengt Holmstrom Re-discovers a Theory of Debt Contracts

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He writes,

The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by using over-collateralised debt that obviates the need for price discovery. Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity, as I will argue later.

Pointer from Timothy Taylor. The theory that debt is used when the underlying assets are opaque is not quite new. My articulation of it owes a bit to the delegated monitoring idea of Doug Diamond.

The natural error for economists to make is to assume that bank creditors “see through” the bank to the underlying assets. What Diamond got me thinking is that the whole point of a debt contract is to ensure that the creditor does not have to see through the bank unless the bank gets into trouble. That is the insight that Holmstrom is re-discovering.