Category Archives: markets

Brad DeLong on Piketty

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Brad writes,

We have a world in which some eminent economists (Larry Summers) say r1 is too low, and other eminent economists (Thomas Piketty) say r2 is too high…

The difference between r1 and r2 is the risk premium. In a well-functioning market economy with well-functioning financial markets, there are powerful reasons to believe that this risk premium should be small: less than 1%-point per year. The fact the risk premium appears to me to be 7%-points per year today is a powerful evidence of the profound dysfunctionality of our financial markets, and of their failure to do their proper catallactic job. But that is a separate and largely independent discussion: that is a dysfunction of our modern market economy which is different from either the dysfunction feared by Summers or the dysfunction freaked by Piketty. For the moment, simply note that it is perfectly possible for all three of these major dysfunctions to occur together.

Pointer from Mark Thoma. Read the whole thing. The risk-premium solution was also suggested here in a comment by Matt Rognlie.

So far, the left-wing journalistic verdict on Piketty is rapture. Economists, even those inclined to agree with Piketty’s conclusions, seem somewhat unsatisfied with with his treatment of capital and interest.

Wealth, Income, and Stock Prices

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As I start to read Piketty, the following train of thought occurred to me.

How would I explain fluctuations in the ratio of wealth to income? In particular, why did that ratio fall in the 1930s and why has it risen in recent decades?

My first thought is to look at stock prices, and at the P/E ratio. As the P/E ratio goes up, the ratio of stock market wealth to earnings goes up.

What drives the P/E ratio? The standard explanation would use some version of the discounted earnings model. That is, the P/E ratio will be high when the discount rate is low and/or expected future earnings are high. Over the past century, stock prices have trended upward because of one or both of these factors. That is, investors have been willing to discount earnings at lower rates or they have raised their expectations for earnings.

Call the discount rate r and the expected growth rate of earnings g. In short, the discounted earnings model says that the P/E ratio will be high when r is low and/or g is high.

Yet Piketty sees the rise in the ratio of wealth to income as caused by the opposite configuration. That is, he thinks it has taken place because r is high and g is low.

Of course, his r is “return to capital,” not the discount rate. And his g is the growth rate of total income, not corporate earnings. But I wonder how one sorts this all out, and how one goes about choosing between the finance-theoretic explanation of changes in the ratio of wealth to income and the Piketty-Marxist explanation.

UPDATE: James Galbraith writes,

when asset values collapsed during the Great Depression, it mainly wasn’t physical capital that disintegrated, only its market value. During the Second World War, destruction played a larger role. The problem is that while physical and price changes are obviously different, Piketty treats them as if there were aspects of the same thing.

And….?

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Nick Timiraos writes,

Mortgage rates could rise by as much as 1.5 percentage points for homeowners with weaker credit or smaller down payments under various legislative proposals to overhaul Fannie and Freddie Mac, according to a study prepared for an industry group.

The study purports to estimate what is seen. How about what is unseen? That is, suppose we reduce the distortions in capital markets that funnel money into high-risk mortgages. That means that the interest rate on high-risk mortgages goes up. And…? Some other interest rate goes down. It might even be the interest rate paid by firms undertaking productive investment.

Why I Want to Break Up the Big Banks

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Matthew C. Klein writes,

Using the lowest estimates, the big banks can attribute almost a fourth of last year’s profits to taxpayer largess. Higher estimates suggest that almost all of the big banks’ earnings in 2013 were due to subsidies rather than productive activity. The IMF notes that even “these dollar values likely underestimate the true TITF subsidy values” because, among other things, the calculations are based on the assumption that shareholders in bailed-out banks would lose everything, which isn’t usually what happens.

Pointer from Patrick Brennan.

Of course, the NY Fed will tell you that there are terrific economies of scale in banking, and that explains the profits of large banks.

UPDATE: Actually, one economist at the NY Fed, Joao Santos, thinks it’s a too-big-to-fail subsidy.

Using information from bonds issued over the past twenty years, this study finds that the largest banks have a cost advantage vis-à-vis their smaller peers. This cost advantage may not be entirely due to investors’ belief that the largest banks are “too big to fail” because the study also finds that the largest nonbanks, as well as the largest nonfinancial corporations, have a cost advantage relative to their smaller peers. However, a comparison across the three groups reveals that the largest banks have a relatively larger cost advantage vis-à-vis their smaller peers. This difference is consistent with the hypothesis that investors believe the largest banks are “too big to fail.”

Pointer from David Dayen via Mark Thoma.

Matt Rognlie Proposes a Solution

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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

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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

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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

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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

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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

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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.