Major Malinvestments Do Not Have to Produce Large Depressions

The United States had an immense boom in the 1990s. That was in the end financial disappointing for those who invested in it, but not because the technologies they were investing in did not pan out as technologies, not because the technologies deliver enormous amounts of well-being to humans, but because it turned out to be devil’s own task to monetize any portion of the consumer surplus generated by the provision of information goods.

Huge investments in high tech and communications. Huge amounts of utility generated. Little financial return. $4 trillion of investors’ wealth destroyed as assets were revalued. That is something like 8 times the fundamental losses we saw in subprime mortgages and home equity loans made on houses in the desert between Los Angeles and Albuquerque from mid 2006-mid 2008.

A 1.5%-point rise in the unemployment rate after 2000 is not nothing–it is a bad thing. But it is not a 7%-point rise. And it is not a failure to close any of the gap vis-a-vis the pre-crisis trend of potential thereafter and a dark shadow over economic growth for a generation thereafter. Yet the fundamental shock from dot-com looks to me 8 times as large as the fundamental shock from subprime.

That tells me that we can deal with such shocks to private sector credit that go wrong: Have them be to equity wealth in the first place, or rapidly transform all the financial asset claims affected into equity on the fly as the crisis hits. Easy to say. Hard to do. We make sure they are diversified. And we do not, not, not, not, not, not let the people in Basle get too clever with their ideas of what reserves and capital structure look like, and allow core reserves to be placed in assets that are not AAA–even if some ratings agency whose revenues depend on pleasing investment banks has labeled them as AAA.

Axel Weber tells this story:

In Davos, I was invited to a group of banks–now Deutsche Bundesbank is frequently mixed up in invitations with Deutsche Bank. I was the only central banker sitting on the panel. It was all banks. It was about securitizations. I asked my people to prepare. I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions. When I was at this meeting–and I really should have been at these meetings earlier–I was talking to the banks, and I said: “It looks to me that since the buyers and the sellers are the same institutions, as a system they have not diversified”.

That was one of the things that struck me: that the industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them.

What was missing–and I think that is important for the view of what could be learned in economics–is that finance and banking was too-much viewed as a microeconomic issue that could be analyzed by writing a lot of books about the details of microeconomic banking. And there was too little systemic views of banking and what the system as a whole would develop like. The whole view of a systemic crisis was just basically locked out of the discussions and textbooks…

Axel Weber knew that this was a dangerous situation. Of course, he had no idea how dangerous it was. Barry Eichengreen, Alan Taylor, and Kevin O’Rourke think that, once the run on the shadow banking system was underway, this was the largest shock relative to the size of the market financial markets have ever experienced. We could have avoided this. If we had done our surveillance sufficiently deeper, we would have seen that this might be coming…

But, even so there was nothing baked in the cake of the housing bubble that in any sense required what the world economy has gone through in the past decade.

Indeed, John Maynard Keynes had a good deal to say about this in Notes on the Trade Cycle:

The preceding analysis may appear to be in conformity with the view of those who hold that over-investment is the characteristic of the boom, that the avoidance of this over-investment is the only possible remedy for the ensuing slump, and that, whilst for the reasons given above the slump cannot be prevented by a low rate of interest, nevertheless the boom can be avoided by a high rate of interest. There is, indeed, force in the argument that a high rate of interest is much more effective against a boom than a low rate of interest against a slump.

To infer these conclusions from the above would, however, misinterpret my analysis; and would, according to my way of thinking, involve serious error. For the term over-investment is ambiguous. It may refer to investments which are destined to disappoint the expectations which prompted them or for which there is no use in conditions of severe unemployment, or it may indicate a state of affairs where every kind of capital-goods is so abundant that there is no new investment which is expected, even in conditions of full employment, to earn in the course of its life more than its replacement cost. It is only the latter state of affairs which is one of over-investment, strictly speaking, in the sense that any further investment would be a sheer waste of resources.[4] Moreover, even if over-investment in this sense was a normal characteristic of the boom, the remedy would not lie in clapping on a high rate of interest which would probably deter some useful investments and might further diminish the propensity to consume, but in taking drastic steps, by redistributing incomes or otherwise, to stimulate the propensity to consume.

According to my analysis, however, it is only in the former sense that the boom can be said to be characterised by over-investment. The situation, which I am indicating as typical, is not one in which capital is so abundant that the community as a whole has no reasonable use for any more, but where investment is being made in conditions which are unstable and cannot endure, because it is prompted by expectations which are destined to disappointment.

It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources; — which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment. But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent. in conditions of full employment are made in the expectation of a yield of, say, 6 per cent., and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2 per cent. in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent. in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom…

Fiscal Policy in the New Normal: IMF Panel

The End of the Bond Bull Market?

3 Month Treasury Bill Secondary Market Rate FRED St Louis Fed

For thirty-five years the market has been selecting for optimistic and enthusiastic bond bulls.

If you were an optimistic bond trader for whatever reason–sensical or nonsensical–you got rich. Your clients got rich. And you got more money to manage. If you were a pessimistic bond trader, again for any reason–nonsensical or sensical–you underperformed, lost your job, and had to move into another part of the business.

Thus we have selected for bond traders with a strong bull bias.

And by now our bond traders are, indeed those who have a strong bull bias–or is it those who chase the thirty-five year trend? How will they react in the future in the Age of Trump and BREXIT? Deficits should push bond prices down. But policy chaos should discourage investment and push bond prices up…

For the fourth five-year period in a row, I am going to say that the bull market in bonds is over. But I said this in 2012, 2007, and 2002 as well…

But now I am convinced I am right!

How Schizo Is Ms. Market These Days?

BofA Merrill Lynch US High Yield Effective Yield© FRED St Louis Fed

I’m confused because it does not seem to me that there is a single Ms. Market out there…

I used to strongly believe that bond and equity markets were tightly coupled by well-defined assessments of risk and a well-specified risk tolerance: take the risk-free rate, and to that the riskiness of a security times the premium per unit of risk, and you got the rate for that security. And as the risk-free rate moved up and down the whole configuration would move up and down, with some widening of spreads as the risk-free rate moved up and contraction as the risk-free rate moved down, but all in a predictable, stable configuration.

Thus safe bond and risky bond and stock prices would move in opposite directions in response to shocks to productivity and profits, and would move together in response to shocks to monetary policy and financial conditions.

Yet that does not seem to be true anymore. Since 2008 the ability of markets to actually make the risk transformation in sufficient volume that is needed for it to make sense to say “the market has a well-specified risk tolerance” seems to have broken down.

Safe bonds to their thing.

Risky bonds do their thing.

Short bonds do their thing.

Long bonds do their thing.

Equities do their thing.

And the spreads between them look like residuals more than relationships. Rather than trade ironing out the market into a single aggregate view, there seem to be three often inconsistent views here…

Some Questions About Low Investment, to Some of Which I Have Half-Adequate Answers…

Gross Private Domestic Investment FRED St Louis Fed

I think the big part of the story is that the investment accelerator is a big thing, even though our models say it should not. Businesses do wait to invest until they are running flat out to invest. It’s a puzzle why they do this–they ought to act like the foresighted agents in our models, shouldn’t they?

I think a large part of the rest of the story of depressed investment is the growth of radical uncertainty. We used to see one 40% real collapse in the value of an important asset class every generation.

Now we have seen three in a decade.

Call it radical uncertainty, call it the collapse of risk tolerance, call it moral hazard in the credit channel’s ability to do the risk transformation as nobody will believe that investment banks produce AAA assets rather than sell you unhedged puts–the failure to satisfactorily mobilize the collective risk bearing capacity of the world to support risky investment is one of the biggest financial stories of the past decade. You look at the bonds of exorbitant privilege possessing reserve currency sovereigns and at the U.S. equity yield hanging up there at 5% real, and we have an equity return premium of the magnitude of the immediate post-WWII years and not seen since.

For residential investment, of course, we have to add regulatory uncertainty. Would you sell thirty-year fixed-rate nominal callable loans when there was no plan for how the mortgage finance GSEs will operate in a decade?

Private Residential Fixed Investment FRED St Louis Fed

Questions to which I do not have any good answers:
Why is it that capital is so very expensive for risky businesses and so cheap for the exorbitant privilege possessing reserve currency sovereigns? How much do we dare ask those sovereigns to take over the business of boosting investment globally via infrastructure for the next decade or so?

Gross Private Domestic Investment Fixed Investment Nonresidential Equipment FRED St Louis Fed

Best Business Books 2016: Economy

Best Business Books 2016 Economy

Over at Strategy+Business: Best Business Books 2016: Economy: The Crisis Is Over: Welcome to the New Crisis:

  • Robert J. Gordon: The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War (Princeton University Press, 2016)

  • Adair Turner: Between Debt and the Devil: Money, Credit, and Fixing Global Finance (Princeton University Press, 2015)

  • Jacob S. Hacker and Paul Pierson: American Amnesia: How the War on Government Led Us to Forget What Made America Prosper (Simon & Schuster, 2016)

It’s been quite a decade for the global economy. The popping of the American housing bubble in 2006, the subprime mortgage financial crisis and its spread to Wall Street in 2007–08, the collapse of the world economy into the first global recession in decades in 2008–09, the knock-on eurozone financial crisis that began in 2010, and a slow, often faltering recovery — it’s been a tumultuous 10 years. And the period has produced a bumper crop of excellent economics books by academics, journalists, and practitioners who have attempted to grapple with the extraordinary macroeconomic disaster. They have examined why it happened, how to fix it, what it means, and how to avoid a recurrence of anything even remotely as hellish. Read MOAR at Strategy+Business

CAPE, Future Expected Equity Returns, the Equity Premium, and Market Timing

I think this, by the very sharp Justin Lahart is badly framed.

Shiller’s CAPE a hair over 27 is telling us that if we buy the S&P Composite and hold it to infinity, we can expect a real return to average 5%/year ±, where the ± can, of course, be substantial. But there is also a reasonable chance that in the next five years the CAPE valuation ratio will revert to 20–in which case you lose 25% on top of that if you have to sell then. And there is some chance that in the next ten years the CAPE will kiss the 15 it kissed in 2009–which means that if you have to sell then you could lose 45%.

The stock market is for prudent, patient investors–not for those who know they will have to sell soon and cannot stand the risk of price declines, or who do not have to sell soon but cannot stand the risk of scanning the newspaper and seeing a disappointing number.

But what other investment promises an expected return of 4%/year for the patient investor? And it is difficult to imagine that any other asset class is exposed to much risk: what will preserve its real value if the collective ownership of the productive capital of the world does not?

With interest rates at their current level of -2%/year real, a CAPE of 27 is not flashing “sell” unless you think the odds of CAPE reverting to 20 in the next year are a quarter or greater.

And, of course, Justin’s point is that the CAPE* that we should be watching is not 27, but rather 18, in which case the real return we should expect on average is not 5%±, but 7%±:

Justin Lahart: Shiller’s Powerful Market Indicator Is Sending a False Signal About Stocks This Time:

A popular valuation metric pioneered by Nobel Prize-winning economist Robert Shiller says that stocks are dangerously expensive. But it may be sending a false signal…

Shiller gained popular fame with his 2000… “Irrational Exuberance”… [and] in a 2005 edition of the book, Mr. Shiller said the housing market was in a bubble. It is a track record that makes Mr. Shiller hard to ignore…. The CAPE  is now at 27… well above its 50-year average of 20. The only times the CAPE has been higher were during the 2000 bubble and bust, and just prior to the 1929 crash….

An alternative CAPE, constructed by The Wall Street Journal… relies on a more consistent earnings measure: The Commerce Department’s quarterly data on total U.S. after-tax corporate profits… Federal Reserve data on the total value of the U.S. stocks, rather than the value of the S&P 500. The result: Stocks look much cheaper than Mr. Shiller’s data suggests….

The two measures tracked each other almost perfectly for decades until 2008, when banks and other businesses, required to follow the latest GAAP rules, suffered huge write-downs that cut earnings. The Commerce Department’s measure, which hasn’t changed, treats bad-debt expenses, asset write downs, and loan-loss provisions as capital losses… rather than cutting earnings. Since both of these measures rely on 10 years of earnings, the disparity stemming from the financial crisis has persisted….

A bigger issue, says Mr. Campbell, is that just because the CAPE is high doesn’t mean that stocks aren’t a better value than comparable, safe investments. Back in 2000, there were great alternatives to expensive stocks, such as 10-year Treasury inflation-protected securities offering a government-guaranteed yield of 4 percentage points above inflation. Today those bonds offer no premium. While stocks are currently expensive, Mr. Campbell says, it isn’t clear that they are a worse investment than their alternatives….

Aswath Damodaran… over the past 50-odd years, he couldn’t find a single way he could make CAPE beat a simple buy-and-hold strategy…. Shiller agrees that the CAPE can’t be used as a market-timing tool, per se…

And I wince at the graphic design of this chart:

Shiller s Powerful Market Indicator Is Sending a False Signal About Stocks This Time WSJ

Hurdle Rates for Public Infrastructure and Private Investment: How Low Should We Go? Under 2% Real in Normal Times, and Still Lower Now

Matthew Yglesias tweeted:

I responded:

Then Matt challenged:

And I think: Gee, if I rise to this, like a moth to the flame, then Chris Shea of–to whom I owe 3000 overdue words on trade, manufacturing, politics, NAFTA, China’s accession to the WTO, and TPP–will be really annoyed that I am letting Matt Yglesias be a higher priority assignment editor than him.

I need to lie down until the desire to respond to Matt goes away, and then get up on things that have, you know, deadlines in the past…

Didn’t work…

Forbidden Planet Images of Krell Technology

We have a pretty good theory of how we ought to make decisions under uncertainty. It is, in fact, the same as our pretty good theory of how we ought to make decisions for society as a whole…

Let’s take the individual-uncertainty version first:

We exist behind a veil of ignorance: We do not know what the future will bring. We can, say, slice the future into 10,000 different 0.01% probability chunks, in each of which we would be different. Maybe only one of those 10,000 will actually happen, and the rest are unreal shadows produced only by our ignorance. Maybe (this is version I prefer) all 10,000 of them “exist” and will “occur”, as they are different branches of the quantum wave function of the multiverse, with each having wave-function amplitude that is the appropriate complex square root of 0.0001. (But the answer to the question of which appears to be unknowable. And which is “true” makes no difference.)

In deciding to take action X today, we are, given the uncertainties, doing something to benefit some of our 10,000 future selves and penalize others. We have some sort of obligation to our future selves, either because it makes us happy to sacrifice some of our present comfort for the sake of our future selves or because we wish to be people who are not total a–holes. (Again, it makes no difference.)

Do we take action X?

The economists’ theory tells us that if the effects on our 10,000 future selves generated by action X are unsystematic–if the variance of the effects over our 10,000 future selves is of the kind that can be diversified away–we should just care about the average effect. Thus we should take action X if the average effect is such that we would judge it worthwhile if we knew that the average effect would occur with certainty.

The economists’ theory further tells us that if the variability of the effects on our 10,000 future selves is systematic–that it tends to make those of our future selves who are relatively poor even poorer, and those who are relatively rich even richer–then we should aggregate the effects on our 10,000 future selves with an egalitarian bias: It makes little difference to our aggregation calculation if action X takes an extra dollar away from a future self with a lifetime income 90% and gives one to one with 110% of the future-self average. But by the time the consequences of our actions are taking wealth away from future selves with 30% and giving them to future selves with 170% of the average–then we need to incorporate a risk premium into our calculations.

And here comes punchline one: The effects of government interventions in infrastructure are about as systematic as are corporate business investments. The two, after all, are very strong complements. If the value of private sector goods produced is lower, the value of the infrastructure that enables the efficient production of those private sector goods is lower as well. If the value of infrastructure is high, that can only be because it is greatly assisting in the production and distribution of high-value goods. Tyler is right in asserting that the hurdle rate for government infrastructure and private sector investments should be roughly the same.

But–and here comes punchline two–Tyler goes wrong in asserting that the price charged by savers to fund private sector corporate investments is the right price from society’s point of view, and the price charged the government for borrowing is the wrong price to use to calculate the common hurdle rate for public infrastructure and private investments

Think of it: Neither government investments in infrastructure nor private sector investments in physical capital are that systematic as far as their risk his concert. And, at least on the scale at which we are currently investing, we are much closer to the 90% – 110% case than to the 30%-170% case. The average return required should therefore be governed by:

  • pure time preference,
  • the speed with which are wealth is increasing, and
  • the degree to which increasing wealth satiates us.

I see few signs that we are at the stage where increasing wealth satiates us to any strong degree. The speed with which our wealth is increasing is a per capita rate of about 1.5% per year. And as for pure time preference–well, from a social choice point of view, such a thing can only be irrational myopia. Your future self has the same philosophical and moral standing that your present self does: there is no compelling reason to prefer the interests of the one over the interests of the other. There is force majeur–your present self is here and now and has its mits on the stuff and controls what happens–but that is not a principal of moral but rather of immoral philosophy. In fact, there is an evolutionary-morality point working in the other direction, if you believe in any form of evolutionary morality. (You don’t have to.) Just because your present self happens to come first and time does not produce a moral principle that the interests of later-comers should be sacrificed to its selfish hedonistic pleasures.

Thus I, at least, find there to be a very strong and not yet refuted by anyone case that the presumption should be for a very low hurdle rate, from a social choice point of view at least. That low hurdle rate should apply to both government infrastructure and to private corporate investments. Claims that a higher hurdle rate is in some sense optimal or appropriate seem to me implausible, and to require very hard argumentative work for plausibility that has not yet been done.

What is this hurdle rate? I think you have to start from the rate of growth of per capita income, and make adjustments up and down from there: 1.5% per year in real terms. That is punchline two.

Why, then, does the financial system of a modern capitalist market economy grind out not a 1.5% per year real interest rate for risky private corporate investments? Why does it grind out a 5% per year rate for β=1 investments? Good question!

In my view, the answer is threefold. The market grinds out a wrong 5%/year rather than the right 1.5%/year because:

  1. Modern capitalist financial markets do a horrible job at mobilizing the potential systematic risk-bearing capacity of society as a whole.
  2. Modern capitalist financial markets singularly fail to solve the enormous moral-hazard and adverse-selection asymmetric-information problems involved in trusting your money to Steve Ballmer or Jamie Dimon–let alone Dick Fuld. (Cf.: Noah Smith.)
  3. We have brains design by evolution to do three things: calculate (a) whether the fruit is ripe; (b) whether it is safe to leap to the next branch, and (c) whether we should and how best to amuse men (women) so that they might mate with us. We do not have ranged can reliably make complicated and appropriate moral-philosophical calculations under conditions of great uncertainty and ignorance.

But that modern private capitalist financial markets are ridden by market failures of human psychological myopia, institutional map-design, and asymmetric information–and thus use the wrong hurdle rate–provides no reason at all for using the wrong hurdle rate when solving the public-sector part of the societal-welfare optimization problem.

Moreover, I have a punchline three: The argument as I have made it so far is a very general argument. It creates, in my mind at least a very strong and so far unrebutted (but possibly, with sufficient very hard intellectual work, rebuttable) presumption that the appropriate real hurdle rate is an expected return of less than 2% per year.

But ever since 2005 or so we have been in a very unusual time. For a large number of poorly understood reasons, the world has been awash in savings and yet short of investment. The appropriate hurdle rate has thus been less than the one established by the general argument. We are still in an unusual time. The U.S. labor market no longer has large obvious amounts of slack, but as the Paul Krugman with his Krell-like brain points out, considerations of asymmetric policy risks and global rather than local macroeconomic balance strongly suggest that the right policy is to still act as though the U.S. still has large obvious amounts of slack, and so needs to penalize saving and encourage investment at the margin by more than it is currently doing.

The Bond Market and Expectations: A Parthian Shot

Parthian shot Google Search

In my The Need for Expansionary Fiscal Policy I quote Greg Ip:

policy makers are rightfully wary about acting in the face of so many contradictory signals. In the U.S., unemployment is moving lower and stocks are hitting new highs. Bonds could be pricing in secular stagnation, or merely a greater bias toward hyper-stimulative monetary policy by central banks…

If bond markets were pricing in a a greater bias toward hyper-stimulative monetary policy by central banks, the yield curve would be very steeply sloped indeed. Just saying.

Must-Read: Christopher L. Foote, Lara Loewenstein, and Paul S. Willen: Cross-Sectional Patterns of Mortgage Debt during the Housing Boom: Evidence and Implications

Must-Read: Christopher L. Foote, Lara Loewenstein, and Paul S. Willen: Cross-Sectional Patterns of Mortgage Debt during the Housing Boom: Evidence and Implications: “[The] reallocation of mortgage debt to low-income or marginally qualified borrowers…

…[in] the early 2000s housing boom… never occurred…. The distribution of mortgage debt with respect to income changed little…. There is no evidence that increases in homeownership during the boom were concentrated among low-income or marginal borrowers. Previous cross-sectional research stressing the importance of low-income borrowers and communities during the mortgage boom was based on the inflow of new mortgage originations alone. As a result, it could not detect offsetting outflows in mortgage terminations that left the allocation of debt with respect to income stable over time.

Must-Read: Atif R. Mian, Amir Sufi, and Emil Verner: Household Debt and Business Cycles Worldwide

Must-Read: Atif R. Mian, Amir Sufi, and Emil Verner: Household Debt and Business Cycles Worldwide: “An increase in the household debt to GDP ratio in the medium run…

…predicts lower subsequent GDP growth, higher unemployment, and negative growth forecasting errors in a panel of 30 countries from 1960 to 2012…. Low mortgage spreads predict an increase in the household debt to GDP ratio and a decline in subsequent GDP growth when used as an instrument. The negative relation between the change in household debt to GDP and subsequent output growth is stronger for countries that face stricter monetary policy constraints as measured by a less flexible exchange rate regime, proximity to the zero lower bound, or more external borrowing. A rise in the household debt to GDP ratio is contemporaneously associated with a consumption boom followed by a reversal in the trade deficit as imports collapse. We also uncover a global household debt cycle that partly predicts the severity of the global growth slowdown after 2007. Countries with a household debt cycle more correlated with the global household debt cycle experience a sharper decline in growth after an increase in domestic household debt.