Must-Read: “Technology is 20% of the S&P 500…::
Technology is 20% of the S&P 500, this chart explains the upward drift in the index’s average multiple over decades pic.twitter.com/XFw4a3LBRM
— Downtown Josh Brown (@ReformedBroker) July 3, 2016
Must-Read: Adding More Periods to Diamond-Dybvig: Fear of Illiquidity, Not Insolvency: “We simply add an extra time period…. It’s a friendly amendment…:
…Agents are ex ante identical. Each agent has an endowment of apples. There is a costless storage technology for apples. There is also an investment technology (planting apples in the ground) which gives a strictly positive rate of return at maturity, but a negative rate of return if you cancel the investment before maturity. Each agent has a 10% probability of becoming impatient (getting the munchies) and wanting to eat all his apples this period. Those probabilities are independent across agents, and there is a large number of agents, so exactly 10% of agents will become impatient each period. Getting the munchies is private information….
Standard Diamond-Dybvig… has… an initial period where agents lend their apples to the bank; a second period where 10% of agents get the munchies and ask for their apples back; and a third period when the investment matures. Banks exist to provide insurance against risk of munchies by pooling assets; normal insurance won’t work because the information is private…. Make it a 4 period model:
- An initial period where agents lend their apples to the bank;
- A second period where 10% of agents get the munchies and ask for their apples back;
- A third period where another 10% of agents get the munchies and ask for their apples back; and
- A fourth period when the investment matures….
The bank credibly commits that it will never cancel an investment before maturity, and stores 20% of apples in reserve. In the good equilibrium… only agents who get the munchies ask for their apples back. Now suppose there is a… run on the bank in the second period…. An agent who does not have the munchies in the second period will rationally join that run on the bank, falsely claiming that he does have the munchies… [because] he might get the munchies in the third period, and if the bank suspends redemptions he will be unable to satisfy his future cravings, so he wants to join the line before the bank runs out of stored apples, so he can store apples at home…. Even if people are 100% confident that the bank is solvent, there can still be bank runs if people cannot predict their own future needs for liquidity, and fear that the bank might become illiquid…. Having a deposit in an illiquid bank is functionally not the same as having a deposit in a liquid bank, even if both are solvent…
Bearing in mind what has happened to me almost every single time since 1997 when I have concluded that Paul Krugman is wrong…
The key, I think, is something hidden in Paul’s column. It is the fact that the effect of pretty much any shock depends on what the private financial market and the public monetary and fiscal policy response to it is:
Still Confused About Brexit Macroeconomics: “OK, I am still finding it hard to understand the near-consensus among my colleagues…:
…about the short- and medium-term effects of Brexit…. [While] Brexit will make Britain somewhat poorer in the long run, it’s not completely obvious why this should lead to a recession in the short run…. So let me give an example of the kind of analysis that I think should raise eyebrows: BlackRock…. “‘Our base case is we will have a recession’, Richard Turnill, chief investment strategist at the world’s largest asset manager, told reporters…. ‘There’s likely to be a significant reduction of investment in the UK,’ he said, adding that Brexit will ensure political and economic uncertainty remains high…
When we say ‘uncertainty’, what do we mean? The best answer I’ve gotten is that for a while, until things have shaken out, firms won’t be sure where the good investment opportunities in Britain are, so there will be an option value to waiting… Brexit might have seriously adverse effects on service exports from the City of London. This would mean that investment in, say, London office buildings would become a bad idea. On the other hand, it would also mean a weaker pound, making investment in industrial properties in the north of England more attractive. But you don’t know how big either effect might be. So both kinds of investment are put on hold, pending clarification.
OK, that’s a coherent story, and it could lead to a recession next year. At some point, however, this situation clarifies. Either we see financial business exiting London, and it becomes clear that a weak pound is here to stay, or the charms of Paris and Frankfurt turn out to be overstated, and London goes back to what it was. Either way, the pent-up investment spending that was put on hold should come back. This doesn’t just mean that the hit to growth is temporary: there should also be a bounce-back…. But that’s not what BlackRock, or almost anyone else, seems to be saying; they’re projecting lower growth as far as the eye can see. They could be right. But I still don’t see the logic. It seems to me that ‘uncertainty’ is being used as a catchall for ‘bad stuff’.
When asset managers–indeed, when anyone anywhere in the world who is not a trained economist–uses the phrase “more uncertainty”, they do not mean what me trained (or mistrained) economists mean: they do not mean that the future distribution of the random variable has a larger variance but the same mean. What they mean, instead, is that the distribution has a larger and longer lower tail. The variance is up and the mean is lower. The principal thing they see as pushing down investment in the near future is the fear of this lower tail–not capitalizing on the option value of waiting until more knowledge comes in.
Back in 1992 Britain exited the ERM. ERMexit had two effects: (1) a small reduction in the desirability of locating in Britain to serve the continental European market because one now faced exchange rate risk, and (2) a large easing of conventional monetary policy and thus lower interest rates and a lower value of the pound because the Bank of England no longer had to maintain the pound at an overvalued parity. The result: boom.
Today Brexit looks to have two effects: (1) a large reduction in the desirability of locating in Britain to serve the continental European market, and (2) ???? (we are not going to get a large easing of conventional monetary policy):
In a proper neoclassical flex-price zero-debt world that was, somehow, at the zero lower bound on nominal interest rates, the response to Brexit would be to bounce the real value of the pound down and to bounce the internal price level down and follow that bounce with higher inflation. The much more strongly negative real interest rate produced by the price level bounce-down-followed-by-inflation would cushion the decline in investment. And the boost to exports from the bounced-down real value of the pound would soak up workers exiting investment-goods industries and maintain full employment.
Of course, the proper neoclassical flex-price zero-debt world is one in which the full operation of Say’s Law is a metaphysical necessity, and so full employment is always attained. We, however, do not live in a proper neoclassical flex-price zero-debt world. It is the job of fiscal and monetary authorities to follow policies that push real prices–real exchange rates, real interest rates, real wage levels–to the values that would obtain in such a world, and so preserve full employment. We can imagine:
*1. Expansion of government purchases: preserve full employment by replacing I with G. Not going to happen in any Britain ruled by anything like this generation of Tories.
2. A helicopter drop: the Bank of England buys bonds for cash, cancels the bonds, and the government cuts taxes by the amount of cancelled bonds. Might happen even with this generation of Tories if they were less thick. But they seem to be very thick indeed.
3. Continued whimpers from Mark Carney that he would not chase away the Inflation-Expectations Imp were she to somehow appear. Not likely to be effective.
4. Everybody becomes so terrified about the safety of their assets in Britain that the real value of the pound bounces low enough that expanding exports soak up all of labor exiting from investment-goods industries.
Paul seem to be betting that (4) is a real live high-probability possibility: the short-term safe real interest rate is pinned at -2%/year for the foreseeable future, but the pound will bounce low enough for expanded exports to preserve full employment. It could happen–the world is a surprising place. But that possibility seems to me to be a tail possibility, not something that should be at the core of one’s forecast.
Must-Read: Cheap Money Talks: “Late last year the yield on 10-year U.S. government bonds was around 2.3 percent, already historically low…:
…on Friday it was just 1.36 percent…. Some… blame the Federal Reserve and the European Central Bank, accusing them of engineering ‘artificially low’ interest rates that encourage speculation and distort the economy… largely the same people who used to predict that budget deficits would cause interest rates to soar…. They’re not making sense….‘Artificially low’ mean[s]… excessively easy money… [what generates] out-of-control inflation. That’s not happening…. If anything, developments in the real economies of the advanced world are telling us that interest rates aren’t low enough….
But why? In some past episodes… the story has been one of a flight to safety…. But there’s little sign of such a fear-driven process now…. Most famously Larry Summers, but also yours truly and others… [say] weak demand and a bias toward deflation are enduring problems… [no] return to what we used to consider normal…. Low short-term interest rates for a very long time, and [so] low long-term rates right away….
Raising rates in the face of weak economies would be an act of folly…. What policy makers should be doing, instead, is accepting the markets’ offer of incredibly cheap financing…. There are huge unmet demands for public investment on both sides of the Atlantic…. This would be eminently worth doing even if it wouldn’t also create jobs, but it would do that too…. Deficit scolds would issue dire warnings…. But they have been wrong about everything for at least the past eight years, and it’s time to stop taking them seriously. They say that money talks; well, cheap money is speaking very clearly right now, and it’s telling us to invest in our future.
Must-Read: Oh Noes! Paul Krugman Has Caught the Tweetstorm Disease!: “Paul Krugman Is, I Think, Highly Likely to Be Correct on the Policy Irrelevance of the Risk Premium. The Mystery Is Why the Very Sharp Ken Rogoff Takes a Different View…:
Must-Read: The Puzzling Aversion to Expansionary Fiscal Policy: ‘Low interest rates are not really low’, or something…:
Must-Read: For a year and a half now I have been trying to understand what this passage means, especially the “in a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader ‘credit surface’ the global economy faces”. In a world in which n + g > rsafe, why isn’t issuing more safe debt, rolling it over forever, and spending the resources buying useful stuff not win-win ex ante for everyone? Who are supposed to be the losers from this, in the sense that acting on these price signals reduces well being because they are “distorted” and “do not necessarily capture the broader ‘credit surface’ the global economy faces”?
Debt Supercycle, Not Secular Stagnation: “Low real interest rates mask an elevated credit surface…(2015):
…What about the very low value of real interest rates? Low rates are often taken as prima facie by secular stagnation proponents, who argue that only a chronic demand deficiency could be responsible for steadily driving down the global real interest rate. The steady decline of real interest rates is certainly a puzzle, but there are a host of factors. First, we do not actually observe the true economic real interest rate; that would require a utility-based price index that is extremely difficult to construct in a world of rapid change in both the kinds of goods we consume and the way we consume them. My guess is that the true real interest rate is higher, and perhaps this bias is larger than usual. Correspondingly, true economic inflation is probably considerably lower than even the low measured values that central banks are struggling to raise.
Perhaps more importantly, in a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader ‘credit surface’ the global economy faces (Geanokoplos 2014). Whether by accident or design, banking and financial market regulation has hugely favoured low-risk borrowers (governments and cash-heavy corporates), knocking out other potential borrowers who might have competed up rates. Many of those who can borrow face higher collateral requirements. The elevated credit surface is partly due to inherent riskiness and slow growth in the post-Crisis economy, but policy has also played a large role. Many governments, particularly in Europe, have rammed down the throats of pension funds, banks, and insurance companies. Financial repression of this type not only effectively taxes middle-income savers and pensioners (who receive low rates of return on their savings) but also potential borrowers (especially middle-class consumers and small businesses), which these institutions might have financed to a greater extent if they were not required to be so overweight in government debt.
Surely global interest rates are also affected by the massive balance sheet expansions that most advanced-country central banks have engaged in. I don’t believe this is as important as the other effects I have discussed (even if most market participants would say the reverse). Global quantitative easing by advanced countries and sterilised intervention operations by emerging markets have also surely had a very large impact on bringing down market volatility measures.
The fact that global stock market indices have hit new peaks is certainly a problem for the secular stagnation theory, unless one believes that profit shares are going to rise massively further…
Must-Read: A Remarkable Financial Moment: “10 and 30 year interest rates today reached all time low levels of 1.32 percent and 2.10 percent…:
…Record low 10 year interest rate were also registered in Germany, France, Switzerland and Australia. Notably Swiss 50 year interest rates are now for the first time negative. Rates out 15 years are negative in Germany and 9 years in France. Such rates would have seemed inconceivable a decade ago and very unlikely even a couple of years ago…. Extraordinarily low rates reflect both subtarget expected inflation even over long horizons and very low real interest rates…. Remarkably the market does not now expect a full Fed tightening until early 2019. This is despite all the Fed speeches expressing optimism about the economy and a desire to normalize interest rates… very low long term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future….
Policymakers still have not made sufficiently radical adjustments in their world view to reflect this new reality of a world where generating adequate nominal GDP growth is likely to be the primary macroeconomic policy challenge for the next decade. Having the right world view is essential if there is to be a chance of making the right decisions. Here are the necessary adjustments…. Neutral real interest rates are likely close to zero going forward…. Second, as counterintuitive as it is to central bankers who came of age when the inflation of the 1970s defined the central banking challenge, our problem today is insufficient inflation…. Evidence from markets and some surveys suggests that inflation expectations are becoming unhinged to the downside…. In a world where interest rates over horizons of more than a generation are far lower than even pessimistic projections of growth, traditional thinking about debt sustainability needs to be discarded…. The conditions Brad Delong and I set out in 2012 for expansionary fiscal policy to pay for itself are much more easily satisfied today than they were at that time.
Fourth, the traditional suite of structural policies to promote flexibility are not especially likely to be successful in the current environment…. In the presence of chronic excess supply structural reform has the risk of spurring disinflation rather than the contributing to a necessary increase in inflation. There is in fact a case for strengthening entitlement benefits so as to promote current demand…. Traditional OECD-type recommendations cannot be right as both a response to inflationary pressures and deflationary pressures. They were more right historically than they are today…. Treatments without accurate diagnosis have little chance success. We need to begin with a much clearer diagnosis of our current malaise than policymakers have today. The level of interest rates provides a very strong clue.
“We have lost 5 percent of capacity… $800 billion[/year]…. A soft economy casts a substantial shadow forward onto the economy’s future output and potential.” It is now three years later than when Summers and the rest of us did these calculations. If you believe Janet Yellen and Stan Fischer’s claims that we are now effectively at full employment, the permanent loss of productive capacity as a result of the 2007-9 financial crisis, the resulting Lesser Depression, and the subsequent bobbling of the recovery is not 5% now. It is much closer to 10%. And it is quite possibly aiming for 15% before it is over:
Lawrence Summers et al. (2014): Lack of Demand Creates Lack of Supply: “Jean-Baptiste Say, the patron saint of Chicago economists…
…enunciated the doctrine in the 19th century that supply creates its own demand…. If you produce things… you would have to create income… and then the people who got the income would spend the income and so how could you really have a problem[?]… Keynes… explain[ed] that [Say’s Law] was wrong, that in a world where the demand could be for money and for financial assets, there could be a systematic shortfall in demand.
Here’s Inverse Say’s Law: Lack of demand creates, over time, lack of supply…. We are now in the United States in round numbers 10 percent below what we thought the economy’s capacity would be today in 2007. Of that 10 percent, we regard approximately half as being a continuing shortfall relative to the economy’s potential and we regard half as being lost potential…. We have lost 5 percent of capacity… we otherwise would have had…. $800 billion[/year]. It is more than $2,500[/year] for every American…. A soft economy casts a substantial shadow forward onto the economy’s future output and potential. This might have been a theoretical notion some years ago, it is an empirical fact today…
What are we going to do?
Well, we are going to do nothing–or, rather, next to nothing. Life would be convenient for the Federal Reserve if right now (a) the U.S. economy were at full employment, (b) a rapid normalization of interest rates were necessary to avoid inflation rising significantly above the Federal Reserve’s 2%/year PCE chain index inflation target, and (c) U.S. tightening were more likely to stimulate economies abroad via greater opportunities to sell to the U.S. than contract economies abroad by withdrawing risk-bearing capacity. And the Federal Reserve appears to have decided to believe what makes life convenient. Thus nothing additional in the way of action to boost the economy can be expected from monetary policy. And on fiscal policy a dominant or at least a blocking position is held by those who, as the very sharp Olivier Blanchard put it recently, even though:
 In the short run, the demand for goods determines the level of output. A desire by people to save more leads to a decrease in demand and, in turn, a decrease in output. Except in exceptional circumstances, the same is true of fiscal consolidation [by governments]…
nevertheless Olivier Blanchard:
was struck by how many times… [he] had to explain the “paradox of saving” and fight the Hoover-German line,  “Reduce your budget deficit, keep your house in order, and don’t worry, the economy will be in good shape”…
Apparently he was flabbergasted by the number of people who would agree with  in theory and yet also demand that policies be made according to , and he plaintively asks for:
anybody who argues along these lines must explain how it is consistent with the IS relation…
Remember: the United States is not that different. As Barry Eichengreen wrote:
It is disturbing to see the refusal of [fiscal] policymakers, particularly in the US and Germany, to even contemplate… action, despite available fiscal space (as record-low treasury-bond yields and virtually every other economic indicator show). In Germany, ideological aversion to budget deficits runs deep… rooted in the post-World War II doctrine of “ordoliberalism”…. Ultimately, hostility to the use of fiscal policy, as with many things German, can be traced to the 1920s, when budget deficits led to hyperinflation. The circumstances today may be entirely different from those in the 1920s, but there is still guilt by association, as every German schoolboy and girl learns at an early age.
The US[‘s]… citizens have been suspicious of federal government power, including the power to run deficits…. From independence through the Civil War, that suspicion was strongest in the American South, where it was rooted in the fear that the federal government might abolish slavery. In the mid-twentieth century… Democratic President Lyndon Baines Johnson’s “Great Society”… threatened to withhold federal funding for health, education, and other state and local programs from jurisdictions that resisted legislative and judicial desegregation orders. The result was to render the South a solid Republican bloc and leave its leaders antagonistic to all exercise of federal power… a hostility that notably included countercyclical macroeconomic policy. Welcome to ordoliberalism, Dixie-style. Wolfgang Schäuble, meet Ted Cruz…
The world very badly needs an article–a long article, 20,000 words or so. It would teach us how we got into this mess, why we failed to get out, and how the situation might still be rectified–so that the Longer Depression of the early 21st century does not dwarf the Great Depression of the 20th century in future historians’ annals of macroeconomic disasters. Such a book would have to assimilate and transmit the lessons of what I think of as the six greatest books on our current ongoing disaster:
Plus it would have to summarize and evaluate Larry Summers’s musings on secular stagnation.
We were lucky that John Maynard Keynes started writing his General Theory summarizing the lessons we needed to learn from the Great Depression even before that depression reached its nadir. But we were not lucky enough. As Eichengreen stresses, only half the lessons of Keynes were assimilated–enough to keep us from repeating the disaster, but not enough to enable us to get out of it. (Although, to be fair, the world of the 1940s emerged from it only at the cost of imbibing the even more poisonous and deadly elixir called World War II.)
Paul? (Krugman, that is.) Are you up to the task?