A History Lesson for Scotland

In Guan's recent post on this blog, "Scotland, sterling and the debt," he notes that Scotland will hold a referendum on independence from the United Kingdom in September 2014. The Scottish Government suggests that an independent Scotland should be in a currency union with the UK. Guan writes:

"There are probably some sound arguments for that: it could take years to join the euro, and much of Scotland’s trade is with rest-of-UK, and vice versa.  

On the other hand, events of recent years have kind of cooled the enthusiasm for currency unions in Europe. It’s not at all clear that it would be a good idea for Scotland to adopt sterling. The UK Government’s position is, sensibly enough, that a currency union would be unworkable without a fiscal and political union, which is kind of absurd when the goal is Scottish independence."

For historical perspective on a potential Sterling Area, we should look back to the Austria-Hungary monetary union of 1867-1918. The monetary union began following the Habsburgs' defeat by Prussia. In "The Logic of Compromise," Marc Flandreau explains that:

"The Austro-Hungarian monetary union was not the result of a monetary marriage but the by-product of a fiscal divorce. Austria and Hungary became in 1867 two sovereign budgetary entities. In the process, they retained a common bank of issue and thus formed a defacto monetary union that would operate until its post-World War I collapse."

A Sterling Area currency union with an independent Scotland would likewise be a product of divorce, not of marriage. An annex to the Scottish Fiscal Commission Working Group's First Report assessing possible currency options for an independent Scotland notes that there are two ways to retain Sterling: through a formal monetary union or through an informal arrangement ("Sterlingisation.") The Scottish Parliament is in favor of the formal monetary union, in which the Bank of England would make monetary policy decisions in consideration of conditions in both Scotland and the rest of the UK.

Scotland's proposed formal monetary union would resemble the set-up in the Austria-Hungary monetary union. At the start of the Compromise, the Austrian National Bank was the sole bank of issue for Austria and Hungary. As Flandreau details, Hungary gained increasing control over the central bank over the years. In 1878 the Bank became the Austro-Hungarian Bank. The Austro-Hungarian Bank inherited its predecessor's balance sheet and became a federal institution, with Managements in both Vienna and Budapest. At least two of the twelve Councillors had to be Hungarian. Over the pre-WWI years, there was "a definite trend in Hungary's formal influence within the common Bank. This trend was also reflected in substantive policies of the Bank...The Austro-Hungarian National Bank transformed itself from being a predominantly Austrian institution in 1867 into being a truly binational institution."

Flandreau explains the political economy behind the transformation at the Austro-Hungarian National Bank:

"Consider a monetary union comprising two parts, a 'large' (Austria) and a 'small' (Hungary) country. The common central bank delivers a range of services that are valuable to both parts, but not equally... If power is proportional to size, the small country has very little control over common decisions. It is bound by the discipline of the union without being able to influence decision-making in a way that would address its own specific interests. Co-operation (that is, participation in the union) is sub-optimal and the small country prefers to quit. Sustained co-operation requires that the large country accepts a decision-making process in which the small country receives a greater voting share than size alone would predict... 

However, it is not clear why the large country should accept this dilution of power. The normal outcome should therefore be secession...[Casella (1992)] shows that if co-operation delivers a number of public goods that are useful to all parts, then the large country may nonetheless accept a reduction of its relative ability to set decisions, since the additional output may compensate for the initial loss."

Flandreau's logic is relevant for a possible Sterling Area. The Fiscal Commission notes that "Over the medium term it may well be in Scotland’s interests to move to an alternative arrangement, should either the performance of the Scottish economy change or the preferences of the people of Scotland change." A "Sterling Area Bank" would have to be acceptable enough to both parts of the Sterling Area to be maintained. In the Austria-Hungary arrangement, Austria had to provide Hungary with considerable incentives to stay on board. Austria was willing to make the necessary concessions because the benefits to Austria of keeping Hungary in the union were sufficiently great. These benefits may have included dynastic and imperial considerations, maintenance of the crown as an international currency, and maintenance of bilateral trade.

According to Flandreau, then, monetary compromises are determined by bargaining power.  It is not clear to me whether the bargaining power dynamics between Scotland and the rest of the UK would be suitable for sustained cooperation. As commenter Absalon says in response to Guan's post, "Scotland would not need the permission of England to continue to use sterling any more than Panama and Ecuador need American permission to use the dollar. Of course, Panama and Ecuador have no say in setting the policies of the Fed." If an independent Scotland wanted some amount of power in a supranational or joint shareholder central bank, it would need enough bargaining power. Bilateral trade is one consideration. Guan describes another attempt to assert bargaining power:

"The argument of the Scottish National Party-led government is that the British pound and the Bank of England (name notwithstanding) are “assets” of the United Kingdom. Assets and liabilities of the United Kingdom should be split up among the constituent countries, and if rest-of-UK refuses to divide the sterling 'asset', then Scotland would refuse to assume its share of the liabilities—the UK national debt."

In Austria-Hungary, Austria was directly responsible for the pre-1867 common debt. Hungary paid an annuity corresponding to a one-third share. (Unlike in the Eurozone, no "stability pact" was signed.) But it took more than just the desire for Hungary to pay its share of the common debt to hold the currency union together. Times were very different during the Austria-Hungary currency union, so there are limits to the lessons that can be drawn. But the union did manage to exist without a formal fiscal union. In many ways, it was beneficial for Hungary. Scotland would like to enjoy similar benefits, but it may not have the necessary bargaining power that Hungary had.

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This is my last post on Not Quite Noahpinion before it reverts to Noahpinion. I really appreciate the opportunity to post here for the past few months and thank you all for reading and commenting. I'll be working on my dissertation and (at least occasionally) posting on my own blog. Keep in touch. 

Happy Thanksgiving!

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The Beggar Maid: Economics and Alice Munro

I can't allow our Nobel-fest to come to a close without a post about Alice Munro. The Canadian recipient of the Nobel Prize in Literature is in some ways a perfect complement to the Fama-Hansen-Shiller trio.

The word economics has its origins in the Greek okionomia, or management of household affairs. Munro's short stories are often categorized as domestic-- which similarly means of or related to the running of a home. Her writing is economic in many senses of the word, in both style and theme. Poverty, desire, selfishness, and self-determination are among the themes she treats with the most skill and nuance.

These themes emerge most notably, perhaps, in "The Beggar Maid," published in 1977, which tells the story of Rose, a college student on scholarship. The title alludes to "King Cophetua and the Beggar Maid," an 1884 painting by Edward Burne-Jones, based on an earlier Elizabethan ballad and a poem by Lord Tennyson. King Cophetua, as you might guess, falls in love with a beggar maid-- or perhaps with the idea of the beggar maid and the beautiful simplicity her poverty represents to him. Munro's story contrasts the romanticization of poverty with the actual experience of poverty.

The story begins, "Patrick Blatchford was in love with Rose." The sentence construction-- with Rose in the passive position--is telling. Rose is given room and board with a female English professor, Dr. Henshawe. Her living situation also arises from her passivity: "She had got to live with Dr. Henshawe by accident." She enrolls in (and despises) an introductory economics course not of her own volition, but because Dr. Henshawe tells her to.

Dr. Henshawe, even before Patrick, romanticizes Rose's poverty; she "liked poor girls, bright girls, but they had to be fairly good- looking girls." Rose satisfies the requirements; she is, so to speak, "working class," although "Before she came to Dr. Henshawe’s, Rose had never heard of the working class." Rose's perception of her family home is altered by her stay with Dr. Henshawe:

"What Dr. Henshawe’s house and Flo’s house did best, in Rose’s opinion, was discredit each other. In Dr. Henshawe’s charming rooms there was always for Rose the raw knowledge of home, an indigestible lump, and at home now her sense of order and modulation elsewhere exposed such embarrassing sad poverty in people who never thought themselves poor. Poverty was not just wretchedness, as Dr. Henshawe seemed to think, it was not just deprivation. It meant having those ugly tube lights and being proud of them. It meant continual talk of money and malicious talk about new things people had bought and whether they were paid for. It meant pride and jealousy flaring over something like the new pair of plastic curtains, imitating lace, that Flo had bought for the front window. That as well as hanging your clothes on nails behind the door and being able to hear every sound from the bathroom. It meant decorating your walls with a number of admonitions, pious and cheerful and mildly bawdy."

One day, in the library, a strange man touches Rose on the leg and then scurries off. "It didn’t seem to her a sexual touch; it was more like a joke, though not at all a friendly one." Rose doesn't particularly want to do anything about it, but she feels the need to tell someone what happened. This is how she comes to meet Patrick, who by chance is studying in a nearby carrel, and how he comes to fall in love with her.

"If she had been trying to make him fall in love with her, there was no better way she could have chosen. He had many chivalric notions, which he pretended to mock, by saying certain words and phrases as if in quotation marks. 'The fair sex,' he would say, and 'damsel in distress.'"

We are told right away about Patrick that "his family was rich." Immediately thereafter comes the following passage, in which he is called poor:

He arrived early to pick Rose up, when they were going to the movies. He wouldn’t knock, he knew he was early. He sat on the step outside Dr. Henshawe’s door. This was in the winter, it was dark out, but there was a little coach lamp beside the door. 

“Oh, Rose! Come and look!” called Dr. Henshawe, in her soft, amused voice, and they looked down together from the dark window of the study. “The poor young man,” said Dr. Henshawe tenderly... She called Patrick poor because he was in love, and perhaps also because he was a male, doomed to push and blunder. Even from up here he looked stubborn and pitiable, determined and dependent, sitting out there in the cold.

Rose does not comprehend at first just how rich Patrick is, and seems to view him with a combination of pity and disgust, especially concerning "that flinching, that lack of faith, that seemed to be revealed in all transactions with Patrick." Notice the use of the word transactions to describe their interactions. The transactional language continues in the following passage, the heart of the story:

"She could not turn Patrick down. She could not do it. It was not the amount of money but the amount of love he offered that she could not ignore; she believed that she felt sorry for him, that she had to help him out. It was as if he had come up to her in a crowd carrying a large, simple, dazzling object — a huge egg, maybe, of solid silver, something of doubtful use and punishing weight — and was offering it to her, in fact thrusting it at her, begging her to take some of the weight of it off him. If she thrust it back, how could he bear it? But that explanation left something out. It left out her own appetite, which was not for wealth but for worship. The size, the weight, the shine, of what he said was love (and she did not doubt him) had to impress her, even though she had never asked for it. It did not seem likely such an offering would come her way again. Patrick himself, though worshipful, did in some oblique way acknowledge her luck."

Whereas economists study commercial transactions that are by necessity and construction mutually beneficial to both parties, here we observe human relational transactions that are at best doubtful, at worst punishing. Patrick becomes the beggar, Rose the king (the object of worship); neither quite knows what they offer or what they receive in return, yet neither is free to decline to transact. We can't help feeling that Patrick and Rose's "transactions" are as violating as the stranger's unwelcome touch of her leg.

Patrick repeatedly tells Rose how "lovely" and "charming" her poverty has made her. He does not understand her experience of poverty, nor she his of tremendous wealth. Then they visit each other's family homes. In preparation for her visit to Patrick's parents' house, "She had sold more blood and bought a fuzzy angora sweater, peach-colored, which was extremely messy and looked like a small-town girl’s idea of dressing up. She always realized things like that as soon as a purchase was made, not before." When she arrives,

"Size was noticeable everywhere and particularly thickness. Thickness of towels and rugs and handles of knives and forks, and silences. There was a terrible amount of luxury and unease."

The trip to visit her stepmother is no better. Actual poverty is not romantic, not beautiful. Afterwards, Patrick says, “'Your real parents can’t have been like that.'” 

"Rose did not like his saying that either, though it was what she believed herself. She saw that he was trying to provide for her a more genteel background, perhaps something like the homes of his poor friends: a few books about, a tea tray, and mended linen, worn good taste; proud, tired, educated people. What a coward he was, she thought angrily, but she knew that she herself was the coward, not knowing any way to be comfortable with her own people or the kitchen or any of it. Years later she would learn how to use it, she would be able to amuse or intimidate right-thinking people at dinner parties with glimpses of her early home. At the moment she felt confusion, misery."

Despite her confusion and misery, Rose agrees to marry Patrick, at which point he gives up his plans to be an academic historian in favor of a lucrative position at his father's company (he previously forswore going into business.) Rose grows ever more miserable until she finally confronts him to call off the wedding, climatically declaring, 

"I don’t have to know what I want to know what I don’t want!"

We believe she has at last taken control of her own destiny. Not long after, though, she spots him in his carrel and has an "barely resistible" temptation to throw herself at him, beg his forgiveness, restore his happiness.

"It was not resistible, after all. She did it."

She neither knows her preferences nor controls her actions. We remember how she hated her economics class, where she probably learned about  homo economicus, the hyper-rational, hyper-calculating representative agent with well-defined preferences. When Jane Smiley presented Munro the Man Booker Prize in 2009, she said, “Millions of readers pick up an Alice Munro story and react with a kind of galvanised self-recognition.” No one wants to recognize herself in homo economicus, the main character of our economics Nobelists (with very mild deviations by Shiller). We want, we believe we want, to be human and distinct, romantic and idealistic. We recognize ourselves in Munro's stories, but it is not a comfortable recognition. Her characters are not exactly homo economicus but neither are they who we want to be. It is not so simple to separate our desires for money, love, sex, worship, power. We can see life "in economic terms" and not, as she describes at the end of the story. The end is told from Rose's perspective many years later, after her ten year marriage to Patrick and eventual divorce.

"When Rose afterward reviewed and talked about this moment in her life...she said that comradely compassion had overcome her, she was not proof against the sight of a bare bent neck. Then she went further into it, and said greed, greed. She said she had run to him and clung to him and overcome his suspicions and kissed and cried and reinstated herself simply because she did not know how to do without his love and his promise to look after her; she was frightened of the world and she had not been able to think up any other plan for herself. When she was seeing life in economic terms, or was with people who did, she said that only middle-class people had choices anyway, that if she had had the price of a train ticket to Toronto her life would have been different. 

Nonsense, she might say later, never mind that, it was really vanity, it was vanity pure and simple, to resurrect him, to bring him back his happiness. To see if she could do that. She could not resist such a test of power."

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Robert Shiller and Radical Financial Innovation

Robert Shiller, who shares this year's Nobel Prize with Eugene Fama and Lars Peter Hansen, is perhaps most famous for his ability to "predict the future." But he also has an impressive grasp of the past. As just one example, in my recent blog post on the history of inflation-protected securities, Shiller's paper on "The Invention of Inflation-Indexed Bonds in Early America" was the most useful reference. Shiller's ability to develop intuition from financial history has, I believe, contributed to his success in behavioral finance, or "finance from a broader social science perspective including psychology and sociology."

Rather than attempting a comprehensive overview of Shiller's work, in this post I would like to focus on "Radical Financial Innovation," which appeared as a chapter in Entrepreneurship, Innovation and the Growth Mechanism of the Free Market Economies, in Honor of William Baumol (2004).

The chapter begins with some brief but powerful observations:

According to the intertemporal capital asset model... real consumption fluctuations are perfectly correlated across all individuals in the world. This result follows since with complete risk management any fluctuations in individual endowments are completely pooled, and only world risk remains. But, in fact, real consumption changes are not very correlated across individuals. As Backus, Kehoe, and Kydland (1992) have documented, the correlation of consumption changes across countries is far from perfect…Individuals do not succeed in insuring their individual consumption risks (Cochrane 1991). Moreover, individual consumption over the lifecycle tends to track individual income over the lifecycle (Carroll and Summers 1991)... The institutions we have tend to be directed towards managing some relatively small risks."

Shiller notes that the ability to risk-share does not simply arise from thin air. Rather, the complete markets ideal of risk sharing developed by Kenneth Arrow "cannot be approached to any significant extent without an apparatus, a financial and information and marketing structure. The design of any such apparatus is far from obvious." Shiller observes that we have well-developed institutions for managing the types of risks that were historically important (like fire insurance) but not for the significant risks of today. "This gap," he writes, "reflects the slowness of invention to adapt to the changing structure of economic risks."

The designers of risk management devices face both economic and human behavioral challenges. The former include moral hazard, asymmetric information, and the continually evolving nature of risks. The latter include a variety of "human weaknesses as regards risks." These human weaknesses or psychological barriers in the way we think about and deal with risks are the subject of the behavioral finance/economics literature. Shiller and Richard Thaler direct the National Bureau of Economic Research working group on behavioral economics.

To understand some of the obstacles to risk management innovation today, Shiller looks back in history to the development of life insurance. Life insurance, he argues, was very important in past centuries when the death of parents of young children was fairly common. But today, we lack other forms of "livelihood insurance" that may be much more important in the current risk environment.

"An important milestone in the development of life insurance occurred in the 1880s when Henry Hyde of the Equitable Life Assurance Society conceived the idea of creating long-term life insurance policies with substantial cash values, and of marketing them as investments rather than as pure insurance. The concept was one of bundling, of bundling the life insurance policy together with an investment, so that no loss was immediately apparent if there was no death. This innovation was a powerful impetus to the public’s acceptance of life insurance. It changed the framing from one of losses to one of gains…It might also be noted that an educational campaign made by the life insurance industry has also enhanced public understanding of the concept of life insurance. Indeed, people can sometimes be educated out of some of the judgmental errors that Kahneman and Tversky have documented…In my book (2003) I discussed some important new forms that livelihood insurance can take in the twenty-first century, to manage risks that will be more important than death or disability in coming years. But, making such risk management happen will require the same kind of pervasive innovation that we saw with life insurance."

Shiller has also done more technical theoretical work on the most important risks to hedge:

"According to a theoretical model developed by Stefano Athanasoulis and myself, the most important risks to be hedged first can be defined in terms of the eigenvectors of the variance matrix of deviations of individual incomes from world income, that is, of the matrix whose ijth element is the covariance of individual I’s income change deviation from per capita world income change with individual j’s income change deviation from per capita world income change. Moreover, the eigenvalue corresponding to each eigenvector provides a measure of the welfare gain that can be obtained by creating the corresponding risk management vehicle. So a market designer of a limited number N of new risk management instruments would pick the eigenvectors corresponding to the highest N eigenvalues."

Based on his research, Shiller has been personally involved in the innovation of new risk management vehicles. In 1999, he and Allan Weiss obtained a patent for "macro securities," although their attempt in 1990 to develop a real estate futures market never took off.

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Financing the Federal Government with Inflation-Protected Securities

In 1997, the U.S. Treasury made the contentious decision to begin issuing Treasury inflation-protected securities (TIPS). Treasury Secretary Robert Rubin proposed the issuance of these inflation-linked securities as a way to reduce the government's borrowing costs and increase the national saving rate, remarking:

"Helping the economy and raising incomes requires increasing productivity, and the saving rate is central to that objective. The initiative we are announcing today has the potential of raising our national saving rate as well as reducing the cost of capital to the federal government. Today we are announcing our intention to issue securities that will offer investors protection against inflation. Americans' retirement savings in their pension plans or their own IRAs can have inflation protection, which can help ensure their retirement security... 

We believe these bonds will offer savers value-added in the form of protection against inflation, plus a real rate of return backed by the full faith and credit of the United States, and in return for offering that value-added, over time the cost of financing to the federal government will be lower than it otherwise would be...This is a common sense approach to government and an excellent example of government reinvention -- protecting Americans from inflation with an innovative investment method, and saving them money as taxpayers by holding down borrowing costs."

In July 2008, however, advisers to Treasury Secretary Henry Paulson recommended that Paulson should eliminate five-year TIPS and reduce the use of TIPS of other maturities, arguing that the inflation-indexed securities had cost taxpayers billions. This advice was not put into effect. The question remains: Has the Treasury benefited from issuing TIPS? I explore the mixed evidence in this post, the second in my series about inflation-indexed debt. The first post in the series, "Academic Scribblers and the History of Inflation-Protected Securities," describes  the origins and re-origins of inflation-linked government debt, which briefly appeared in 1780 and then disappeared for two centuries.

First, why might we expect TIPS to hold down borrowing costs in theory? Nominal bonds expose investors to inflation risk, so their yields presumably contain an inflation risk premium; by issuing indexed bonds, the Treasury can avoid paying the premium. John Campbell and Robert Shiller pointed out in 1996 that the magnitude--and even the sign--of the inflation risk premium was unknown. How could the inflation risk premium possibly be negative? According to the classic text on asset pricing by John Cochrane,

"All assets have an expected return equal to the risk-free rate, plus a risk adjustment. Assets whose returns covary positively with consumption make consumption more volatile, and so must promise higher expected returns to induce investors to hold them. Conversely, assets that covary negatively with consumption, such as insurance, can offer expected rates of return that are lower than the risk-free rate...You might think that as asset with a volatile payoff is `risky' and thus should have a large risk correction. However, if the payoff is uncorrelated with the discount factor m, the asset receives no risk correction to its price, and pays an expected return equal to the risk-free rate!"

In short, the inflation risk premium does not depend directly on how uncertain or volatile inflation is. What matters for the inflation risk premium is how future inflation covaries with future consumption (alternatively, with the stock market), and that is not obvious. In 1996, Campbell and Shiller estimated the premium by several different methods and came up with an estimate of 50 to 100 basis points for a five-year zero-coupon nominal bond: in short, non-trivial savings for the government. These anticipated savings were part of the reason why the Treasury began issuing TIPS.

Why then, in 2008, did the Treasury Borrowing Advisory Committee recommend that TIPS should play a smaller role in meeting future financing needs? A member of the committee "estimates that the cumulative cost of the TIPs program to the Treasury since inception, when comparing the total expense relative to nominal bonds issued at a similar time, approaches $30 billion with the bulk of that cost a direct result of significantly higher inflation than estimated by the markets 'breakeven' level when issued." They attribute part of the cost to a liquidity cost, since TIPS are less liquid than nominals so investors must be compensated for the lower liquidity. They point out that the first factor--higher realized inflation than breakeven inflation--needn't necessarily continue. I would also point out that TIPS could gain liquidity over time as the TIPS market develops further, but the Committee's recommendation would very likely have reduced TIPS' liquidity.

An academic study in 2010 supports the view of the Treasury Borrowing Advisory Committee. In "Why Does the Treasury Issue Tips? The Tips–Treasury Bond Puzzle,"  Matthias Fleckenstein, Francis Longstaff, and Hanno Lustig estimate that "On average, the U.S. government has to levy $2.92 more in taxes, in present discounted value, to repay $100 of debt issued if the debt is indexed rather than nominal." They add that, in issuing TIPS, the government gives up a valuable fiscal hedging option. Fleckenstein et al. say that "To the best of our knowledge, the relative mispricing of TIPS and Treasury bonds represents the largest arbitrage ever documented in the financial economics literature."

Jens Christensen and James Gillan (2011), in contrast, say that the Treasury has benefited overall from using TIPS. There are two main premiums to consider: the inflation uncertainty premium and the liquidity premium. The former can help the government lower its borrowing costs by using TIPS, and while the latter can raise its borrowing costs. Both premiums can vary over time. Christensen and Gillan attempt to quantify the size of each premium and construct a liquidity-adjusted inflation risk premium. They come up with a range of estimates, and the most conservative is plotted below. The fact that it is, on average, positive (and less conservative estimates more obviously positive) supports Treasury's continued use of TIPS. I find their results fairly convincing, particularly in light of another study

Source: Christensen and Gillan (2011)

Another study, by William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer (2009) also comes out in support of TIPS as a cost-effective form of government financing. Their estimates of the inflation risk premium by maturity of issue are in the table below. They find that the liquidity compensation was around 200 basis points in 1999 but has since fallen drastically to well below 50 basis points. The positive risk premium and low liquidity compensation in combination imply cost savings for the Treasury.

Source: Dudley, Roush, and Steinberg Ezer (2009)

In my interpretation, the balance of evidence supports the idea that TIPS are mildly cost-effective, or at least not cost-increasing, for the Treasury. The government's borrowing cost is not the only factor to consider when evaluating the net effect of TIPS. Rubin, remember, suggested that TIPS would increase the nation's saving rate and in turn increase productivity. John Campbell and Robert Shiller listed other potential upsides and downsides to TIPS in their 1996 "A Scorecard for Indexed Government Debt." I'll discuss some of these other issues in future posts.

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Part 1 of series: Academic Scribblers and the History of Inflation-Protected Securities

**Disclaimer: This post not intended as investment advice.

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No, Economics Is Good for Lots of Things

Survey Research at Work

Perhaps the greatest intellectual casualty of the 2008 financial crisis was the credibility of economics as a science. "Why didn't economists foresee the crisis?" people asked, and this lingering suspicion came to a head in a recent NYT editorial blasting economics as a scientific discipline. On first pass, I thought it was just one of those silly articles that crops up on occasion, but the more that I thought about the editorial, and compared it with some of the economic insights I have absorbed as a student, the more I was angered. And thus, I felt compelled to rant.

What should be kept in mind is that, like engineering, economics is a broad discipline that covers many different fields. Just as some engineers study computers and others study nuclear reactors, some economists study taxes, other study financial markets, and still others study how psychological biases should change the design of policy. So to use the chaos in financial markets as a reason to discredit all of economics is analogous to discrediting all of engineering on the count of a Fukushima disaster. While portions of macroeconomics may be made up of smoke, mirrors, and misleading standard errors, even a brief introspection can reveal why that is not representative of economics as a whole.

In economic models, people do whatever maximizes their self interest. However, this leaves no room for intellectual growth -- any new insight or strategy would have already been discovered by the omniscient agents! But people are of finite intelligence. As a result, their self-interest can be up for reinterpretation.

In this area, economists play the important role of introducing new *ideas* about policy. Precisely because people are not as omniscient as the agents in economic models, it's important that governments have a solid foundation on ideas to conceptualize and defend policies from critics. By introducing a new framework or a new empirical fact, economists can cast policy into a different light and redirect the conversation and agenda.

Let us first consider the canonical example of auction theory. Game theorists have been remarkably effective at designing auction mechanisms. The late Ronald Coase famously argued that the U.S. should auction off spectrum rights. Yet in his Congressional testimony, he was met with disbelief, with a congressman asking "is this a joke"? Later on, when the FCC changed its mind, it fell to economists (game theorists, no less!) to design the details of the auction. Designing such an auction is not a trivial task. Since it's advantageous to have radio frequencies in geographically contiguous areas, what a company is willing to bid on one spectrum in an area is dependent on whether it can win in other areas. Moreover, there are a host of protections you need to design. How do you stop firms from colluding? How do you make sure firms can't manipulate the bids to pay extremely low prices? When these issues were ignored in the Australian and New Zealand auctions, many hundreds of millions of dollars were lost.

Economists have also managed to change the way we talk about poverty policies in the United States. A common misconception is that impoverished people are just lazy, and that nothing can be done for them. And as a result, welfare just represents an unproductive transfer from the makers to the takers. However, survey data from the Survey Research Center at the University of Michigan has shown that poverty is most often a transitory phenomenon, and that no, welfare is not about Cadillac queens or subsidizing sloth, but rather about providing insurance for a wide range of people who live on the threshold of poverty. The fact that the national conversation sometimes forgets this point is a reminder that economists do have an important role to play in shaping the welfare policy debate, and that neglecting this can have serious human impact.

And when we take a look at the the role of economists in analyzing aid and development, the impact is even larger. The foundations of international finance and the study of capital flows explains what kinds of aid are better than others, and why it's important not only to provide money but also personnel and expertise. On a micro level, pioneering experimental work, as popularized by Esther Duflo and Abhijit Banjeree in their book titled "Poor Economics", has added an additional subtlety to the design of development policy. By integrating insights from psychology and political science, development economists like them have gone on to revise how to better provide fertilizers to farmers or how to limit the extent of patronage politics. These are all critical issues in the task of economic development, and it has fallen to economists to address them.

So far, I have focused on micro topics. But there are actually a surprisingly robust set of results about how emerging markets should handle capital flows. Stephen Salant (who is teaching me applied micro modeling this fall!) laid the foundation for speculative attacks on stockpiles of resources, such as oil or food. His model later led to Krugman's pioneering work on how currency crises happen, and the lessons from the literature on currency crises showed why external debt could be so harmful for developing economies. Anton Korinek has also made great contributions outlining the welfare arguments for avoiding external debt and currency crises. Indeed, those economies who had large stocks of external debt relative to foreign reserves were precisely the ones who suffered the most during the financial crisis. While it may not be a direct result, it is now clear to all emerging markets that a combination of external debt and exchange rate pegs can be extremely dangerous. And the absence of those two fault lines has put the emerging markets on much more stable footing during the current sell-off.

Even in the controversial field of monetary policy we're doing better. Back in the 1920's, it was thought that monetary policy should ease during the boom and tighten during the bust. This was called the Real Bills Doctrine, and ended up amplifying the business cycle. Doubt about the effect of Quantitative Easing is not equivalent to ignorance about money's effect on the macroeconomy. We might not be clear on magnitudes, but we at least know which way goes up and which goes down.

From a methodological standpoint, economists are valuable because we are trained to think about social issues through a quantitative and empirical framework. While other social sciences such as sociology and psychology are also known for their increasingly quantitative measures, economists are special because the variables we are interested in -- income, prices, population -- are easily measured and interpreted quantitative measures.

(As a digression, I was surprised that this notion of economics as socially applied statistics was completely missing from the conversation about economath. Without the work in mathematical statistics, economists would have been unable to do the measurements that we do, and the empirical studies that I describe above would not have been possible. I remember Miles Kimball joking with me that empirical macro is all about interpreting measurement error, yet without the work of generations of econometricians, we would not know of how to do that kind of analysis.)

From a personal standpoint, I will also be contributing towards this kind of research this year. Since University of Michigan is a state school, we are of course very concerned about how all of our students -- across socioeconomic classes -- are doing. And therefore I will be heading a project to design a survey instrument and analysis methodology to measure how students are doing in the off campus housing markets and to identify the potential severity of this kind of socioeconomic segmentation. (See picture). While it may be true that my project will have various flaws, I still think of it as representative of the power of empirical economics. Identify problems. Collect data. Make lives better. Wash, rinse, repeat. And at least from personal experience, this mode of analysis -- of looking at bivariate relationships, of thinking about longitudinal effects -- is not as common among my fellow social scientists from psychology or political science.

This explicitly empirical tack built into modern economics is important because the alternative to a world with economists is not some non-partisan paradise. Rather, it will be filled by the Keith Olbermanns and Sean Hannities of the world, who rely instead on cheap rhetorical tricks instead of well grounded theory and empirics.

Yet in spite of my strong conviction that economists do create value for society, I do recognize that economics, on the most part, is not an experimental science. But that should not necessarily be seen as a flaw. Economists are tasked with evaluating policies that can play such a large role in the welfare of the masses. And once you know that a certain policy is harmful, it would be a profound breach of ethics to repeatedly apply such failed policy so that you could "replicate" and make the results "scientific".

I want to wrap up this post with a joke.

A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Lets smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Lets assume that we have a can-opener..."

The punchline suggests that instead of solving problems, economists just assume them away. But the real work of economics actually comes after the initial assumption. A real economist goes "..then if we had a can opener, we would be set. So let's go make a can opener." The joke misrepresents the work of economists by focusing on "opening a can" -- a task that has neither ambiguity nor great subtlety. On these issues, of course the hard sciences will be superior. But what if we asked a different question such as "how should we reduce carbon dioxide emissions"? In this case, there is no clear answer. But the economist would go "let's assume there were a price to carbon. Then the first welfare theorem means there's no inefficiency. So let's go price carbon!"

The big social problems of our day -- long term poverty, global warming, the middle income trap -- have few direct solutions, and any solution will affect portions of society in largely differing ways. And without economists to help work out the theory and empirics, how do you plan on tackling such dilemmas?

---

Update: Indeed, long term unemployment is a more severe problem than just an intellectual scruffle. But it really does seem that after the Great Recessions, economists are (perhaps rightly) viewed with more skepticism.

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Low Interest Rates, Savers, and the Recovery

This is a brief addendum to my recent post, "Do Savers Need to be Saved?"

Back in March, I wrote about Paul Krugman and Charles Plosser's takes on near-zero nominal interest rates and household saving. Both noted that households were deleveraging and the zero lower bound was binding. Both agreed about Krugman's diagnosis of a "persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy." But their suggested cures were quite different.

I just came across a piece written in May by Raghuram Rajan, new Governor of the Reserve Bank of India, called "Central Bankers under Siege," that takes on the same issue. He, too, makes a similar diagnosis but suggests different cures. In my post on savers and low interest rates, I discussed the income and substitution effects of low interest rates, and mentioned that near-retirees are commonly cited as examples of people for whom the income effect dominates. Rajan actually uses this exact example:

"First, while low rates might encourage spending if credit were easy, it is not at all clear that traditional savers today would go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside. 

Alternatively, low interest rates could push her (or her pension fund) to buy risky long-maturity bonds. Given that these bonds are already aggressively priced, such a move might thus set her up for a fall when interest rates eventually rise. Indeed, America may well be in the process of adding a pension crisis to the unemployment problem."

Rajan and Plosser match up point for point. Here's Plosser:

"In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small...

I have heard from various business contacts that the low interest rate environment is spurring institutional and individual investors to “search for yield.” This may entail taking on more credit risk than these investors are typically comfortable with in a reach for yields that may ultimately be illusive and result in losses they are ill-equipped to handle. Very low yields may also be distorting other investment decisions, inducing firms to undertake long-run investment projects that may prove to be unprofitable in a rising interest rate environment."

Both Rajan and Plosser fear that lower interest rates won't help the economy because either the income effect dominates the substitution effect or because low interest rates will cause "reaching for yield." My fellow Not Quite Noahpinion author John Aziz suggests:

"Savers looking for a larger rate of return should... take their money out of low interest savings accounts and out of the failed financial intermediation industry and invest it into quality economic projects that create jobs and growth. This could involve buying the stock or debt of large companies that wish to expand, or it could involve starting your own business, or investing in a startup or a mixture of these things. The easiest way to return to growth — and thus higher interest rates, and higher returns for things like pension funds — is for today’s savers complaining about low interest rates to turn into tomorrow’s investors seeking out and pouring money into quality projects that increase incomes, create jobs and create products that people desire and want to use."

The question is whether low interest rates have the beneficial effect on investment that Aziz describes, or the harmful reach-for-yield effect. Returning to Plosser, Krugman, and Rajan, it is interesting that the three economists seem to diagnose what is ailing the economy quite similarly (a "persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy"), but make different prescriptions. First, they differ in their opinions of unconventional monetary policy:

• Plosser: "The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner. As I said, I see little if any benefit from these purchases, and growing costs. The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds."
• Krugman: "Unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried)."
• Rajan: "We really don’t know. Given the dubious benefits of still lower real interest rates, placing central-bank credibility at risk would be irresponsible."

They also differ in their general policy prescriptions:

• Plosser wants removal of fiscal-policy-induced uncertainty: "There remains significant uncertainty about the choices that will be made. How much will tax rates rise? How much will government spending be cut? U.S. fiscal policy is clearly on an unsustainable path that must be corrected. Efforts by Congress and the administration at the end of last year reduced some of the near-term uncertainty over personal tax rates. But the impact of the sequester, the debate over the continuing resolution to fund the federal government beyond this month, and the debt ceiling, which will once again become binding in the spring, all have clouded the fiscal policy situation. So, the resultant uncertainty will likely be a drag on near-term growth. In my view, until uncertainty has been resolved, monetary policy accommodation that lowers interest rates is unlikely to stimulate firms to hire and invest."
• Krugman thinks the fiscal multiplier is large, and fiscal retrenchment would be destructive: "the logic for a biggish multiplier and the logic of the crisis itself are very closely linked: times like these, the aftermath of a credit bubble, are precisely when you expect fiscal multipliers to be large. And that in turn says, once again, that fatalism — or worse yet, demands for fiscal retrenchment — in the aftermath of such a bubble are deeply destructive."
• Rajan looks to helping households refinance, and (somehow) improving workforce capabilities: "We cannot ignore high unemployment. Clearly, improving indebted households’ ability to refinance at low current interest rates could help to reduce their debt burden, as would writing off some mortgage debt in cases where falling house prices have left borrowers deep underwater (that is, the outstanding mortgage exceeds the house’s value)... But it is also important to recognize that the path to a sustainable recovery does not lie in restoring irresponsible and unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance... Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes."

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Four Ways to Answer Economics Questions

I recently came across a saying about the four ways of answering questions according to the Pañha Sutta.

1. There are questions that should be answered categorically [straightforwardly yes, no, this, that].
2. There are questions that should be answered with an analytical answer, defining or redefining the terms. 
3. There are questions that should be answered with a counter-question. 
4. There are questions that should be put aside.

A lot of the questions that economists get asked a lot can be answered in all four ways. I thought it would be fun to play a little "Economics Q&4A." I'll provide a few examples. If you wish, chime in with your own Q&4As in the comments.

Q: Is economics a science?

1. Yes.
2. This depends on exactly how you define science and what you consider to be the bounds and scope of economics. For the most part, economists cannot do controlled laboratory experiments. You can see lots of people's opinions on this question here, and you can read Mark Thoma and Paul Krugman here.
3. Does this really matter? If it were not a science, should we stop trying to do it?
4. **goes back to work**

Q: Is all this quantitative easing going to cause an inflation problem?

1. No.
2. You are probably asking about the Federal Reserve's unconventional monetary policies. For an explanation of why they haven't (and probably won't) cause problematically high inflation, see these posts.
3. What do you mean by inflation problem? Isn't it possible that a bit more inflation would be a good thing? Do you see any signs of an inflation problem? Don't we have bigger problems than inflation?
4. **sighs**

Q: If households have to tighten their belts, shouldn't the government?

1. No.
2. By belt-tightening, I presume you mean reducing the deficit of the federal government. You might have heard President Obama say, in 2010, "Small businesses and families are tightening their belts. Their government should too." But households are different than the government. You can read some bloggers' reactions here and here.
3. Is the government a household?
4. **slumps**

Q: How should I invest my money?

1. Wisely.
2. This depends on your situation and your financial goals. I don't know of any guaranteed get-rich-quick investment schemes. You should probably try to diversify, and not keep all your money under your mattress or in gold. I'm also not an investment adviser, just a young academic economist with no experience, so I'm horribly underqualified to help you with this.
3. How much money do you have? And what are your investment goals? And why are you asking an economics grad student?
4. **shrugs wildly**

Q: Should we go back on the gold standard?

1. No.
2. Here is an excerpt from Barry Eichengreen's answer: 

"Envisioning a statute requiring the Federal Reserve to redeem its notes for fixed amounts of specie is easy, but deciding what that fixed amount should be is hard. Set the price too high and there will be large amounts of gold-backed currency chasing limited supplies of goods and services. The new gold standard will then become an engine of precisely the inflation that its proponents abhor. But set the price too low, and the result will be deflation, which is not exactly a healthy state for an economy...The distributional effects of deflation are no happier than those of inflation.... The populist revolt of the 1880s was stoked by farmers with fixed mortgages who labored under growing debt burdens and financial distress as a result of falling crop prices. Nor is deflation likely to support robust economic growth, as any close observer of the Japanese economy will tell you.... 

And even if we are lucky enough to get it right at the outset, consider what happens subsequently. As the economy grows, the price level will have to fall. The same amount of gold-backed currency has to support a growing volume of transactions, something it can do only if the prices are lower, unless the supply of new gold by the mining industry magically rises at the same rate as the output of other goods and services. If not, prices go down, and real interest rates become higher. Investment becomes more expensive, rendering job creation more difficult all over again. Under a true gold standard, moreover, the Fed would have little ability to act as a lender of last resort to the banking and financial system...Its proponents paint the gold standard as a guarantee of financial stability; in practice, it would be precisely the opposite." 

3. What have you learned from history?

4. **cowers**

Q: When is Noah coming back?

1. In about 3 months.
2. If you mean coming back to the blog, that will be in about 3 months. However, he has never left Twitter. If you mean coming back to the United States, I think that already happened. 
3. What, don't you like us?
4. **checks watch**

Your turn!

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Perceiving Job Insecurity

A study in the Journal of Occupational & Environmental Medicine finds evidence linking perceived job insecurity in the Great Recession to poor health outcomes, even among workers who remain employed. The authors, Sarah Burgard, Lucie Kalousova, and Kristin Seefeldt, find that insecure workers--those that believe they are at risk of being laid off--are more likely to report poor self-rated health, symptoms of depression, and anxiety attacks. Sad, but not hugely surprising.

I originally intended to point to this study as yet more evidence of the harmful consequences of prolonged high unemployment. I intended, in particular, to write about how the anxiety and poor health consequences associated with the fear of losing a job must fall especially hard on people with low income. So I set out to gather a bit more data to back up that particular hypothesis, imagining it would be quick and simple task. Not quite.

Most of us are pretty aware of the unemployment rate in the U.S.--7.4% as of July 2013. But for people who do have a job, the more relevant statistic for their financial decision-making (and apparently also for their health) is the probability that they (and members of their household) will keep their job. This statistic is much harder to come by. How aware are workers of their risk of being laid off? How do you quantify job security?

The first place I looked was the Bureau of Labor Statistics, which provides data on layoffs and discharges. The monthly layoff and discharge rate for total nonfarm employment is around 1.3%. It peaked at 2% in early 2009 (see graph below). If we all believed we had a 1 or 2% chance of being laid off, we probably wouldn't be too stressed out about it. But the layoff and discharge rate does not directly translate into an individual worker's probability of losing a job, and it definitely does not translate into a worker's perceived probability of losing a job (the statistic most relevant for their health).

How can we get at people's perceived job insecurity? One way is to ask them. The Michigan Survey of Consumers asks survey participants, "During the next 5 years, what do you think the chances are that you (or your husband/wife) will lose a job that you wanted to keep?"

Broken down by income tercile, here is a graph of the mean responses. What initially surprised me the most is that the lowest income tercile has the lowest perceived job insecurity. In 2012, on average, people in the lowest income tercile reported a 17% chance of job loss, while people in the middle and upper terciles reported 19% and 20% chances, respectively.

Mean perceived chance of job loss by respondent or partner in next 5 years, by income tercile. Source: Carola Binder with data from Michigan Survey of Consumers. Moving-average filtered.

When you look at the distribution of responses, however, it becomes clear that you have to interpret the mean with a large grain of salt. Respondents are allowed to say any number from 0% to 100%. But they mostly just say one of two numbers: 0% or 50%. This is a common tendency across income levels, but especially among the lowest income tercile. In 2012, around 70% of respondents in the lowest income tercile chose 0% or 50% as their response. In the middle and upper income terciles, 58% and 47% of respondents chose those responses.

Percent of respondents who say that their chance of job loss in next 5 years is either 0% or 50%, by income tercile. Source: Carola Binder with data from Michigan Survey of Consumers. Moving-average filtered.

Prior to answering the question, survey takers are given this brief intro to help them understand probabilities: "Your answers can range from zero to one hundred, where zero means there is absolutely no chance, and one hundred means that it is absolutely certain. For example, when weather forecasters report the chance of rain, a number like 20 percent means 'a small chance', a number around 50 percent means 'a pretty even chance,' and a number like 80 percent means 'a very good chance.'" Nonetheless, most people seem to have tremendous difficulty quantifying their probability of job loss. Over half of people choose 0% or 50% as their response.

Whether or not you will lose your job can be represented by a bernoulli random variable. A bernoulli random variable is summarized by its mean (p). The Principle of Insufficient Reason, or Principle of Indifference, says that "if we are ignorant of the ways an event can occur (and therefore have no reason to believe that one way will occur preferentially compared to another), the event will occur equally likely in any way." This principle was discussed by Bernoulli, Laplace, and Poincare, among others. For a bernoulli variable, this principle says that if we are totally ignorant about its mean, our prior is that the mean is 0.5. This has a corresponding result in information theory: the entropy of a bernoulli distribution is maximized when p=0.5 (think of a 50% chance as being the "most uncertain.") If we have absolutely no information about how likely we are to lose our job, we might just guess that we have a 50% chance of losing it.

Keynes himself summarized the Principle of Indifference in his 1921 Treatise on Probability as follows:

"if there is no known reason for predicating of our subject one rather than another of several alternatives, then relatively to such knowledge the assertions of each of these alternatives have an equal probability" (pg. 52-53).

Keynes was one of many to critique this principle. His views on probability and uncertainty remain controversial, as does the Principle of Insufficient Reason. There is actually quite a large body of literature in statistics concerning "noninformative priors" that continues to study the fascinating and controversial issue of how to represent ignorance. There are also subfields of behavioral economics that study how people treat probability, particularly when it comes to low-probability events (like job loss, usually).

This post doesn't have a real conclusion, just some open questions. What do people do when they don't know their chances of having a job in the future? Do people "underplan" or "overplan" for the possibility of job loss? Would people be better off in general if they could estimate their probability of job loss more precisely? How would you readers estimate your own probability of losing a job in the next 5 years?

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Popping the "Bubble" Bubble

Without a doubt, QE has been an incredible boon for financial markets. Backed by QE3, the SP500 stock index has risen by more than 12% year to date. Yet in spite of this increase in the stock market, overall real economic conditions remain relatively stagnant. Year over year inflation as measured by the core PCE price index ticks in at only 1.2% YoY, and last quarter's real GDP grew by only 1.4% YoY. This disconnect is a bit unsettling, because it suggests that bullishness in the stock market has failed to translate into broader growth. On this basis, some commentators, such as Frances Coppola, have argued that quantitative easing does nothing for the broader economy and worsens economic inequalities. But this concern can be reduced to an even simpler question: Has recent stock market growth just been a bubble?

There are a few reasons why this question is important. First, people make a lot of noise over the financial instability hypothesis that monetary policy is just fueling speculative excess. So for the sake of practical monetary policy, it matters if signs of a bubble are appearing. Second, if it can be shown that we are not in a bubble, and that recent financial market movements are based on fundamentals, this means that monetary policy is passing through to the economy. It's not just some scheme to enrich the wealthy. Moreover, the tools that we develop to analyze this issue can help us determine in the future if certain monetary policies are passing through to the economy. Third, analyzing this issue leads to some more insights on how finance and macro can work together. While I am sympathetic with Scott that finance should be kept out of theories of money, given that financial indicators function so well as forecasts, it would be a shame to not use as much data from the financial markets as possible.

Because this is a highly charged question, I want to make the conversation as concrete as possible. When I talk about a bubble, I don't just mean "stock prices are high". Rather, I want to define a bubble as when stock prices are "out of line" with the fundamentals of the underlying companies. What this means is that if China blows up next year, and the price of stocks fall, that doesn't mean the bubble popped. A blowup in China is an exogenous event that would change fundamentals, and prices would adjust as a result. The type of bubble that I'm talking about is a noise trader, "beauty contest" bubble, in which people go into a frenzy bidding up the price of securities on the belief that everybody else will bid them up as well.

So let's start by talking about how monetary policy affects stock prices. On first approximation, the value of a stock should be equal to the present discounted value of all dividend payments. Sure, there's excess volatility around the edges, but this simple model of cash flows is still accurate on average. In doing so, it gives us two ceteris paribus predictions about stock prices. First, a stock price should go up in response to higher expected future cash flows. Second, a stock price should go down with higher expected real interest rates, because a higher real rate reduces the discounted value of future cash flows. These are the two main channels through which monetary policy impacts stock prices. Monetary policy can either (1) raise the cash flows by improving the economic environment, or (2) lower the discount rate by maintaining an extended period of low real rates.

These two channels split quite nicely into a positive and negative take on the effect of monetary policy. If monetary policy raises stock prices because of current and future cash flows, that should be seen as a good sign of a recovering economic environment. This corresponds to "the Fed is improving the fundamentals of the economy." On the other hand, if monetary policy affects stock prices only through a lower discount rate, that is just a sign of an "immaculate conception", with stock prices rising without an improving economy.

Most market monetarists believe it's the former, whereas some fiscalists have made an argument that it's just the latter. But here's the kicker -- we should be able to distinguish the two by looking at the actual earnings data. By comparing the earnings of companies and the stock prices, we can actually make concrete the discussion about whether the stock market is in a bubble. In particular, we can distinguish between the two stories by looking at price to earnings ratios, or the ratio between the price of a stock and the earnings per share -- both in the trailing 12 months and 1 year forward estimates. If the fundamental story is correct, then we should observe that the price to earnings ratio stays relatively constant. Yes, stock prices are rising, but that's only because earnings are stronger. If the speculative excess story is correct, then the price to earnings ratio should be rapidly rising as the price is bid up, but the underlying earnings remain unchanged.

On this note, it doesn't look good for the bubble mongers. Below I have trailing 12 month and 1 year forward price to earnings ratio plotted for the SP500 index as a whole. The index P/E ratio is calculated through a market capitalization weighting process of the underlying index securities. What this shows is that, right now, stocks are quite cheap. The trailing 12 months PE ratio is at 15.5, a far cry from the heady tech bubble days with a peak P/E of 30 or even the moderate 2002-2008 period when the PE ratio tended around 18. The trailing 12 months ratios mean that prices aren't out of line with past performance. The fact that forward ratios are also relatively low and near the trailing ratios indicates that stock prices aren't up on the back of extremely optimistic future forecasts. Even though high PE ratios aren't sufficient conditions for a bubble, they're certainly necessary ones. If this is a beauty contest, it's awfully fair.

The moderate P/E ratio signals that people are not overpaying for performance. This isn't the 1990's -- market participants are not basing valuations off of overly optimistic views of future earnings. Rather, people are just paying reasonable amounts of money to buy into each company's earnings, resulting in reasonable stock prices.

Now, in my analysis above I glossed over one more channel that's relevant for the financial stability debate. It's possible that the liquidity provided by monetary policy encourages people to take riskier investments because they're "reaching for yield." But we should differentiate two versions of this hypothesis. The first is that people are over weighting risky sectors at the expense of safe ones. But this should not be a concern of policy because it's not systemic. When the reach for yield reverses itself, some stock investors will win, others will lose, and while there may be blood, policy makers need not wash their hands. On the other hand, if people are just pouring their money into stocks in general because they are dying for yield, then policy makers might be concerned. But the low PE ratios belie this hypothesis, so policy makers can still rest easy.

So if equities aren't a bubble, this means that the recent rise in stock prices corresponds to better fundamental performance for these companies. Therefore we should expect a pass through to the overall economy and for conditions to improve. Monetary policy was certainly not futile.

This can also give us a sense of where the economy is going as well. From the P/E ratios and the actual index level of the SP500, we can back out a quarterly earnings index -- both expected future earnings and actual trailing twelve months. By comparing expected earnings with the actual earnings one year later, we can actually evaluate how accurate forecasters were. Surprisingly enough, post dot com bubble, earnings forecasts were pretty accurate during normal times, and only when there was a policy failure (in 2008), was there a significant deviation. This suggests that earnings should continue to grow, and that the real concern shouldn't be on whether the stock market is getting frothy, but on whether overly contractionary monetary policy will send the recovery off course.

Now, this recovery may not be pretty. It's entirely possible for median household incomes to continue their stagnation. Remember, stable nominal GDP is consistent with almost any configuration of the real economy. You can have severe inequality, a low labor share, and inefficient labor markets and still have a monetary policy that keeps nominal GDP on track.

So if you want to avoid those bad, unequal, configurations, then you will earn my respect as you fight for targeted fiscal interventions. Just keep your hands off my monetary policy, because the most dangerous idea you can have is that it doesn't matter.

Update: Fixed some typos. Changed "monetary policy" in fifth sentence of first paragraph to "quantitative easing"

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