Steve Williamson explains modern macro

...Well, not actually all of modern macro. Just the way that modern macroeconomists define the "business cycle". But since the "business cycle" is the phenomenon that macroeconomists want to explain, this is really key, and it's something that doesn't get talked about a lot. So go read Steve Williamson; the post is really quite excellent, you will learn more about modern macro from reading it than from days of reading a graduate textbook. After you are done reading, then come back and continue this post.

What is a "business cycle"? It's not immediately obvious what it is. We have this idea that sometimes the economy does well, and sometimes it doesn't do well. Sometimes jobs are hard to find and don't seem to pay very well, sometimes jobs are easy to find and just throw perks at you. Sometimes lots of new buildings are going up, sometimes not many are. Etc.

Unlike seasons, these business "cycles" seem not to all last the same amount of time, or come at regular intervals. So maybe the "cycle" is really just randomness. Sometimes something happens to make the economy go well, sometimes something happens to make the economy not go well.

BUT, here's the thing...the economy seems to do steadily better and better over time. Only rarely do things get so bad that we actually produce less stuff than the year before. So people often think of the economy as containing a "trend" - some underlying force making us do better and better - and a "cycle" - some random thing that makes the economy do even better than the trend, or even worse, for a short while before going away.

The Hodrick-Prescott "Filter" (or H-P Filter) does not clean your water supply. It is a method for turning a time-series - say, GDP - into a "cycle", by subtracting out the "trend". If you are a "business cycle theorist", what you do for a living is basically this:

Step 1: Subtract out a "trend"; what remains is the "cycle".

Step 2: Make a theory to explain the "cycle" that you obtained in Step 1.

The H-P Filter is just a method for doing Step 1. You take a jagged time-series and you smooth it out, and you call the smoothed-out series the "trend". That's it. Whatever is left you call the "cycle", and you make theories to try to explain that "cycle".

But how much do you smooth? That's a really key question! If you smooth a lot, the "trend" becomes log-linear, meaning that any departure of GDP from a smooth exponential growth path - the kind of growth path of the population of bacteria in a fresh new petri dish - is called a "cycle". But if you don't smooth very much, then almost every bend and dip in GDP is a change in the "trend", and there's almost no "cycle" at all. In other words, YOU, the macroeconomist, get to choose how big of a "cycle" you are trying to explain. The size of the "cycle" is a free parameter.

Now, let's think about those explanations. One such explanation is the original RBC ("real business cycle") model, invented by the same Prescott who invented the Hodrick-Prescott Filter. This model won Prescott a Nobel Prize in 2004. I've criticized the RBC model, but let's forget about that criticism for now. How did Prescott show that his model explained the business cycle? What he did was this: First, he chose some values for the parameters in the RBC model that seemed reasonable to him ("calibration"). Then, he simulated an economy with the RBC model, and measured the size of the simulated fluctuations that it produced. Finally, he compared the size of those fluctuations with the size of the "cycle" that he got out of an H-P Filter, and decided that the two were pretty close in size. Thus, he concluded, the "cycles" of economic activity that we see in the real world could be generated by the RBC model, and hence the RBC model was a good one.

Now, I've criticized this method of validating models (which is called "moment matching"). But let's put aside that criticism for now, and think about the H-P Filter. Remember that we get to choose how much to smooth the time-series. The less we smooth, the smaller the "business cycle" becomes. So, up to a point, by choosing how much to smooth, we can choose to make the business cycle as big or as small as we like!

So what Prescott did was:

A) Chose how big of a "business cycle" he wanted to model,

B) Built a model of business cycles that produced fluctuations of about the size he chose in step A, and

C) Claimed to have explained the business cycle.

Now this may sound like a big fat hoax, but it's not quite. The amount of smoothing in the H-P filter is a free parameter, but if you choose it too big or too small, people will be skeptical. After all, we have other measures of recessions, like the "NBER recessions". If you smooth so much or so little that your "cycles" don't coincide at least roughly with those recessions, people won't buy your theory. They will say "Aww come on, really?" And in fact, some people responded that way to the RBC theory when it came out. But a critical mass of people gave it credence, which is why it became the basis of most subsequent models of the business cycle, and won a Nobel Prize.

What I want to point out here is how many judgment calls there are in modern macro. There is the judgment call of how big you think the "business cycle" is compared to the "trend". There is the judgment call of the parameters you think are reasonable to stick into your model. And there is the judgment call of whether you think the simulated fluctuations produced by your model are "close enough" in size to the real fluctuations. Actually, there are more judgment calls I haven't even talked about, such as the judgment call of whether a "shock" (a random thing that causes "cycles") is "structural" or not (see here if you want to learn more about that).

Now, some modern macroeconomists will tell you that all these judgment calls are fine. A theorist's conclusions, they will tell you, follow from their assumptions. Judgment calls are just assumptions.The job of a theorist, they will tell you, is to make a theory that is internally consistent. The purpose of the mathematics is to show that the conclusions - the policy recommendations, the forecasts - flow logically from the assumptions, or judgment calls. As for which judgment calls are appropriate, well, that is what academics spend their time arguing about, using their common sense to guide them.

Doesn't it seem to you that this way of doing "science" is a little too vulnerable to cultural/political biases among the body of practicing macroeconomists? It seems that way to me. But maybe I am wrong.

reade more... Résuméabuiyad

"This time it's different": China edition

I confess: I take a guilty pleasure in reading articles that claim "This time it's different". Back in 2004-5, when I started reading financial and economics news, all of those yarns were about how U.S. housing prices had reached a permanently high plateau, or how the financial system had evolved to be able to spread risks to the people most willing to bear them, etc. etc. It was fun. Everyone seemed to know it was BS. We just sat there imagining who would possibly believe it.

Anyway, the fun is back. As China slips into a slowdown, a few people are piping up to claim that no, this time it's different, China has it all figured out, their culture is different, their government is better, and so forth. But so far, I haven't seen anyone do this routine as beautifully as James White, analyst at Colonial First State. In an article flagged by Izabella Kaminska of FT Alphaville, he writes:

China’s rise confounds economic history, but not necessarily economic theory...[its] foundations seem brittle to western investors used to judging the health of an economy through the returns on capital. But the Chinese are comfortable with low capital returns if the pay-off is a stronger economy. This has been the case... 

The Chinese don’t play chess. They play wei qi [also known as Go]...The Chinese government views the economy as though it’s wei qi. Each piece has its own role in the economy, but each is no more important than another. 

This is an important observation. In the developed world...Falling or negative returns on capital are a sure sign of economic weakness reflecting the end of a period of over-investment...In China, capital is just one piece on the board where the aim is to raise living standards of all households...The government’s role is paramount. Despite claims of dramatic imbalances (investment spending has made up to 45% of GDP in recent years, compared to below 15% in some developed economies), investment is driving sustainably higher economic growth... 

At a macro-level, the higher allocation of capital in China has led to falling profit growth and lower returns for capital...Since 2004...China['s stock market] is up just 46%...2011 has been punctuated with stories of large capital losses across the economy... 

By not using capital returns as a scorecard for economic progress, China improves the allocation of capital in its economy and raises living standards. Effectively, China takes a broader perspective to the value of capital in an economy... 

First, and most obviously, the government has the ability to fund losses on individual capital projects through the accumulated financial reserves, totalling at least $3.2 trillion. Second, and most importantly, the Chinese government, as ultimate capital allocator, can recoup returns from projects by capturing the positive externalities from projects in the form of higher tax revenues created by higher levels of activity... 

China’s economic performance in the last 20 years has been remarkable; very strong growth and low inflation...The government, as the largest capital allocator, can both manage losses from individual projects and capture the benefits of loss-making projects through its taxcollecting authorities. 

I love this. It has all the classic hallmarks of a "This time it's different" piece. First - and this is my personal favorite - we have the cultural analogy. Chinese people don't play chess, they play Go! And by realizing this we can understand why low capital returns are irrelevant! It's all about the Eastern Mystique...this time it's different because these people are different.

(Of course, an astute reader might point out that Japanese people also play Go, and until the last couple of decades absolutely dominated international Go competitions. That didn't prevent the Japanese economy from tanking, and it didn't change the fact that wasteful investment was a central feature of said tanking.)

Next we have the faith in the government. China's government, we are told, is a benevolent sort of oligarchy, whose "aim is to raise living standards of all households". Never mind the massive corruption and state-corporate collusion. Never mind the negative real rates of return on Chinese household deposits. Never mind China's slow consumption growth and low share of household consumption in GDP. Never mind the Latin America-like levels of inequality. China's government, unlike our Western variety, is all for The People, despite the curious fact that The People there have less say in the government's operations. (Note how this also plays to Orientalist stereotypes: the Chinese as a Confucianist hive mind.)

But the Chinese government isn't just benevolent, it's omnipotent! The government can bail out loss-making capital projects with its massive stock of foreign asset reserves. Never mind the fact that the government acquired those reserves from private banks by swapping government liabilities for foreign assets. 

Finally we have the blatant trend extrapolation. China has grown strongly for the last 20 years; hence it will continue to grow strongly. It's growth is "sustainably higher" than that of other countries. If you bet against China in 2001, you were a sucker; hence, if you bet against China now, you are a sucker.

So because China's government cares more about the general populace than about the profits of capitalists, which somehow has to do with the fact that they play Go instead of chess, it will use its foreign asset reserves to bail out loss-making projects that produce positive externalities that raise GDP growth overall. Hence, "This time it's different", and we should view the 20-year trend of Chinese growth as something structural instead of the kind of transitory catch-up phase observed in every other country in history, including Japan, South Korea, and Taiwan. Therefore, the market's expectation that growth will slow - reflected in the only-46% rise in Chinese stocks since 2004 - is seriously wrong.

Got it.

Anyway, fun-poking aside, I have always been struck by the sheer volume of words expended on the question of whether newly industrializing economies will break the Solow Model or not. Really, it's very hard to see how you can break the Solow Model - keep accumulating capital, and your growth will be fast but steadily decreasing as you converge to the rich-world average. Sure, you can fall short of the Solow Model and get stuck in a "middle income trap". Sure, there are questions as to how fast technology can be transferred from richer countries, or whether investment has a maximum "speed" beyond which it becomes more wasteful, or what kind of institutions are optimal. But the idea that growth must slow - gently or otherwise - as a country gets richer should, in my opinion, be the jumping-off point for any predictions about development. 

It's very weird that after all these years, we're still trying to extrapolate countries' futures based on what kind of board games they play.

reade more... Résuméabuiyad

Inflation for the People

For the past few weeks I've been getting acquainted with the popular wing of the "Austrian economics" movement. First I discovered the Bizarro Economics World of online forums, then I got re-acquainted with Zero Hedge, which seems to have taken a more and more inflationista/goldbuggy/Austrian tone in recent years.  Then a bunch of Texan friends started posting "End the Fed!" memes to my Facebook feed. So I went on Facebook and I asked: "Why do people want to end the Fed?" In response, a friend sent me this video:

In the video, a guy loses his house, and his American Dream is crushed. He is then taken back in time by a guy with a horribly fake African-American accent, to witness the source of his problems. As it turns out, everything is the fault of bankers, who steal people's money through fractional reserve banking. Eventually, banking power is concentrated in the hands of a shadowy cabal headed by the Rothschilds, to whom even J.P. Morgan must kowtow. Thomas Jefferson and Andrew Jackson temporarily hold off the evil bankers here in America, ushering in a huge boom "with real money, backed with real gold." But eventually the bankers get in, and end up forming the Fed, which proceeds to steal people's hard-earned money even more via inflation and collaboration with the IRS. 

Anyway, for now I'll ignore the oddity of anti-semitic video makers latching onto an economic philosophy (Austrianism) invented by a Jewish guy and a movement (the Ron Paul movement) inspired by another Jewish guy. Anti-semitism has always been a bit weird like that. I'll also put aside the thing about fractional reserve banking (a subject for another post). Instead, I'd like to talk about inflation.

The classic simple example of inflation is this: The Fed (or the banking system, giant Rothschild robots, whatever) doubles the money supply. So money becomes only half as valuable as before. Therefore, the price of everything doubles. So:

Price of a gallon of milk:  $4 --> $8

Price of a gallon of gasoline:  $4 --> $8

Price of a new house: $200k --> $400k

..and so on. BUT, inflation also doubles your salary, in exactly the same way:

Salary: $40k --> $80k

However, (unless you own a special kind of bond called TIPS), inflation does not change the size of your bank account:

Your savings: $80k --> $80k

So while prices and your salary double, the number of dollars in your savings account stays the same. This makes you poorer, because you can't buy as much stuff with your savings:

Your savings: 20,000 gallons of gasoline --> 10,000 gallons of gasoline

So inflation steals your money, right? Well, sure. BUT, wait a second. What if you have a mortgage? Suppose you already bought a house, but you haven't paid off your mortgage yet. You have debt! What happens to this debt when inflation happens? Does it go up? Nope! Just like your bank account, it stays the same:

Your mortgage debt: $160k --> $160k

Now remember, your salary went up when inflation happened. So now, it takes you much less work to pay off your mortgage:

Your mortgage debt: 4 years of your salary --> 2 years of your salary

Inflation stole money from you by shrinking your bank account, but it put money in your pocket by shrinking your mortgage debt!! Notice that the way I have the numbers here, your net worth went up, because your mortgage debt was bigger than your bank account. 

So if your net worth goes up and the purchasing power of your income stays the same, as in this simple example, inflation makes you richer. Inflation hurts people who have more savings than debt, and helps people who have more debt than savings.

Who has more savings than debt? Old people and rich people. Who has more debt than savings? Young workers who are paying off mortgages. In other words, the video has it exactly backwards - inflation will not take your house away from you, inflation will prevent your house from being taken away from you. It will save your American Dream. If you don't believe me, go back and look at my example again. It works.

And that hyperinflation that people on Zero Hedge are always screaming about? Well, first of all, it's not coming. But if it did happen, it would mean that your mortgage would be paid up instantly. Really. If our money turned into Monopoly money, you could just pay off your mortgage with a wheelbarrow full of Monopoly money. Perfectly legal!

(Now, you may say "Inflation is still bad, because it punishes saving and rewards reckless borrowing." Well, you're right. That's a danger that the Fed thinks about when they are trying to decide whether to print money in an attempt to boost GDP growth.)

Anyway, what's interesting is that inflation was not always seen as the enemy of the common people. When Thomas Jefferson railed against banks, he worried about deflation as much as inflation. And in the 1800s, the Populist Movement - basically, a bunch of small farmers in the South and West - fought for inflation! At that time, farmers owed a bunch of money to big banks on the East Coast (including J.P. Morgan, who was presumably busy kowtowing to his secret immortal Rothschild masters). Without inflation, they would have to sell their farms to the banks and go be factory workers. So they fought for the United States to go off the gold standard and go on the silver standard - debasing the currency in order to reduce their debts! 

Actually, the big banks defeated the Populist farmers. The gold standard was maintained, inflation was prevented, and a lot of people lost their farms. So maybe the robotic Rothschild octopi had the last laugh after all. But they didn't do it through inflation! Quite the opposite. Time was, inflation and currency debasement were seen as the savior of the common man.

Just remember: Inflation hurts people with savings and helps people with debt. An awful lot of Americans these days fall into that second category. Before you go embracing the hard-money, Austrian, gold-standard stuff, think about which category includes you!

(Then again, why should you believe me? After all, I am a Jew. I could be working for...THEM...dum dum dummmmmm...)

reade more... Résuméabuiyad

How Zero Hedge makes your money vanish

In 2001, Brad Barber and Terrance Odean published a very famous finance paper called "Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment". The upshot is this:

Theoretical models predict that overconfident investors trade excessively...Psychological research demonstrates that, in areas such as finance, men are more overconfident than women. Thus, theory predicts that men will trade more excessively than women. Using account data for over 35,000 households...We document that men trade 45 percent more than women. Trading reduces men’s net returns by 2.65 percentage points a year[.]

It has been known for quite some time that individual investors - this means you, sitting at your computer clicking away on e*Trade - almost all underperform the market. In other words, you suck at investing. In 1999, Odean found that a lot of this poor performance comes from the fact that individual investors trade too much. In other words, one reason you suck at investing is because you have an itchy trigger finger. And this 2001 Barber and Odean paper found that men have itchier trigger fingers than women.

Which brings me to the website Zero Hedge.

Zero Hedge is a financial news website. The writers all write under the pseudonym of "Tyler Durden", Brad Pitt's character from Fight Club. Each post comes with a little black and white icon of Brad Pitt's head. On Zero Hedge you can read news, rumors, facts, figures, off-the-cuff analysis, and political screeds (usually anti-Obama, anti-government, and pro-hard money). On the sidebars, you can click on ads for online brokerages, gold collectibles, and The Economist. 

The site is a big fat hoax. And if you read it for anything other than amusement, you're almost certainly a big fat sucker.

That's a bold claim! Why do I make this claim? Well, in one sense, all financial news is a hoax. Financial news, by definition, is public information - if you've read it, you can bet that thousands of other people have too. That means that if the market is anywhere close to being efficient, any information in any article you read will already have been incorporated into the price of financial assets. Reading or watching public information should not, in theory, give you any "alpha".

But OK fine, suppose the market is not efficient. Suppose there are some smart people who can interpret the public news really well, and some suckers who take home the wrong message. And also suppose that the suckers stupidly believe that they are the ones taking home the right message, and that the other folks are suckers. In that case, the smart people can make money by reading Zero Hedge, interpreting it correctly, and taking money from the suckers who either didn't read Zero Hedge or who took home the wrong message...right?

Wrong. Because there's another problem here. If the writers of Zero Hedge really knew some information that could allow them to beat the market, why in God's name would they tell it to you? If they had half a brain, they'd just keep the info to themselves, trade on it, and make a profit! Maybe then, after they had made their profit, they'd release the news to the public (and collect ad revenue), but by then the news would be worthless. Financial news sites, you should realize, are not in the business of giving you insider tips out of the goodness of their hearts.

So the only way you can make money by reading Zero Hedge is if you're not only smarter than a bunch of suckers who look and act a lot like you, but if you're smarter than Zero Hedge's writers too. Not gonna happen. The fact that financial news is big business fits perfectly with the mass suckering of America's individual investors documented by Barber & Odean (2001). Financial "news" is noise.

As you might expect, it's not hard to look back at Zero Hedge's predictions and see that a large number of them are junk. For example, here's a bunch of posts from 2009 predicting imminent hyperinflation. Hope you didn't make any trades based on that bit of wisdom! (Note for the sake of fairness: Yes, in terms of giving "hot tips", there are a lot worse sites than Zero Hedge...see Update 3 below.)

So how does Zero Hedge get away with this hoax? Barber & Odean (2001) give a big hint. Tyler Durden, whose name and image grace every Zero Hedge Post, is a symbol of masculinity. More specifically, he is a nerd's imagined vision of what a really masculine nerd would be like. In Fight Club, Durden says: "All the ways you wish you could be, that's me. I look like you wanna look, I f*** like you wanna f***, I am smart, capable, and most importantly, I am free in all the ways that you are not."

In other words, you are a young smart (i.e. nerdy) guy sitting at your computer with rivers of testosterone coursing through your veins. And now here comes Tyler Durden, your generation's Platonic ideal of pure masculinity, telling you that Real Men Take Risks. At the top of the site, there is a Tyler Durden quote: "On a long enough timeline the survival rate for everyone drops to zero." In other words, gamble. Bet that you're the smart guy and not the sucker. Because hey, you're going to die anyway, so there's no use hedging your bets. Zero hedge, right? (Or you can read a sister site called "Testosterone Pit".  Not kidding!)

In other words, "Tyler Durden" knows what Barber & Odean (2001) knew. Men take risks that, on average lose them money. Zero Hedge is a brilliant behavioral-finance technology that uses the predictable regularities of human psychology to extract money from testosterone-addled dupes. The people who run the site are far from idiots; they are geniuses. In fact, I wouldn't be surprised if "Tyler Durden" were actually a bunch of behavioral finance grad students, snickering behind their hands at everyone who takes their site seriously.

Now, dear reader, maybe you are a fan of Zero Hedge. Maybe you have been getting angrier and angrier as you read this post, and maybe even now you have a comment box open and are typing the first words of an angry diatribe: "You're an idiot and you teach at a shit school which does not acknowledge fact or logic which is keystone in finance and econ!!!" (an actual Tweet I received the other day from a self-described drunk undergrad.)

And maybe you're right. Maybe I am an idiot who is blinded to the obvious wisdom dispensed by Zero Hedge, wisdom that would make me rich if I was just smart enough to read the site and man enough to make some big bets. Maybe. But before you hit the "send" button on that comment, take a glance in the mirror. You're young, right? You're a man, right? You trade pretty frequently, right? And you're not a rich, successful hedge fund manager or investment bank trader, are you?

Here's a radical thought: Maybe you're the sucker.


Update: I showed this post to a few friends in the finance industry, and while all of them agreed, one came up with by far the best one-line response: "Retail investor is retail."

Update 2: John Aziz has a rebuttal over at Zero Hedge, in which he says: 1. The rise in the price of gold shows that hedging against hyperinflation has been a good bet, 2. The name "Zero Hedge" actually doesn't mean you shouldn't hedge, it means you should hedge against a total crash of the financial system, and 3. Zero Hedge has done a good job of exposing corruption in the financial system. I don't think I need to respond to point (1). Point (2) is interesting, I hadn't thought of that, but I'm not particularly convinced it's true. And Point (3) is true; good news is a good thing good to read, and journalism that exposes corruption is valuable. But reading news is different than trading on it, which is what I'm talking about in this post.

Update 3: Some people have pointed out that in terms of offering trading tips, there are a lot worse offenders than Zero Hedge. That's certainly true - The Motley Fool and StockTwits come to mind, not to mention Jim Cramer or any show on CNBC. Compared to those sites, Zero Hedge has a lot more news and less tips. I just picked on Zero Hedge because the testosterone thing gave me a perfect opportunity to whip out Barber & Odean. And also because it's become a haven for goldbug/"Austrian"/"hyperinflation-is-coming"/"the Fed is a UN conspiracy to destroy the white race" kind of BS.

reade more... Résuméabuiyad

John Taylor uncovers a hideous threat to our freedoms

John Taylor uncovers a dire and hitherto little-known threat to the freedoms we Americans hold dear:

In a recent speech at Stanford former Wells Fargo Chairman and CEO Dick Kovacevich told the full story of how he was forced to take TARP funds even though Wells Fargo did not need or want the funds. The forcing event took place in October 2008 at a now well-known meeting at the U.S. Treasury with Hank Paulson, Ben Bernanke, as well as several other heads of major financial institutions... 

“You might ask why didn’t I just say no, and not accept TARP funds.” [Kovacevich] then explained: “Hank Paulson turned to Chairman Bernanke, who was sitting next to him and said ‘Your primary regulator is sitting right here. If you refuse to accept these TARP funds, he will declare you capital deficient Monday morning.’ This was being said when we were a triple A rated bank. ‘Is this America?’ I said to myself.”... 

According to Kovacevich: “It was truly a godfather moment. They made us an offer we couldn’t refuse.” It was also truly a deviation from the principles of economic freedom, such as those I have highlighted in my book First Principles—predicable policy, rule of law, reliance on markets, limited scope for government... 

[A]fter his talk, I asked Dick Kovacevich why more business people were not speaking out on this important issue. He explained how he had in fact waited a long time after he left Wells Fargo before speaking out because he did not want to risk some kind of retribution. He said he thought many others had a “fear” of speaking out.” 

In their book Free to Choose Milton and Rose Friedman wrote about this problem: “Restrictions on economic freedom inevitably affect freedom in general, even such areas as freedom of speech and press.” (p. 67) They quoted from a letter they received from business executive Lee Grace. I was reminded of this letter when I heard Dick Kovacevich answer my question. In the letter Grace had said “We grow timid against speaking out for truth…government harassment is a powerful weapon against freedom of speech.” 

My reactions:

1. "Oh noooo!!! The government is forcing us to take billions of dollars!!! THE HORROR!!! IS THIS AMERICA?!!!"

2. Wells Fargo suffered a ratings downgrade in December 2008, shortly after the events described. Something tells me it was not because they took TARP funds. Something tells me it was because they owned some amount of assets whose value had been called into question by the recent crisis. So Kovacevich's assertion that "we were a triple A rated bank" is a little disingenuous.

3. The "violation of freedom of speech" discussed by John Tayor is not based on anything anyone in the government actually did. It is based entirely - 100% - on the statement of one man, Dick Kovacevich, that he was afraid of "some kind of retribution" if he spoke out. First of all, Kovacevich obviously has a vested interest in saying this. But even if Kovacevich is being honest, he might not be right. There might have been no implicit threat from the government except in his own mind. But despite all this, John Taylor takes Kovacevich's statement at face value.

4. UPDATE: Commenter MaxUtility writes: "[H]asn't this episode been public knowledge for several years now? I guess all the government jack booted thugs threatening people to keep the secret got laid off." Pretty much.

Basically, this John Taylor post is an exercise in unintentional self-parody. Well, probably unintentional.

reade more... Résuméabuiyad

Excess volatility and NGDP futures targeting

Steve Williamson has a post arguing against NGDP targeting. I just wanted to throw my two cents in, and consider an issue that Steve didn't mention.

When he talks about "NGDP targeting", Scott Sumner actually means the following (quoting Williamson):

In its current incarnation, here's how NGDP targeting would work, according to Scott Sumner. The Fed would set a target path for future NGDP. For example, the Fed could announce that NGDP will grow along a 5% growth path forever (say 2% for inflation and 3% for long run real GDP growth). Of course, the Fed cannot just wish for a 5% growth path in NGDP and have it happen...One might imagine that Sumner would have the Fed conform to its existing operating procedure and move the fed funds rate target - Taylor rule fashion - in response to current information on where NGDP is relative to its target. Not so. Sumner's recommendation is that we create a market in claims contingent on future NGDP - a NGDP futures market - and that the Fed then conduct open market operations to achieve a target for the price of one of these claims.

So basically, the Fed would do its utmost to keep NGDP futures prices on a certain path.

I have a problem with that. The problem is called "excess volatility". According to some theories, asset prices should be an optimal forecast of (discounted) future payouts - for example, the price of a stock should be an optimal forecast of discounted future dividends, etc. An optimal forecast should not respond to "noise"; in other words, if something happens that doesn't affect dividends, it shouldn't affect the forecast. This means that actual dividends should be more variable than prices - the dividends should have lots of "surprises".

But we can actually look at whether or not this is true! All we have to do is wait for actual dividends to come in, and then see whether past prices bounced around less than the dividends, or more. Robert Shiller was one of the first to do this, and here is what he found:

The jagged black line is the S&P 500, and the lighter, less jagged lines are dividends discounted by various discount rates. It's easy to see that no matter what discount rate we use, stock prices are a lot more variable than the fundamental value of stocks. This means that there is "noise" in stock prices - prices may respond to information about dividends, but they also respond to some other stuff that has nothing to do with dividends. They display "excess volatility". Lots of researchers have tried to kill the excess volatility puzzle, but none have really succeeded. In other words, markets may be "efficient" in the sense that you can't predict future returns, but those returns are probably going to depend partly on things other than fundamental value.

Now back to NGDP futures targeting. An NGDP futures price will probably experience excess volatility too. It will bounce around more than changes in actual NGDP. This means that the Fed will be trying to hit a very volatile moving target. One quarter, futures prices will soar, the next month they will crash, and the Fed will be trying to keep up, tightening dramatically in the first quarter and loosening dramatically in the second. This will happen even if a true optimal forecast of NGDP (which of course no one really knows) is relatively stable! Asset market volatility will cause policy volatility.

If you think that policy volatility has no costs, this is fine. But if you think that the Fed bouncing around wildly from quarter to quarter sounds scary, you should be scared of NGDP futures targeting. For example, volatile Fed policy, even if it adheres rigidly and credibly and permanently to an NGDP futures targeting rule, may cause expectations to become more volatile if a substantial number of economic actors fail to believe that NGDP targeting will succeed in hitting the target. That could cause volatility in things like inflation and real GDP.

Of course, this is also true of any Fed policy rule that takes market prices as a measure of expectations (for example, using TIPS spreads as a measure of inflation expectations) and then responds to those "expectations". This is one reason why, contra John Taylor, I support combining rules with judgment. But even in terms of rules, we can make guesses about excess volatility. If excess volatility is an increasing function of actual volatility, then using NGDP futures should worry us more than using inflation expectations. Real GDP bounces around a lot more than inflation, as this graph from Stephen Williamson shows:

If excess volatility is, say, 50% of actual volatility, then using NGDP futures in Fed policy is going to cause a lot more bouncing around than using inflation futures alone.

Anyway, this is not to say that NGDP targeting is a hopeless idea. But the futures-market aspect of what Scott Sumner is proposing relies on a version of market efficiency that is much stronger even than what most finance professors would accept.

Update: In an email exchange, Scott Sumner has clarified the nature of his NGDP futures market proposal. In a nutshell, he proposes that the Fed act as a market maker, buying and selling infinite quantities of NGDP futures at the target price. Demand for NGDP futures would then be used to determine Fed policy; if NGDP futures demand increased, the Fed would commence open-market operations to bring down expected NGDP. The price of NGDP futures would not move, but demand would swing from positive to negative, moving Fed policy as it swung.

It seems to me that the concerns expressed in this blog post apply to this sort of market as well. In the stock market, prices move in response to demand (not, generally, supply); we can infer from excess price volatility that demand exhibits excess volatility as well. Now, if prices could not move (which is really the same thing as banning resale), it's possible that excess volatility would diminish or even vanish. However, this is far from obvious. For example, if excess volatility is caused by overconfidence, as many behavioral finance theories predict, excess volatility would persist in Sumner's proposed setup. 

If people believe that noise is actually information, that noise will directly feed through into Fed actions, causing Fed actions to bounce around too much.

reade more... Résuméabuiyad

The liberty to pee

The freedom to pee is not in your contract!

My advisor, Miles Kimball, requested a blog post on the recent debate over workplace freedom, so here it is.

The debate started with an excellent article by the folks at Crooked Timber, detailing how the libertarian philosophy, which chooses to focus only on government, overlooks the ways in which employers restrict the freedoms of their employees. This is one instance of what I've called "the liberty of local bullies", so I'm very sympathetic to the idea. Tyler Cowen then argued against the Crooked Timber post, basically making three points, which were: 1) employees agreed to workplace restrictions on freedom when they made their employment contracts, 2) most of the violations of workplace freedom cited by Crooked Timber are not objectionable, and 3) employee shirking and theft are just as significant as bosses' abuse of power.

I do not agree with Tyler.

I want to ask two questions about workplace restrictions. First, do they decrease liberty? And second, do they decrease utility?

Liberty first. There are many definitions of liberty. For example, consider the "liberty" to walk down the street without seeing an Armenian person. John Locke wouldn't consider that a natural right, nor would most modern Americans. But why not? Only because of people's feelings. Only because of their opinions. We've realized that for centuries. People feel that the liberty to walk down the street without seeing an Armenian is less important than an Armenian's liberty to walk down the street, and that is the only reason we prize one over the other. (Feel free to argue otherwise in the comments, but try to do so without resorting either to A) impenetrable jargon, or B) arguments from authority, and you'll see how incredibly hard it is.)

So here is my argument that workplace restrictions can violate liberty: People often feel that they violate liberty. When you really need to pee, and the boss forbids you from going to pee, chances are you will feel that your liberty has been violated, even if it's perfectly legal and in your contract. For quite a lot of people, the liberty to enter into long-term binding contracts is less important than the liberty to pee.

Of course, I have not proven my case yet, because to do so I would have to take a poll. But that's all I'd have to do. The relative value of different types of liberty is a matter of opinion (or, if you prefer, it's axiomatic). And many people feel that workplace restrictions - especially arbitrary ones, decided day to day by individual bosses with respect to individual employees - make them less free.

Note that in terms of liberty, Tyler's argument about employee shirking doesn't hold much water. The reason is simply power asymmetry; the employee who shirks is breaking the rules, whereas the boss who legally abuses an employee is not. The reality of theft does not equal the freedom to steal.

Now, on to the question of utility. Miles makes a number of good arguments on this front, mostly related to agency problems within the firm. But let me add a couple of my own.

First, there is the question of dynamic inconsistency. Why do we not allow indentured servitude? Because people make choices that they later regret. In your impetuous youth you may sell yourself into servitude, imagining that it's a good deal, and then wake up one day ten years later and say "Dang, I wish I hadn't done that." By banning indentured servitude, our government prevents people from making binding choices that they are highly likely to regret.

Second, there is the idea of adverse selection. When you consider going to work for an employer, you don't know precisely what your's going to get. Your boss might be nice or he might be mean, and you can't always tell in advance. Libertarians often argue that you always can tell in advance, because of reputation. But although reputation does exist, it doesn't always work, whatever libertarians claim. So in reality there is a certain chance that when you agree to go work for someone, you are purchasing a lemon. In a rational world, adverse selection causes markets to break down (which is bad from a utilitarian perspective). But in the real world, people are often just tricked. That is also bad from a utilitarian perspective.

So whether you care first and foremost about liberty, or whether you are a utilitarian, you can probably see why (depending on the situation) there could be a good reason for government to restrict the liberty of employers to do certain things to their employees, even if those things are permitted by contract. Of course, if you are a modern American libertarian, you may value a highly counterintuitive hierarchy of freedoms in which the liberty to pee is always subordinate to the liberty to sign away your right to pee. But your definition is no more or less arbitrary than anyone else's, and quite possibly has the side effect of convincing normal human beings that you are - in the parlance of our times - a bit of a schmuck. 

(Final note: Just for the record, Armenians are awesome.)


Update: Here is more from Alex Tabarrok. Here is more from John Holbo of Crooked Timber.

Update 2: Here is a really good post on the subject from Adam Ozimek, who points out the difference between dynamic and static conceptions of liberty.

reade more... Résuméabuiyad