Thursday, April 19, 2018

Q is better than you think

This lovely graph comes from "Learning and the Improving Relationship Between Investment and q" by Daniel Andrei, William Mann, and Nathalie Moyen. The careful investment and q measurement make it much better than similar figures I've made for example Figure 4 here. Their paper explores the puzzle, just why did q theory work worse before 1995?

The graph also bears on the "monopoly" debate. Corporations are making huge profits, stocks are high, yet we don't see investment, the story goes -- marginal q must be much less than average q, indicating some sort of fixed factor or rent. Not in the graph.

Wednesday, April 18, 2018

Two more points occur to me regarding share buybacks. 1)When buybacks increase share prices, and management makes money on that, it's a good thing. The common complaint that buybacks are just a way for managers to enrich themselves is exactly wrong. 2) Maybe it's not so good that banks are buying back shares.  3) The tax bill actually gives incentives against buybacks. What's going on is despite, not because.

Recall the example. A company has $100 in cash, and$100 profitable factory. It has two shares outstanding, each worth $100. The company uses the cash to buy back one share. Now it has one share outstanding, worth$100, and assets of one factory. The shareholders are no wealthier. They used to have $200 in stock. Now they have$100 in stock and $100 in cash. It's a wash. Why do share prices sometimes go up when companies announce buybacks? Well, as before, suppose that management had some zany idea of what to do with the cash that would turn the$100 cash into $80 of value. ("Let's invest in a fleet of corporate Ferraris"). Then the stock would only be worth$180 total, or $90 per share. Buying one share back, even overpaying at$100, raises the other share value from $90 to$100.

That was the big point. Share buybacks are a good way to get money out of firms with no ideas, into firms with good ideas. We want firms to invest, but we don't necessarily want every individual firm to invest. That's the classic fallacy that I think it turning Washington on its head. Best of all we want money going from cash rich old companies to cash starved new companies. Buybacks do that.

1) Management getting rich on buybacks is good.

OK, on to management. Management, buyback critics point out, often has compensation linked to the stock price. They might own stock or own stock options. So when the buyback boosts the stock price, then management gets rich too. Aha! The evil (or so they are portrayed) managers are just doing financial shenanigans to enrich themselves!

The fallacy here, is not stopping to think why the buyback raises the share price in the first place. If it is the main reason given in the finance literature, that this rescues cash that was otherwise going to be mal-invested, then you see the great wisdom of giving management stock options and encouraging them to get rich with buybacks.

Friday, April 13, 2018

Fiscal theory of monetary policy

Teaching a PhD class and preparing a few talks led me to a very simple example of an idea, which I'm calling the "fiscal theory of monetary policy." The project is to marry new-Keynesian models, i.e. DSGE models with price stickiness, with the fiscal theory of the price level. The example is simpler than the full analysis with price stickiness in the paper by that title.

It turns out that the FTPL can neatly solve the problems of standard new Keynesian models, and often make very little difference to the actual predictions for time series. This is great news. A new-Keynesian modeler wanting to match some impulse response functions, nervous at the less and less credible underpinnings of new-Keynesian models, can, it appears, just change footnotes about equilibrium selection and get back to work. He or she does not have to throw out a lifetime of work, and start afresh to look at inflation armed with debts and deficits. The interpretation of the model may, however, change a lot.

This is also an extremely conservative (in the non-political sense) approach to curing new-Keynesian model problems. You can keep the entire model, just change some parameter values and solution method, and problems vanish (forward guidance puzzle, frictionless limit puzzle, multiple equilibria at the zero bound, unbelievable off-equilibrium threats etc.) The current NK literature is instead embarked on deep surgery to cure these problems: removing rational expectations, adding constrained or heterogeneous agents, etc. I did not think I would find myself in the strange position trying to save the standard new-Keynesian model, while its developers are eviscerating it! But here we are.

The FTMP model

(From here on in, the post uses Mathjax. It looks great under Chrome, but Safari is iffy. I think I hacked it to work, but if it's mangled, try a different browser. If anyone knows why Safari mangles mathjax and how to fix it let me know.)

Here is the example. The model consists of the usual Fisher equation, $i_{t} = r+E_{t}\pi_{t+1}$ and a Taylor-type interest rate rule $i_{t} = r + \phi \pi_{t}+v_{t}$
$v_{t} =\rho v_{t-1}+\varepsilon_{t}^{i}$
Now we add the government debt valuation equation $\frac{B_{t-1}}{P_{t-1}}\left( E_{t}-E_{t-1}\right) \left( \frac{P_{t-1}% }{P_{t}}\right) =\left( E_{t}-E_{t-1}\right) \sum_{j=0}^{\infty}\frac {1}{R^{j}}s_{t+j}$
Linearizing $$\pi_{t+1}-E_{t}\pi_{t+1}=-\left( E_{t}-E_{t+1}\right) \sum_{j=0}^{\infty }\frac{1}{R^{j}}\frac{s_{t+j}}{b_{t}}=-\varepsilon_{t+1}^{s} \label{unexpi}$$ with $$b=B/P$$. Eliminating the interest rate $$i_{t}$$, the equilibrium of this model is now $$E_{t}\pi_{t+1} =\phi\pi_{t}+v_{t} \label{epi}$$
$\pi_{t+1}-E_{t}\pi_{t+1} =-\varepsilon_{t+1}^{s}$
or, most simply, just $$\pi_{t+1}=\phi\pi_{t}+v_{t}-\varepsilon_{t+1}^{s}. \label{equil_ftmp}$$

Here is a plot of the impulse response function:

Thursday, April 12, 2018

Intellectual property

The China trade argument has boiled down to intellectual property and trade. Roughly it has gone like this:
"We need to stop China from selling us all this stuff. Bring the jobs home!"
"Uh, right now the jobs problem is that employers can't find workers. Cheap stuff from China is a boon to American consumers. Tariffs like that on steel cost more steel-using jobs than they save."
"Hm. Ok, but we have to threaten with tariffs to get China to stop requiring our companies to share intellectual property!"
I'm still skeptical about the intellectual property and trade argument. OK, suppose China says that in order for a US company to produce there, it must share intellectual property with a Chinese partner. Just how terrible is this? Just how terrible for the US economy, and society as a whole, justifying a robust policy response -- obviously the company would rather make more profits, but that's not a basis for economic policy.

Intellectual property is different from real property, in that it is nonrival. If you live in my house, I can't live in it. But if you use my equation, my blueprints, my recipe for nanoscale lubricants,  or my designs for specialty oilfield equipment, that does not hamper my use of the same ideas.

Because of this feature, intellectual property is quite different in law, and in economics, than other kinds of property. Ideally, once an idea is produced, it should be distributed freely to everybody. The marginal cost is zero, it is nonrival, so society is best off if everyone gets to use new ideas immediately. Economic growth is the spread of better ideas, and the faster the better. Period.

Wednesday, April 11, 2018

Why not taxes?

Reaction to the Washington Post oped (blog post, pdf) on debt  has been sure and swift. We suspected we might get criticized by Republicans for complaining about deficits are a problem.  Instead, the attack came from the left.  Justin Fox hit first, followed by a joint oped by Martin  Baily, Jason Furman, Alan Krueger, Laura Tyson and Janet Yellen. It's almost an official response from the Democratic economic establishment.

Their bottom line, really, is that entitlements and deficits are not a problem. They put the blame pretty much entirely on the recently enacted corporate tax cut.   (I'm simplifying a bit. As did they, a lot.)

By contrast, we focused on entitlement spending -- Social Security, Medicare, Medicaid, VA, pensions, and social programs -- as the central budget problem, and entitlement reform (not "cut") together with a strong focus on economic growth as the best answer. Our warning was that interest costs could rise sharply and unexpectedly and really bring down the party.

Well, deficit equals spending minus tax revenue, so why not just raise taxes to solve the budget problem?

First, let's get a handle on the size and source of the problem.

I. Roughly speaking the long term deficit gap is 5 rising to 10 percentage points of GDP. And the big change is entitlements -- social security, medicare, medicaid, pensions.

For example, even Fox's graph shows social security spending rising from 11% of payroll in 2006 and asymptoting at 18%.

The most recent 2017 CBO long-term budget outlook is quite clear. Long before the tax cut that so upsets our critics was even a glimmer in the President's eye, they were warning of budget problems ahead:
If current laws generally remained unchanged, the Congressional Budget Office projects, ..debt...would reach 150 percent of GDP in 2047. The prospect of such large and growing debt poses substantial risks for the nation....
Why Are Projected Deficits Rising?
In CBO’s projections, deficits rise over the next three decades—from 2.9 percent of GDP in 2017 to 9.8 percent in 2047—because spending growth is projected to outpace growth in revenues (see figure below). In particular, spending as a share of GDP increases for Social Security, the major health care programs (primarily Medicare), and interest on the government’s debt.
The CBO gives us this nice graphs to make the point:

Another CBO's graph follows. Top graph -- where is the spending increase? Social security, health, and interest. Not "other noninterest spending."

(In the bottom graph you see a rosy forecast that individual income taxes will rise a few percent of GDP to help pay for this. Don't be so sure. This comes from inflation pushing us into higher tax brackets and assuming congress won't do anything about it. Notice also how small corporate taxes are in the first place.)

The more recent CBO budget and economic outlook is equally clear: The near term problem is 5 percentage points of GDP:
CBO estimates that the 2018 deficit will total $804 billion....[GDP is$20 Trillion, so that's 4% of GDP]  ... In CBO’s projections, budget deficits continue increasing after 2018, rising from 4.2 percent of GDP this year to 5.1 percent in 2022... Deficits remain at 5.1 percent between 2022 and 2025 ... Over the 2021–2028 period, projected deficits average 4.9 percent of GDP..
Then, things get worse,
In CBO’s projections, outlays for the next three years remain near 21 percent of GDP, which is higher than their average of 20.3 percent over the past 50 years. After that, outlays grow more quickly than the economy does, reaching 23.3 percent of GDP ... by 2028.
That increase reflects significant growth in mandatory spending—mainly because the aging of the population and rising health care costs per beneficiary are projected to increase spending for Social Security and Medicare, among other programs. It also reflects significant growth in interest costs, which are projected to grow more quickly than any other major component of the budget, the result of rising interest rates and mounting debt. ...
And that's only 2028.

You see the problem in our critic's complaint:
"The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending. This year, revenue is expected to fall below 17 percent of gross domestic product."
Let us take the estimate that the recent tax cut cost $1.5 trillion over 10 years, i.e.$150 billion per year or 0.75% of GDP.  Compared to the $800 billion current deficit it's small potatoes. Compared to the 5 percent to 10 percent of GDP we need to find in the sock drawer, it's peanuts. (Compared to the$10 trillion or more racked up in the last 10 years it's not huge either!)

[Update: Thanks to commenters, I now notice the "had been expected." OK, we expected 4% of GDP deficits, and then they passed a tax cut and now it's 5% of GDP. Sure. On the day that the tax cut was passed, the entire increase in the deficit was due to the tax cut. But our article, and the economy, is about the overall level of the deficit. The problem is what had been expected, not the recent minor change!]

Here is what the CBO has to say about it:
For the next few years, revenues hover near their 2018 level of 16.6 percent of GDP in CBO’s projections. Then they rise steadily, reaching 17.5 percent of GDP by 2025. At the end of that year, many provisions of the 2017 tax act expire, causing receipts to rise sharply—to 18.1 percent of GDP in 2026 and 18.5 percent in 2027 and 2028. They have averaged 17.4 percent of GDP over the past 50 years.
17, maybe 18. We're waddling around in the 1% range, when the problem is in the 10 percent range. The long run budget problem has essentially nothing to do with the Trump tax cut. It has been brewing under Bush, Obama, and Trump. It fundamentally comes from growth in entitlements an order of magnitude larger.

It is simply not true that "The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending."

To call us "dishonest" -- to call George Shultz "dishonest," in the printed pages of the Washington Post -- for merely repeating what's been in every CBO long term budget forecast for the last two decades really is a new low for economists of this stature. Is Krugmanism infectious?

Put another way, US government debt is about $20 trillion. Various estimates of the entitlement "debt," how much the government has promised more than its revenues, start at$70 trillion and go up in to the hundreds.

To be clear, I agree with the critic's complaint about the tax cut.
"The right way to do reform was to follow the model of the bipartisan tax reform of 1986, when rates were lowered while deductions were eliminated."
Yes! As in many previous blog posts, I am very sad that the chance to do a big 1986 seems to have passed. A large, revenue neutral, distribution neutral, savage cleaning and simplification of the tax code would have been great. There are some elements in the current one -- the lower marginal corporate rate is nice, and there is some capping of deductions, which is why it was a "good first step." But it fell short of my dreams too in many ways.

If only these immensely influential authors had been clamoring for their friends in the Resistance to join forces and pass such a law, rather than (Larry and Jason in particular) spend the whole time arguing that corporate tax cuts just help the rich, perhaps it might have happened. Having to do the whole thing under reconciliation put a lot of limits on what the Republicans could accomplish.

All that aside though, we're still talking about 0.75% of GDP cut compared to a 5%-10% of GDP problem. The long run deficit problem does not come from this tax cut.

II OK, so why not just tax the rich to pay for entitlements?

I hope I have sufficiently dismissed the main line of this particular criticism -- that deficits are all due to the Trump tax cut and all we have to do is put corporate rates back to 35% and all will be well.

On to the larger question, echoed by many commenters on our piece. OK, social security and health are expensive. Let's just tax the rich to pay for it. Like Europe does, so many say.

I do think that roughly speaking we could pay for American social programs with European taxes. That is, 40% payroll taxes rather than our less than 20%; 50% income taxes, starting at very low levels; 20% VAT; various additional taxes like 100% vehicle taxes and gas that costs 3 times ours.

I don't think we can pay for European social programs with European taxes, because Europe can't do it. Their debt/GDP ratios are similar to ours. And their lower growth rates both are the result of this system and compound the problem. Many European countries are responding exactly as we suggest, with deep reforms to their social programs -- less state-paid health insurance, more stringent eligibility requirements and so on.

But that's the option: heavy middle class taxes for middle class benefits, at the cost of substantially lower growth, which itself then drives the needed tax rates up further.

America in fact already has a more progressive tax system than pretty much any other country. Making it more progressive would increase economic distortions dramatically.

A key principle here is that the overall marginal tax rate matters.  There is a tendency, especially on the left, to quote only the top Federal marginal rate of about 40%, and to say therefore that high income Americans pays less taxes than most of Europe. But that argument forgets we also pay state and sometimes local taxes.

The top federal rate is about 40%. In California, we add 13% state income tax, and with no deductibility we're up to 53% right there. But what matters is every wedge between what you produce for your employer and the value of what you get to consume. So we have to add the 7.5% sales tax, so we're up to 60.5% already.

But we're not done.  The Federal corporate tax is now 21%, and California adds 8.84%, so roughly 29% combined. Someone is paying that. If, like sales tax it comes out of higher prices, then add it to the sales tax. Those on the left say no, corporate taxes are all paid by rich people, which is why they were against lowering them. OK, then they contribute fully to the high-income marginal rate.

What about property tax? The main thing people do with a raise in California is to buy a bigger house. Then they pay 1% property tax. As a rough idea, suppose you pay 30% of your income on housing and the price is 20 times the annual cost (typical price/rent ratio). Then you are paying 6% of your income in property taxes. Add 6 percentage points.

I'm not done. All distortions matter. In much of  Europe they charge taxes and then provide people health insurance. We have a cross subsidy scheme, in which you overpay to subsidize others. It's the same as a tax, except much less efficient.  In terms of economic damage, and the overall marginal rate, it should be included. If you live in a condo, whose developer was forced to provide "affordable housing" units, you overpaid just like a tax and a transfer. And so on. I won't try to add these in, but all distortions count.

In sum, we're at a pretty high marginal tax rate already. The notion that we can just blithely raise another 10% of GDP from "the rich" alone without large economic damage does not work.  This isn't a new observation. Just about every study of how to pay for entitlements comes to the same conclusion.

Again, my argument is not about sympathy for the rich. It is a simple cause and effect argument. Marginal tax rates a lot above 70% are going to really damage the economy and not bring in the huge revenue we need.

Bottom line: Paying for the current entitlements entirely by taxes would involve a big tax hike on middle income Americans.

The most important answer is economic growth. 30 years of 3% growth rather than 2% growth gives you 35% more GDP, and thus 35% more tax revenue. If federal revenues are 20% of GDP, that's 7%
of the previous GDP right there.  Deregulation and tax reform -- get on with the lower marginal rates and simplification that we agree on -- are important.

(The CBO also writes,
In CBO’s projections, the effects of the 2017 tax act on incentives to work, save, and invest raise real potential GDP throughout the 2018–2028 period....
The largest effects on GDP over the decade stem from the tax act. In CBO’s projections, it boosts the level of real GDP by an average of 0.7 percent and nonfarm payroll employment by an average of 1.1 million jobs over the 2018–2028 period. During those years, the act also raises the level of real gross national product (GNP) by an annual average of about $470 per person in 2018 dollars. This is not a terrible result!) Our oped was clear to say social program "reform" not just "cut." Little things like changing indexing and retirement ages make a big difference over 30 years. We argue for reducing the growth and expansion of entitlements, not "cut." Removing some of the very high work disincentives would help people get off some programs. Europe is facing this too, and many countries are a good deal more stringent about qualification than we are. Our critics say that to point out America cannot pay for the entitlements we have currently promised "dehumanizes the value of these programs to millions of Americans." No. Failing to reform entitlements now and gently will lead to chaotic cuts in the future, on programs that people depend on. If we're going to throw around accusations of heartlessness, denying the problem is the heartless approach. Friday, April 6, 2018 Unraveling Economists delight in unravelings -- behavioral responses that undo bright ideas. A subsidy for skunks produces cats with white stripes. Two good ones came up this week. As hare-brained as they are, I have to opine that the actual economic consequences of US steel import tariffs and Chinese soybean tariffs are essentially zero. (Political comment: tariffs are taxes on imports. It would do fans of the Administration's trade policies good to utter the correct "tax" word to describe tariffs. Or "self-inflicted sanctions." ) Why do I say that? Each country is assessing a tariff on goods produced only by the other country. Well then, why not park the ships overnight in Vancouver, or Tokyo, fill out some paperwork, and say steel is imported first from China to Canada, and then Canada to the U.S., and vice versa? Trade bureaucrats are smart enough to catch that. But they cannot hope to stop essentially the same thing: China sells steel to Canadian steel users, who currently buy from Canadian firms. Canadian steel producers reorient their production to the US, and sell to US companies who formerly bought from China. The steel is genuinely Canadian. Thursday, April 5, 2018 Buybacks full oped Now that 30 days have passed I can post the full oped on buybacks at the Wall Street Journal. As the Republican tax reform has gained popularity, the Democrats have had to update their messaging. To cast corporate tax cuts as a “scam” and redistribution to the wealthy, opponents have shifted their focus to the evils of stock buybacks and dividends. “Corporations have been pouring billions of dollars into stock repurchasing programs, not significant wage increases or other meaningful investments,” declared Senate Minority Leader Chuck Schumer Feb. 14. Such buybacks, he claimed, “benefit primarily the people at the top” and come at the expense of “worker training, equipment, research, new hires, or higher salaries.” Other Democrats have echoed the theme, and their media friends are cheerfully passing it on. Economic logic isn’t strong in Washington these days, but this effort stands out for its incoherence. Share buybacks and dividends are great. They get cash out of companies that don’t have worthwhile ideas and into companies that do. An increase in buybacks is a sign the tax law and the economy are working. Thursday, March 29, 2018 Debt Oped An oped on debt in the Washington Post. Growing debt and deficits are a danger. If interest rates rise, debt service will rise, and can provoke a crisis. Really the only solution is greater long-run economic growth and to reform -- reform, not "cut" -- entitlements. And the sooner the better, as the size and pain of the adjustment is much less if we do it now. This is written with Mike Boskin, John Cogan, George Shultz, and John Taylor. George Shultz was the inspiration, and wrote the first draft. He radiates an ethic of government as responsible stewardship, and displeasure when he does not see such. It is a pleasure of my job at Hoover to work with such distinguished colleagues. The Post gave it two headlines, in one "horizon" and in the other "doorstep," in different versions. The latter is a bit more alarmist than we care for. Like living above an earthquake fault, living on a mountain of debt can be quiet for a long time. Until all of a sudden it isn't. A pdf version *** A Debt Crisis is on the Horizon By Michael J. Boskin, John H. Cochrane, John F. Cogan, George P. Shultz and John B. Taylor We live in a time of extraordinary promise. Breakthroughs in artificial intelligence, 3D manufacturing, medical science and other areas have the potential to dramatically raise living standards in coming decades. But a major obstacle stands squarely in the way of this promise: high and sharply rising government debt. Tuesday, March 27, 2018 Friedman 1968 at 50 This month marks the 50th anniversary of Milton Friedman's The Role of Monetary Policy, one of the most influential essays in economics ever. To this day, economics students are well advised to go read this classic article, and carefully. The Journal of Economic Perspectives hosted three excellent articles, by Greg Mankiw and Ricardo Reis, by Olivier Blanchard, and by Bob Hall and Tom Sargent. Friedman might have subtitled it "neutrality and non-neutrality." Monetary policy is neutral in the long run -- inflation becomes disconnected from anything real including output, employment, interest rates, and relative prices. But monetary policy is not neutral in the short run. There are three big ingredients of the macroeconomic revolution of the 1960s and 1970s. 1) The remarkable neutrality theorems including the Modigliani Miller theorem (debt vs. equity does not alter the value of the firm), Ricardian equivalence (Barro, debt vs. taxes doesn't change stimulus), and the neutrality of money. 2) The economy operates intertemporally, not each moment in time on its own. 3) Basing macroeconomics in decisions by people, not abstract relationships among aggregates, such as the "consumption function" relating consumption to income. Efficient markets, rational expectations, real business cycles, etc. integrate these ingredients. You can see all three underlying this article. As money is not neutral in the short run, the neutrality theorems are not true of the world in their raw form, but they form the supply and demand framework on which we must add frictions. Friedman's permanent income hypothesis really kicked off the latter, and The Role of Monetary Policy is a central part of the first. I. The Phillips curve Friedman's view on the Phillips curve is the most durable and justly famous contribution. William Phillips had observed that inflation and unemployment were negatively correlated. (The observation is often stated in terms of wage inflation, or in terms of the gap between actual and potential output.) For fun, I plotted the relationship between inflation and unemployment in data up until 1968, with emphasis in red on the then most recent data, 1960-1968. This was the evidence available at the time. The Keynesians of Friedman's day had integrated this idea into their thinking, and advocated that the US exploit the tradeoff to obtain lower unemployment by adopting slightly higher inflation. Friedman said no. And, interestingly for an economist whose reputation is as a dedicated empiricist, his argument was largely theoretical. But it was brilliant, and simple. Friday, March 16, 2018 Unintended consequences Unintended consequences of well-intentioned policies, unexpected behavioral changes in response to ignored incentives, unusual supply (or demand) responses to demand (or supply) interventions, and clever new pathways for changes to happen are the sorts of mechanisms that make economics fun, and I hope useful to cause-and-effect understanding of human affairs. A case in point is an Atlantic article from 2012 that a friend pointed me to last week, by Richard Sander and Stuart Taylor Jr. ... UCLA, an elite school that used large racial preferences until the Proposition 209 ban [on overt racial preferences] took effect in 1998... Many predicted that over time blacks and Hispanics would virtually disappear from the UCLA campus. And there was indeed a post-209 drop in minority enrollment as preferences were phased out. Although it was smaller and more short-lived than anticipated, it was still quite substantial: a 50 percent drop in black freshman enrollment and a 25 percent drop for Hispanics... [However,] ...The total number of black and Hispanic students receiving bachelor's degrees were the same for the five classes after Prop 209 as for the five classes before. How was this possible? Indeed, I too would have guessed, if I didn't think hard about it, that eliminating racial preferences would have to have reduced the number of minorities who graduated, and that the affirmative action argument would have gone on to other pros and cons. But that's wrong. First, the ban on preferences produced better-matched students at UCLA, students who were more likely to graduate. The black four-year graduation rate at UCLA doubled from the early 1990s to the years after Prop 209. Yes. Half the admits but double the graduation rate leaves constant the number of graduates. Second, strong black and Hispanic students accepted UCLA offers of admission at much higher rates after the preferences ban went into effect; their choices seem to suggest that they were eager to attend a school where the stigma of a preference could not be attached to them. This mitigated the drop in enrollment. Third, many minority students who would have been admitted to UCLA with weak qualifications before Prop 209 were admitted to less elite schools instead; those who proved their academic mettle were able to transfer up to UCLA and graduate there. Thus, Prop 209 changed the minority experience at UCLA from one of frequent failure to much more consistent success. The school granted as many bachelor degrees to minority students as it did before Prop 209 while admitting many fewer and thus dramatically reducing failure and drop-out rates. To be absolutely clear, this post is about pathways. I do not wish to wade into a perilous pro or anti affirmative action debate, a basically radioactive topic for white male economists. (Though I am pleased to report a quick Google search that suggests both Sanders and Taylor still employed, something that might not happen if their book were published today.) And a proponent of affirmative action could nonetheless make many arguments consistent with this work. Perhaps dropping out of UCLA is good for people. Perhaps more minorities on campus is useful for white students' social perceptions, even if it harms its intended beneficiaries. Perhaps things were going on at other universities that drove minority upperclasspeople UCLA's way. UCLA is part of the California state system, which encourages transfers at year two, which is not the case everywhere. I also don't know how the numbers are holding up post 2012. Finally, racial preferences seem to have advantaged whites by keeping asians out, which is an interesting scandal by the silence surrounding it. Today's post is not about this larger argument. I'm willing to bet Brad DeLong still blogs I'm racist for even mentioning the topic, but that will be an interesting test of today's political climate. Wednesday, March 14, 2018 Bear Stearns Anniversary Justin Baer and Ryan Tracy have an excellent article in the Wall Street Journal commemorating the tenth anniversary of the Bear Stearns bailout. The Federal Reserve tried to limit the damage with extraordinary actions, first extending the firm credit before forcing it into a hasty weekend shotgun marriage to JPMorgan Chase with$29 billion in assistance.
More specifically,
Ten years ago, Bear’s crisis week began with rumors of liquidity problems following steep losses from mortgage bonds. Mr. Schwartz, the CEO, phoned JPMorgan Chief Executive James Dimon to ask for a simple overnight loan. By that Thursday, Bear’s lenders and clients had backed away, and the firm was running out of cash. Mr. Schwartz called Mr. Geithner for more help.
Fearing a Bear-induced panic could spread throughout the banking system, the Fed arranged a $12.9 billion emergency loan routed through JPMorgan. It ultimately agreed to purchase$29.97 billion in toxic Bear assets.
First, Bear lost a lot of money in mortgage backed securities. Second, like Lehman to follow, Bear was mostly financing that investment with borrowed money, and short-term borrowed money at that, not with its own money, i.e. equity capital. Small losses then made it more likely Bear would not be able to pay back its debtors. Third, there was a run.  Short term creditors ran out the doors just like Jimmy Stewart's depositors in a Wonderful Life. More interestingly, Bear's broker-dealer clients started running too. Just how investment banks like Bear were using their broker-dealer clients to fund investments is a great lesson of the event.  Darrell Duffie lays this out beautifully in The failure mechanics of dealer banks and later How big banks fail.

Thursday, March 8, 2018

Fama Portfolio

The Fama Portfolio, is a new book from the University of Chicago Press. This is a collection of Gene Fama's papers, edited by Toby Moskowitz and me. It includes introductory essays by a group of Gene's distinguished colleagues, Ken French, Bill Schwert, René Stulz, Cliff Asness, John Liew, Campbell Harvey, Jan Liu, Amit Seru, and Amir Sufi.

The essays explain the ideas in modern terms, tell you why the papers are important, explain how the papers influenced subsequent thinking, update you on where our understanding on each point is today, and speculate about where new ideas may go. The continuing vitality of this work, even parts decades old, is impressive.

The task was hard. Which Fama papers should one read? Well, all of them! but we nonetheless had to pick. We typically chose a famous one from early in one of Gene's many research programs, and then a less known later one that really sums it up clearly. Gene's ideas get clearer over time, just like the rest of ours do.

The press lets us post our essays.  Here are mine (most joint with Toby):

Other authors may post their essays on their webpages. Otherwise, you'll just have to buy the book!

The contents:

Monday, March 5, 2018

A short oped for the Wall Street Journal here  on stock buybacks. As usual, they ask me not to post the whole thing for 30 days though you can find it ungated if you search. An excerpt:

Sunday, March 4, 2018

Economists letter on tariffs

Once per decade or so it is worth revisiting the famous 1930 economists' letter on Tariffs. (The link, at econjournalwatch.org, has a concise history and links to more.) 1028 economists -- a huge proportion of the number then around -- signed the following, urging President Hoover to veto the Smoot Hawley tariff.

We know how it turned out. No, we did not win that trade war. Well, not until about 1945.

What will this one lead to? I see some hope in that President Trump is at last uniting the country. As Greg Mankiw points out
How often do Jeffrey Sachs and the Wall Street Journal editoral writers agree?
Perhaps, as with DACA, the President using the existing law, which allows and even encourages widespread protectionism, this action will spur Congress to pass trade laws that require a bit more than vague "injury" to industry or "national security" fantasies. But I am straining to find a silver lining.

The darker possibility. Many administrations start with some policy victories -- judicial nominees, deregulation, tax reform -- and then over reach. This may be the start of over reach.

Rereading the letter, it is impressive for stressing simple truths that apparently remain mysterious to many even today. If we buy a good from overseas, the dollar must come back, either as a purchase of American goods or investment in American capital. Conversely that purchase or investment cannot happen if we do not allow foreigners to sell us things. Open trade is important to peace and stability, not just prosperity. It  stresses the final effects on people who end up paying more and working less, not just downstream producers.

Plus ça change, plus c'est la même chose.
The undersigned American economists and teachers of economics strongly urge that any measure which provides for a general upward revision of tariff rates be denied passage by Congress, or if passed, be vetoed by the President.
We are convinced that increased protective duties would be a mistake. They would operate, in general, to increase the prices which domestic consumers would have to pay. By raising prices they would encourage concerns with higher costs to undertake production, thus compelling the consumer to subsidize waste and inefficiency in industry. At the same time they would force him to pay higher rates of profit to established firms which enjoyed lower production costs. A higher level of protection, such as is contemplated by both the House and Senate bills, would therefore raise the cost of living and injure the great majority of our citizens.

Wednesday, February 28, 2018

Tremors

A debt crisis does not come slowly and predictably. This year's short term bond holders, a very risk averse lot, are mostly interested in whether next year, new bondholders will show up, to lend the government money to pay this year's bondholders back. Bondholders can run on small jitters over that expectation.

When bondholders get nervous, they demand higher interest rates. More than higher interest rates, they diversify their portfolios, or just refuse. Debt gets "hard to sell" at any price. A different class of bondholders, willing to take risks for better rates, must come in to replace the safety-oriented clientele that currently holds short-term government debt.

As interest rates rise, interest costs on the debt rise. At $20 trillion of debt, when interest rates rise to 5%, interest costs rise to$1 trillion dollars, essentially doubling the deficit. That makes markets more nervous, they demand even higher interest rates, and when that spiral continues, you have a full blown debt crisis on your hands.

Short term debt compounds the problem. Since the US has borrowed very short term, interest increases make their way to the budget more quickly. If the US had borrowed everything in 30 year bonds, the spiral mechanism from higher rates to higher deficits would be cut off.

The crisis typically comes in bad times -- when in a war, recession, or financial crisis, the government suddenly needs to borrow a lot more and markets doubt its ability to repay.

But there is a case for a crisis to happen in good times as well. We have known for decades that the fundamental US problem is promised entitlement spending far beyond what our current tax system can fund. Markets have, sensibly I think, presumed that the US would fix this problem sooner or later. It's not that hard as a matter of economics. Well, say markets in 2005, OK for now, you have a war on terror and a war in Iraq on your hands, we'll trust you to fix entitlements later. Well, say markets in 2012, OK for now, you're recovering from a massive financial panic and great recession. We'll trust you to fix entitlements later, and we'll even lend you another $10 trillion dollars. But what's our excuse now? At 4% unemployment, after 8 years of uninterrupted growth, if we can't sit down now and solve the problem, when will we? Markets have a right to think perhaps America is so fractured we won't be able to fix this in time. Or, more accurately, markets have a right to worry that next year's markets will have that worry, and get out now. All this is well known, and most commenters including me think that day is in the future. But the future comes often quicker than we think. With that prelude, two pieces of news strike me as distant early warning signs. Here, from Torsten Sløk's excellent email distribution are two graphs of the bid-to-cover ratio in Treasury auctions. Torsten's interpretation: The first chart below shows that the bid-to-cover ratio at 4-week T-bill auctions is currently at the lowest level in almost ten years.... demand is also structurally weaker when you look at 10-year auctions, see the second chart. The main risk with issuing a lot of short-dated paper such as 4-week T-bills is that in 4 weeks it all needs to be rolled over and added to new issuance in the pipeline. In other words, the more short-dated paper is issued, the bigger the snowball in front of the US Treasury gets. Things are so far looking ok, but the risks are rising that the US could have a full-blown EM-style fiscal crisis with insufficient demand for US government debt, and such a loss of confidence in US Treasury markets would obviously be very negative for the US dollar and US stocks and US credit. The fact that this is happening with a backdrop of rising inflation is not helpful. Investors in all asset classes need to watch very carefully how US Treasury auctions go for any signs of weaker demand. The last part is the mechanism I described above. As an ivory tower economist, I tend to overlook such technical issues. If the bid to cover ratio is low, well, then that just means we need higher rates. But higher rates aren't a panacea as above, since higher rates make paying it back harder still. As I look at debt crises, also, it isn't just a matter of higher rates. There comes a point that the usual people aren't buying at all. Again, we're not there yet, and I think we have a long way to go. But this is a little rumble. The second tremor is Why International Investors Aren’t Buying U.S. Debt in the Wall Street Journal. The overall message is also that international investors are getting nervous. US 10 year yields are 2.9% already. German yields are 0.68%. Why aren't people buying our debt? Well, number one, they are worrying a further slide in the dollar. Which comes when next year's international bond holders really don't want to hold US debt. Most of the article is.. well, difficult for this former finance professor to follow. The article claims that one used to be able to lock in the difference, "Last year, buying Treasurys and swapping the proceeds back into euros provided European investors with a higher return than buying German sovereign bonds."[my emphasis] This sounds like arbitrage, "covered interest parity violations." That arbitrage is not perfect, but my impression is that it's not whole percentage points either. And you really can't lock in 10 years of funding. Besides which, someone else is on the risk-taking side of the swap. So the interviewed traders must be only partially hedging the difference. Perhaps it's really "uncovered interest parity," where you borrow Europe 0.68% invest in the US 2.9% and pray or only partially hedge the exchange rate risk. (On that, "The New Fama Puzzle by Matthieu Bussiere, Menzie D. Chinn, Laurent Ferrara, Jonas Heipertz, blog post at econbrowser documents that uncovered interest parity, where you invest in the high yield currency and take the risk, is losing its profitability. Interest spreads seem to correspond to future exchange rate changes after all.) All to follow up on for another day. Mostly, it rang a bell as a little tremor that people who answer WSJ reporter's phone calls are expressing nervousness about US debt. Again, these are little rumbles. I still think that a full blown crisis will come only amid a large international crisis, featuring some big country defaults (Italy?), big financial trouble in China, perhaps a war, state and local pension failures, and the US comes to markets with unresolved entitlements and asks for another$10 trillion. But I could be wrong. We live on an earthquake fault of debt, and the one thing I know from my own past forecasting ability (I have lived through 1987, the dot com boom and bust, 2008, the recent boom, and more, and saw none of them coming in real time) that I will not see it coming either.

Update:  Reply to Benjamin Cole, below. The US has never spent less on defense, as a fraction of GDP or of the federal budget, than it is doing today, since the 1930s. Here is defense / GDP. Defense / federal budget is even less, as the budget has expanded as a share of GDP.

Monday, February 26, 2018

A great EFG

On Friday, I went to the NBER EFG (Economic Fluctuations and Growth) meeting at the SF Fed. Program and papers here.  The papers were great, the discussions were great, the comments were great, even the food was good. (You know you're in California when the conference snack is avocado toast.)

The papers:

Saturday, February 24, 2018

Slok on QE, and a great paper

DB's Torsten Sløk writes in his regular email analysis:
Yesterday I participated in the annual US Monetary Policy Forum here in Manhattan, and the 96-page paper presented concluded that we don’t really know if QE has worked. This was also the conclusion of the discussion, where several of the FOMC members present actively participated. Nobody in academia or at the Fed is able to show if QE, forward guidance, and negative interest rates are helpful or harmful policies.
Despite this, everyone agreed yesterday that next time we have a recession, we will just do the same again. Eh, what? If we can’t show that a policy has worked and whether it is helpful or harmful how can we conclude that we will just do more next time? And if it did work, then removing it will have no consequences? There is a big intellectual inconsistency here.

Investors, on the other hand, have a different view. Almost all clients I discuss this topic with believe that QE lowered long rates, inflated stock prices, and narrowed credit spreads. Why? Because when the Fed and ECB buy government bonds, then the sellers of those government bonds take the cash they get and spend it on buying higher-yielding assets such as IG credit and dividend-paying equities. In other words, central bank policies lowered risk premia in financial markets, including in credit and equities. As QE, forward guidance, and negative interest rates come to an end, risk premia, including the term premium, should normalize and move back up again. And this process starts with the risk-free rate, i.e. Treasury yields moving higher, which is what we are observing at the moment.
These lovely paragraphs encapsulate well the academic and industry/policy view, and the tension in the former.

I'm interested by the latter tension: Industry and media commenters are deeply convinced that the zero interest rate and QE period had massive effects on financial markets, in particular lowering risk premiums and inflating price bubbles.

Wednesday, February 14, 2018

Deficits

The graph is federal surplus (up) or deficit (down), not counting interest costs, divided by potential GDP. I made it for another purpose, but it is interesting in these fiscally ... interesting .. times.

Taking interest costs out is a way of assessing overall fiscal stability. If you pay the interest on your credit card, the balance won't grow over time. Granted, interest costs are increasing -- 5% times a 100% debt/GDP ratio is a lot more than 5% times a 30% debt/GDP ratio, and interest costs threaten to crowd out much of the rest of the budget if interest rates go up. But still, as an overall measure of fiscal solvency, whether one way or another you are paying interest and then slowly working down debt, or if you are not even making the interest payments and the balance is growing over time,  is the relevant measure.

I divided by potential rather than actual GDP so that we would focus on the deficits, and not see variation induced by GDP. If GDP falls, then it makes deficit/GDP larger. The point is to detrend and scale deficits by some measure of our long-run ability to pay them. Yes, deficits after 2008 are even larger as a fraction of actual rather than potential GDP. So this is the conservative choice.

Now, comments on the graph. Once you net out interest costs, it is interesting how sober US fiscal policy actually has been over the years. In economic good times, we run primary surpluses. The impression that the US is always running deficits is primarily because of interest costs. Even the notorious "Reagan deficits" were primarily payments, occasioned by the huge spike in interest rates, on outstanding debt. On a tax minus expenditure basis, not much unusual was going on especially considering it was the bottom of the (then) worst recession since WWII. Only in the extreme of 1976, 1982, and 2002, in with steep recessions and in the later case war did we touch any primary deficits, and then pretty swiftly returned to surpluses.

Until 2008. The last 10 years really have been an anomaly in US fiscal policy. One may say that the huge recession demanded huge fiscal stimulus, or one may think $10 trillion in debt was wasted. In either case, what we just went through was huge. And in the last data point, 2017, we are sliding again into territory only seen in severe recessions. That too is unusual. Disclaimer: All of these measures are pretty bad. Surplus/deficit has lots of questionable reporting in it, and the interest cost only has explicit coupon payments. I thought it better here to show you how the easily available common numbers work than to get into a big measurement exercise. I'll be doing that later for the project that produced this graph, and may update. Update: Sometimes a blog post makes a small point that can easily be misinterpreted in the broader context. So it is here. The US fiscal situation is dire. The debt is now$20 trillion, larger as a fraction of GDP than any time since the end of WWII. Moreover, the promises our government has made to social security, medicare, medicaid, pensions and other entitlement programs far exceeds any projection of revenue. Jeff Miron wrote to chide me gently for apparently implying the opposite, which is certainly not my intent. One graph from his excellent "US Fiscal Imbalance Over Time":

Here, Jeff adds up the promises made each year for spending over the next 75 years. Others, including Larry Kotlikoff, make the same point by discounting the future payments, to estimate that the actual debt -- the present value of what the US owes less what it will take in --  is between $75 trillion and$200 trillion -- much more than the $20 trillion of actual GDP. I've been one of those guys wandering around with a sign "the debt crisis is coming" so long that I forget to reiterate the point on occasion, and Jeff rightly points out my graph taken alone could be so misinterpreted. In a nutshell, the problem is this: The US has accumulated a huge debt. Interest costs on that debt are already in the hundreds of billions per year. If interest rates rise, those costs will rise more.$20 trillion of debt times 5% interest rate is $1 trillion extra deficit, or even faster-rising debt. Unlike the case after WWII, when the spending was in the past, the US has also promised huge amount of spending in the future. And, as Jeff points out, this did not start in 2008. Entitlements have grown and crowded out regular spending. Now they are growing to crowd out interest payments. Soon they will grow more. Update 2 Deficits / Potential GDP; Interest costs / Potential GDP; (Deficit + interest costs)/Potential GDP Debt / GDP. (Thanks Vic Volpe for suggesting this better graph.) Wednesday, February 7, 2018 Stock Gyrations Is this 1929, the beginning of the end? Or 2007? Is it 1974, annus horribilis in which the stock market drifted down 40% having something to do with stagflation, and did not recover until the 1980s? Is it 1987, a quick dip followed by recovery in a year? Or just an extended version of the flash crash, when the market went down 10% in a few hours, and bounced back by the end of the day? Are we in a "bubble" that's about to burst? How much does this have to do with the Fed? Of course I don't know the answer, but we can think through the logical possibilities. (Note: This post has equations, graphs and quotes that tend to get mangled when it gets picked up. If it's mangled, come back to the original here.) Why do prices fall? Stock prices fall when there is bad news about future profits, or when the discount rate rises. The discount rate is the rate investors require, looking forward, to get them to buy stocks. If people require a better rate of return, with no change in their expected cashflows, prices drop. Stop and think about that a second, as it's counterintuitive. Yes, the only way to get a better return out of the same profits or dividends is for today's price to drop. Another way to think about it: Suppose all of a sudden there are good profitable opportunities for your money -- bond interest rates rise, or it's a good time to take money out of markets and invest in your company. Well, people will try to move money to those alternatives. But the stock market is a hot potato; someone has to hold the stocks. So stock prices must decline until the rate of return going forward matches the other attractions on a risk-adjusted basis. Good news about returns going forward is bad news about a downward jump in stock prices. Bad news about cashflows is, well, bad news. The dashed line shifts down. Your stocks are not going to pay off as well as before. Higher required returns are neutral, really, for long-term investors. The price drops today, but the higher returns mean the price will slowly recover, just as long-term government bonds do. So is this a moment of bad cashflow news or higher discount rate? Most commentary suggests it's not bad news about cashflows. The economy seems finally to be growing, and there isn't anything like a brewing subprime or other problem, as there was in 2007. Maybe we don't know about it, but one certainly doesn't read about it. So let's think about discount rates. Why might investors require a higher return on stocks? Is it interest rates, a risk premium, and is the Fed behind it all? Where are we? Are we in a "bubble'' that is about to pop? Let's start by reviewing some facts. Here is the cumulative return on the NYSE since 1990. (This is the CRSP NYSE. Sadly the data stops 12/31/2017 so I don't show the recent drop. The larger index including NASDAQ shows a larger rise and fall in the tech boom and bust, but is otherwise about the same.)  Cumulative return NYSE since 1990. Source CRSP This graph does not show anything terribly unusual about the recent period. Stocks drift up during expansions, and take a beating in recessions. There are also little blips like the Krugman election panic of November 2016. (Sorry, I couldn't resist.) Why have stocks gone up so much? Well, mostly because the expansion has gone on so long. The recent period is also notable in that the little wiggles are much smaller -- less volatility. That ended last week too. Update: Thanks to Torsten Slok at DB the last year follows. His point, it's sharp but not all that big. Next, look at the price-dividend ratio. (For a variety of reasons this is a better valuation measure than the commonly used price earnings ratio. This (CRSP) measure of dividends includes all cash payment to shareholders. No, repurchases don't cause a problem.)  Price / dividend ratio, NYSE. Source CRSP You can see prices were high relative to dividends in the booming 1960s; they really rose in the late 1990s before the big 2000 bust. Then you see the 2008 crisis and recovery, and more recent wiggles. You can see prices fall in recessions, even relative to dividends which also fall in recessions. Where is the booming stock market? Stock prices relative to dividends have not grown at all since the end of the recession. Well, evidently, dividends have been rising just as fast as prices in the current expansion -- which again weren't rising all that fast anyway. So the main reason stock prices are high is that dividends are high, and people expect that slow growth to continue. So here we were before the recent drop. Are prices too high? Well, not as much as in 1999 for sure! But P/D is a lot higher than historical norms. Is this the beginning of a drop back to historic levels like 30, or even 20? Or is this a new normal? There is way too much commentary lately that whatever we remember from 20 years ago was "normal" and that things have to go back to that. Not without a reason. Interest rates and stock prices To think about this question we need some basics of what determines price-dividend ratios. Over long time periods, the return you get on stocks is the dividend yield -- how many dividends they pay per dollar invested plus the growth in dividends. Over short time periods you also get price appreciation per dividend, but over long time periods, the ratio of price to dividends comes back and price growth is the same as dividend growth. In sum, return = dividend yield + growth rate $r = \frac{D}{P} + g$This is also where price comes from. The price you're willing to pay depends on the expected return going forward, and expected dividend growth (Prices are high relative to current dividends if people expect a lot more dividends in the future.)$\frac{D}{P} = r - g = r^l + r^e - g$$\frac{P}{D} =\frac{1}{r - g} =\frac{1}{ r^l + r^e - g}$ Here I broke apart the expected return into components. First, the expected return on stocks is equal to the long-term real risk-free rate $$r^l$$ plus the risk premium $$r^e$$. This is just a definition -- the risk premium is $$r^e=r-r^l$$. So, looked at either as D/P or P/D, we now have the tools to think about what pushes stock prices around. (There is nothing inherently rational'' or efficient markets'' about this. Behavioral finance just says the expectations are wrong, for example that people think $$g$$ is big when in fact $$r$$ is small.) Stock prices are very sensitive to real interest rates, risk premiums, and growth expectations. At our current P/D of 40, for example, this means $$r-g=1/40=0.025$$ or 2.5%. Just half a percent change in expected return or growth rate, $$r-g=0.02$$ would mean $$P/D=1/0.02=50$$, a 25% rise in stock prices. Conversely, a half percent rise in real interest rates would mean $$r-g=0.03$$, a decline to $$P/D=33$$ a 16.7% fall. No wonder stocks are (usually) volatile! Now, to what's going on? If we take growth rate expectations off the table, then stock prices are moving because of changes in interest rates. And small interest rate changes do indeed imply big stock valuation changes -- though, again, take heart because it means the rate of return is higher, as in the first picture. Does this relationship hold historically? Here is the D/P ratio (P/D upside down) and a measure of long-term real interest rates.  NYSE D/P, Cleveland Fed 10 Year real rate, and 10 year TIPS (The problem with 10 year real rates is knowing what 10 year expected inflation is, given that we did not have TIPS. There are lots of other problems too, such as unwinding the liquidity premium in government bonds. Here I used the Cleveland Fed's real rate model, which is in part based on survey expectations. I added the 10 year TIPS yield where we have it to confirm the general pattern of the Cleveland Fed's calculation.) This is a remarkable graph: The entire rise in valuations from 1980 to 2008 corresponds exactly to the decline in real interest rates. By this measure, the decline in real rates was huge, from 7% to essentially 0%. Plug that in to $$P/D=1/(r-g)$$ and we're done. Stock prices are exactly where they should be. In fact, by this measure, stock prices are too low. In 2008, real rates kept right on trundling down another two percentage points, but the dividend yield stabilized. Well, I was careful to say "corresponds to" not "caused by" for a reason. The risk premium and growth expectations changed as well. Arguably the move to a low-growth economy starting in 2000, cutting one to two percentage points off $$g$$, offset the decline in real rate. Or perhaps the risk premium isn't as low as we think it is. This isn't just waffling -- the relationship is basically an identity. One of those options must be true. If the dividend yield is 2.5%, and the real interest rate is 0%, then $$r^e-g$$ is 2.5%, and has grown since 2000. Either the risk premium has grown 2.5% -- so much for the low risk premium'' -- or growth expectations have fallen 2.5%. Or the long-term real rate is profoundly mismeasured here. More on all this in a minute. But the graph reminds us 1) Real rates have come down a lot, and 2) persistent changes in real rates really are an important part of stock market valuations. Oh, and they have nothing to do with risk appetite'' and all that other blather. Stocks are valued like bonds plus risk. We are noticing here that the bond-like component got much more valuable. That alone, not the risk component or the growth component, accounts for two decades of huge price rises. This actually updates significantly some of my own work, and the asset pricing consensus. The great question why do price-dividend ratios vary so much occupied us a lot in the late 1980s and early 1990s, including myself, John Campbell, Bob Shiller, Gene Fama and Ken French. The rough answer we came to -- pretty much all variation in D/P or P/D comes down to variation in risk premiums, the $$r^e=r-r^l$$ term. The underlying fact is that times of high P/D are not reliably followed by higher dividend growth (Shiller), and they are reliably followed by low excess returns (Fama and French). If you add it up, the risk premium effect neatly accounts for all the variation in P/D (Campbell and Shiller, me). Well, in the data up to 1990, we didn't see much persistent variation in real rates of interest, and what we did see was not correlated well with stock prices. Well, that was 1990, and now is now. This graph suggests that in fact a lot of the recent variation in P/D corresponds to lower real interest rates. Also, it's the low frequency, decade to decade movement in P/D that is not well accounted for by any models. An academic version of this observation needs to be written. Practical bottom line: The stories that the recent stock price decline comes from rising long-term real interest rates make sense. They might be wrong, but they make sense. That's saying a lot more than most of the other stories being bandied around right now. Interest rates, growth, stock prices, and the Fed. The story is not that easy however. We have to think about real interest rates $$r$$ and growth $$g$$ together. And there is this puzzle to answer -- how can it be that good news about the economy sends the market down? If $$P/D=1/(r-g)$$ more $$g$$ should raise $$P$$, no? It should shift up the dashed line in my first graph? No. We have to think about where real interest rates come from. One of the most basic relationships in economics is that higher growth means higher real interest rates. If everyone will be richer in the future -- growth -- they need an incentive to save and not blow it all today. And growth means a higher marginal product of capital, and hence higher interest rates. As a simple equation, $\text{real rate} = \gamma g$where $$\gamma$$ is a parameter, usually between about 1/2 and 2, and get ready for a bar fight at the AEA convention over just what value to use. 1% higher growth means about a half percent to two percent higher real interest rate. (There is a second term too, important in understanding things like the financial crisis. More uncertainty means lower interest rates. Not today.) If $$\gamma=1$$, if one percent growth means one percent higher real interest rates, then higher growth has no effect at all on stock prices or price dividend ratios. ($$D/P = r^l + r^e - g.$$ Raise $$r^l$$ and $$g$$ by the same amount.) If, as I think is more likely right in this case, $$\gamma>1$$, then higher growth lowers stock prices. Yes. Higher growth means a higher discount rate as well as more dividends. The discount rate effect can overwhelm the cashflow effect. This has nothing to do with the Fed. There is a natural human tendency to look for Agency, for some man or woman behind the curtain pulling all the strings, and these days that means the Fed. For example, the WSJ Editorial on stocks: "The paradox of the equity-market correction is that it’s taking place even as the real economy looks stronger than it’s been since at least 2005 and maybe 1999. " "So why are stocks falling amid all the good news? The best answer we’ve heard is that stocks are reflecting a return to volatility and risk after years of the Fed’s financial repression. With its quantitative easing bond purchases, the Fed has for a decade suppressed market price signals in bonds." "Investors may finally be figuring out that the global quantitative-easing monetary party is ending." Look back at my graph. Real interest rates have been on a slow downward trend since 1980. That trend is unbroken since 2008. There is not a whiff that QE or anything else has budged that trend. (Lots of good graphs on this point in 8 heresies of monetary policy here. ) If the Fed has anything to do with it, it is the slow victory over inflation expectations, not QE and a lot of talk. Yes, the papers like to say that higher growth will induce the Fed to raise rates. The Fed can put a finger in this dike for a bit if they want to, but even the Fed cannot long fight the positive or negative relationship between real growth and real interest rates. So it makes perfect sense, at least as a logical possibility, that more growth lowers stock prices! Again, this is like my lower line in the first picture -- and actually a bit better because we also raise the terminal point. If this is what happened, well, regret that you didn't see it happening and stay out during the dip, but be reassured the market will make it back. Risk premiums What about the unusually low risk premium''? Aren't the Fed's massive QE and abnormally low interest rates distorting risk premiums and causing asset price bubbles?'' (The best definition of bubble'' I can muster is a risk premium that is too low, distorted somehow.) Here is the contrary view. We are at the late summer of the business cycle. The economy is relatively healthy, at least if you're a stock market investor. (Many of these own companies.) Economic volatility is still at an all time low. Bonds are still giving pretty atrocious real returns. Yeah, stocks look pretty healthily priced -- as you contemplate your $$P/D = 1/(r^l + r^e - g)$$ it looks like the extra return from stocks $$r^e$$ is pretty low. But what else are you going to do with the money? You can afford a little risk. Contrariwise, the same investors in the bottom of the great recession, with very low $$P/D$$ signaling a high risk premium $$r^e$$, said to themselves or their brokers, yes, this is a buying opportunity, stocks will likely bounce back. But my business is in danger of closing, my house might get foreclosed, I just can't take any risk right now. In short, it is perfectly rational for investors to be more risk-averse, and demand a higher risk premium $$r^e$$ in the bottom of recessions, and to hold stocks despite a low risk premium in quiet good times like right now. And this has nothing to do with the Fed, QE, or anything else. John Campbell and I wrote a simple model of this phenomenon a long time ago, and I've reviewed it several times since, most recently here. Sorry for flogging the same ideas, but this possibility still hasn't made it to, say, the Fed-obsessed WSJ editorial pages, to say nothing of the Trump-obsessed pages at other outlets. John and I tied risk aversion to consumption trends. If consumption is high relative to the recent past, in good times, you more willing to hold risk. If consumption is declining relative to the recent past, you get more scared. Lots of other mechanisms, including debt, work much the same way. If you don't like the precise model, consumption relative to recent past is a good general business cycle indicator. Let's look historically. Here is consumption less a moving average (I used $$x_t = \sum_{j=0}^\infty 0.9^j c_{t-j})$$, plotted with the log of the price/dividend ratio. The two series have different scales. The point is to see the correlation.  Consumption minus a moving average, and log P/D on NYSE. The pattern is longstanding. In good times, when consumption rises relative to recent past, stock valuations go up. In bad times, such as the great recession, consumption falls and so do stock valuations. People are scared. The same pattern happens regularly in the past. The two lines drift apart, but as we saw above real interest rates account for that. Then the business-cycle related risk premium here accounts for the rises and dips. And, if I may belabor the point, there was no QE, zero interest rates, and so forth going on in all these past instances when we see exactly the same pattern. Higher real interest rates are a regular, simple, utterly normal part of expansions, and lower risk premiums are a regular, simple, utterly normal part of expansions. I was interested to read Tyler Cowen at Bloomberg back in to this view, based entirely on intuition: In a volatile and uncertain time politically, we have observed sky-high prices for blue-chip U.S. equities. Other asset prices also seem to be remarkably high: home values and rentals in many of the world’s top-tier cities, negative real rates and sometimes negative nominal rates on the safest government securities, and the formerly skyrocketing and still quite high price of Bitcoin and other crypto-assets. Might all of those somewhat unusual asset prices be part of a common pattern? Consider that over the past few decades there has been a remarkable increase of wealth in the world, most of all in the emerging economies. Say you hold enough wealth to invest: What are your options? In relative terms, the high-quality, highly liquid blue-chip assets will become expensive. So we end up with especially high price-to-earnings ratios and consistently negative real yields on safe government securities. Those price patterns don’t have to be bubbles. If this state of affairs persists, with a shortage of safe investment opportunities, those prices can stay high for a long time. They may go up further yet. These high asset prices do reflect a reality of wealth creation. They are broadly bullish at the global scale, but they don’t have to demonstrate much if any good news about those assets per se. Rather there is an imbalance between world wealth and safe ways of transferring that wealth into the future To sum this all up in a single nerdy finance sentence, in a world where wealth creation has outraced the evolution of good institutions, the risk premium may be more important than you think. Except for this business about "shortage of safe assets," that's pretty much the intuition. (Tyler: all assets are in fixed supply in the short run. Prices adjust. This isn't really a shortage.'') The point that high valuations extend to homes, bonds, bitcoins, and global stocks is a good indicator that the phenomenon is generalized risk aversion rather than something specific to one market or economy. This view should not necessarily make you sleep at night however. It means that a downturn will be accompanied by higher risk aversion again, and not only will dividends fall, prices will fall further. Moreover, historically, asset price falls have been preceded by periods of higher volatility. Alas, many periods of higher volatility have just faded away, so it's a warning sign not a signal. Sure, this mechanism means they will bounce back, but if you are clairvoyant enough to see it coming it will be better to avoid the fall! If not, well, be read to buy when everyone else is scared -- if you are one of the lucky few who can afford not to be scared. The VIX, volatility, technical factors There is another kind of discount factor variation,'' including 1987 and the flash crash. Sometimes the machinery of markets gets in the way, and prices fall more than they should. They quickly bounce back. If you can buy at the bottom you can make a fortune, but the prices fell precisely because it's hard to buy. There were scattered report on Monday of hours long delays for retail customers to trade. (Can't find link.) But I do not get a sense this was a big clog in the markets. I would be curious to hear from people closer to markets. The bigger news is the return of volatility -- big daily changes. To put this in historical perspective, here are two plots The surprise, really, is just how low low volatility had become. Historically the stock market index has had a volatility around 15-20% per year -- a typical year saw a 15-20% change, and a typical day saw a $$15-20 / \sqrt{250} \approx$$ one percent change. But, as you see in the top graph, volatility also declines in the late summer of the business cycle. Volatility has many occasional little eruptions, typically around price drops, and then washes away. Except when volatility rises in advance of the next recession and market decline. Which is this? I wish I knew. Volatility is not about "fear" nor is it about "uncertainty." Volatility occurs when options change quickly. Constant bad news or good news just leads to constantly low or high prices. This is a sign of a time when either a lot of real information is hitting the market, or a lot of people are trying to process what's going on ahead of everyone else. The "VIX bust" is hot in the news. A lot of people bet that the graph you saw above would not rise. To be short volatility'' means basically that you write insurance to people who worry about markets going down, (volatility is a big part of the value of put options) and you write insurance to people who are worried about events like right now in which markets start to move a lot. Hello, when you write insurance, occasionally you have to pay up. As the graphs make clear, writing volatility insurance, or betting that volatility will continue to go down, is like writing earthquake insurance. Not much happens for many years in a row, and you can post nice profits. Then it jumps and you lose big time. Anyone who did this based just on historical returns is now crying the tears of the greedy neophyte. But they have lots of company. Back in the 1990s, Long Term Capital Management went under, basically for betting that similar looking graphs would continue to go down. Well, if after all these years people are at it, P.T. Barnum had a good word for them. But did this have something to do with the stock market crash? How Bets Against Volatility Fed the Stock Market Rout in WSJ is an example of this train of thought. On first glance, sure, a lot of people lost a ton of money, and then sold out other risky positions. But Econ 101: for every buyer there is a seller. Derivatives contracts are pure cases of this fact -- the net supply really is zero, for everybody who lost a dollar shorting VIX somebody else made a dollar buying it. To get a story like this to go you need all sorts of market discombobulations. Somehow the people who lost money must be more important to markets than the people who made money. This can happen -- if a bunch of traders in a complex obscure security all lose money, and all try to sell, there is nobody to buy. But I don't really see that case here, and stocks are not a complex obscure security. A trader friend also tells me that he has seen lots of people stop hedging -- so sure low volatility would continue that they don't cover the downside. He said many have lost a ton, and now are frantically selling to cover their positions. Such price pressure can have short run impacts, but does not last long. Inflation and real interest rates So we're back at hints of higher long-term real interest rates as the main likely culprit behind this week's decline and gyrations. Here too most of the stories don't make much sense. Inflation per se should not make much difference. If expected inflation rises, interest rates rise, but real interest rates are unaffected. Inflation may make the Fed act more quickly, but there is not much correlation between what the Fed does with short term rates and the behavior of 10 year or more rates that matter to the stock market -- or to corporate investment. Yes, there is some correlation -- especially at the end of expansions, short and long rates rise together. But the correlation is a whole lot less than the usual Wizard of Oz behind the curtain stories. And even the Fed cannot move real rates for very long. There is a good chicken-and-egg question whether the Fed can hold short rates down for long when long rates want to rise. The Fed pretty much has to jump in front of the parade and pretend to lead it. Inflation does seem finally to be rising. The fact that higher rates are associated with the dollar falling suggests that a lot of the higher rates are due to inflation, and TIPs have not moved (top graph.) So, the question before us is, are long-term real rates finally rising -- back to something like the historical norm that held for centuries, and if so why? The good story is that we are entering a period of higher growth. Depending on your partisan tastes, point to tax cuts and deregulation, or state that Obama medicine is finally kicking in. This would raise real growth, with $$\gamma>1$$ lead to a small stock price decline, but higher stock returns and bond returns going forward. There is a bad story too. Having passed a tax cut that left untouched will lead to trillion-dollar deficits, Congressional leaders just agreed to$300 billion more spending. The Ryan plan that tax cuts would be followed by entitlement reform may be evaporating. Publicly held debt is $20 trillion. At some point bond markets say no, and real rates go up because the risk premium goes up. The US is in danger that higher interest rates mean higher interest costs on that debt, which means higher deficits, which means higher interest rates.$20 trillion times 5% interest = \$1 trillion in interest costs.

The former leads to some inflation if you believe in the Phillips curve. The latter leads to stagflation in a tight fiscal moment.

Which is it? I don't know, I'm an academic not a trader.

One consolation of the stock market decline: I hope we don't have to hear how all the corporate tax cut did was to boost the stock market!

Well, two days ago this was going to be a short post responding to the WSJ's view that the Fed is behind it all, and Tyler's nice intuition. It got a bit out of hand, but I hope it's still interesting.

****

Data Update (Geeks only).

P/D isn't really "better" than P/E or other measures. A measure is what it is, you have to specify a question before there is an answer. Ideally, we want a measure that isolates expected returns, and tells us if prices are higher or lower given the level of expected dividends.  So ideally, we would account for expected future dividends and the result would be a pure measure of expected returns (rational or not). P/D works pretty well that way because dividends are not very forecastable. Price divided by this year's dividends turns out to be a decent approximation to price divided by anyone's forecast of future dividends. But not perfect. P/E is less good that way because earnings bat about a bit more than dividends. For individual companies you can't use P/D, because so many of them do not pay dividends. Following Fama and French, the ratio of market value to book value is better there, because book value is usually positive, or not so frequently zero.

I use the CRSP definitions. I start from the CRSP return with and without dividends and infer the dividend yield. ''Dividends" here includes not only cash dividends but all cash payments to shareholders. So, if your small company gets bought by Google, and the shareholders get cash, that is a "dividend" payout. I suspect this accounts for the difference noted by WC Varones below. As others point out, earnings has all sorts of measurement issues, and also does not control for leverage.

Dividends are very seasonal, so you can't divide price by this month's dividends or you get a lot of noise. I use the last year's worth of dividends, brought forward by reinvesting them. This introduces some "return" into the dividend series. If you just sum dividends, though, identities like $$R_{t+1} = (P_{t+1}+D_{t+1})/P_t$$ no longer hold in your annual data.

caldt = x(:,1);
totval = x(:,2);
usdval  = x(:,3);
sprtrn = x(:,4);
spindx = x(:,5);
vwretd = x(:,6);
vwretx = x(:,7);

[yr,mo,day,crsp_date_number] = decode_date(caldt);

T = size(vwretd,1);
vwretda = (1+vwretd(1:T-11)).*(1+vwretd(2:T-10)).*(1+vwretd(3:T-9)).*...
(1+vwretd(4:T-8)).*(1+vwretd(5:T-7)).*(1+vwretd(6:T-6)).*...
(1+vwretd(7:T-5)).*(1+vwretd(8:T-4)).*(1+vwretd(9:T-3)).*...
(1+vwretd(10:T-2)).*(1+vwretd(11:T-1)).*(1+vwretd(12:T));

vwretxa = (1+vwretx(1:T-11)).*(1+vwretx(2:T-10)).*(1+vwretx(3:T-9)).*...
(1+vwretx(4:T-8)).*(1+vwretx(5:T-7)).*(1+vwretx(6:T-6)).*...
(1+vwretx(7:T-5)).*(1+vwretx(8:T-4)).*(1+vwretx(9:T-3)).*...
(1+vwretx(10:T-2)).*(1+vwretx(11:T-1)).*(1+vwretx(12:T));

vwdp = vwretda./vwretxa-1; %D_t+1/P_t+1 = [(P_t+1+D_t+1)/P_t] / [P_t+1/P_t] -1;
vwdda = vwdp(13:end)./vwdp(1:end-12).*vwretxa(13:end);   % D_t+1/D_t = D_t+1/P_t+1 / D_t/P_t * P_t+1/P_t
vwdda = [ones(23,1)*NaN; vwdda];
cumval = cumprod(1+vwretd);
vwdp = [ ones(11,1)*NaN; vwdp]; % keep length of series the same

I get stock data from CRSP via WRDS. This is the NYSE only. I can't post the full data, as it belongs to CRSP. Here is an excerpt that will let you calculate the last year, and check that things are right if you download the whole thing.

%crsp_nyse_new_2018.txt
%   caldt            totval                  usdval                 sprtrn         spindx        vwretd        vwretx
19260130       27624240.80       27412916.20      0.022472       12.74      0.000561     -0.001395
19260227       26752064.10       27600952.10     -0.043956       12.18     -0.033046     -0.036587
19260331       25083173.40       26683758.10     -0.059113       11.46     -0.064002     -0.070021
19260430       25886743.80       24899755.60      0.022688       11.72      0.037019      0.034031
...
20160129    17059005700.00    17976992500.00     -0.050735     1940.24     -0.050111     -0.051700
20160229    16986848800.00    17001893900.00     -0.004128     1932.23      0.005104      0.002251
20160331    18122913200.00    16951468600.00      0.065991     2059.74      0.072190      0.069562
20160429    18503144900.00    18082712100.00      0.002699     2065.30      0.023324      0.021716
20160531    18479138100.00    18410229900.00      0.015329     2096.96      0.006124      0.003392
20160630    18613173100.00    18422135300.00      0.000906     2098.86      0.011175      0.008957
20160729    19054705700.00    18557630600.00      0.035610     2173.60      0.028433      0.026872
20160831    18993464300.00    19049575300.00     -0.001219     2170.95      0.000196     -0.002532
20160930    18829544800.00    18880924600.00     -0.001234     2168.27     -0.003876     -0.005878
20161031    18404742600.00    18802632900.00     -0.019426     2126.15     -0.021331     -0.022944
20161130    19220882900.00    18383296300.00      0.034174     2198.81      0.048548      0.045701
20161230    19568491300.00    19178151000.00      0.018201     2238.83      0.021566      0.019486
20170131    19824534000.00    19526674900.00      0.017884     2278.87      0.014007      0.012623
20170228    20355248600.00    19781803200.00      0.037198     2363.64      0.031422      0.028905
20170331    20237616500.00    20334429600.00     -0.000389     2362.72     -0.003961     -0.006103
20170428    20286715000.00    20194157100.00      0.009091     2384.20      0.003950      0.002468
20170531    20299003900.00    20276905500.00      0.011576     2411.80      0.002199     -0.000507
20170630    20602218600.00    20256933000.00      0.004814     2423.41      0.018204      0.016235
20170731    20747539100.00    20488018000.00      0.019349     2470.30      0.015290      0.013394
20170831    20593088100.00    20742392900.00      0.000546     2471.65     -0.005133     -0.007874
20170929    21147810200.00    20381001300.00      0.019303     2519.36      0.030435      0.028662
20171031    21343546700.00    21130998500.00      0.022188     2575.26      0.011831      0.010360
20171130    21904734200.00    21302790800.00      0.028083     2647.58      0.030537      0.027670
20171229    22016063100.00    21683038400.00      0.009832     2673.61      0.015914      0.014117

If I screwed up, let me know and I'll fix it!