Saturday, February 24, 2018

Slok on QE, and a great paper

DB's Torsten Sl√łk 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


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.

x = load('crsp_nyse_new_2018.txt');

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)).*...

vwretxa = (1+vwretx(1:T-11)).*(1+vwretx(2:T-10)).*(1+vwretx(3:T-9)).*...
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.

%   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!

Sunday, February 4, 2018

Truck automation

Two bits from Marginal Revolution on truck automation are so good they merit passing on here. Dan Hanson writes this amazing comment
I wonder how many of the people making predictions about the future of truck drivers have ever ridden with one to see what they do?
One of the big failings of high-level analyses of future trends is that in general they either ignore or seriously underestimate the complexity of the job at a detailed level. Lots of jobs look simple or rote from a think tank or government office, but turn out to be quite complex when you dive into the details.
For example, truck drivers don’t just drive trucks. They also secure loads, including determining what to load first and last and how to tie it all down securely. They act as agents for the trunking company. They verify that what they are picking up is what is on the manifest. They are the early warning system for vehicle maintenance. They deal with the government and others at weighing stations. When sleeping in the cab, they act as security for the load. If the vehicle breaks down, they set up road flares and contact authorities. If the vehicle doesn’t handle correctly, the driver has to stop and analyze what’s wrong – blown tire, shifting load, whatever.

Friday, February 2, 2018

Convexification and complication

From Richard Rubin at WSJ:
The new tax law’s treatment of deductions gives people more reasons to concentrate giving in certain years, both inside and outside donor-advised funds. 
A donor-advised fund is an investment account held for charitable purposes. Donors take tax deductions when they put money in, then recommend grants to charities over time. 
Mr. Young,...added $30,000 to a donor-advised fund run by the Los Altos Community Foundation. His plan: alternate years between taking the standard deduction and donating to his fund and claiming itemized deductions.
How very clever. The tax law allows a $24,000 per year standard deduction. Arrange things so that in some years you have zero actual deductions, and get $24,000 free deduction. Pile all the real deductions into other years.

In economics we call this "convexification". There are lots of clever ways to draw lines through a stair step.

Of course, you can also just give $50,000 to charity in alternate years, and let the charity put it in the bank. Donor-advised funds are useful if you think your local charity's endowment investment policy isn't that smart. If they invest in obscure high-fee hedge funds and private equity deals and you'd rather they invested your money in transparent low-fee assets, then set up a donor-advised fund.

In a rare moment of sanity and good government from my ex-home state, Marc Levine, chairman of the Illinois state board of investment, pulled all of Illinois' pension assets out of high-fee obscure hedge funds.

Industry “experts” suggested we keep these investments to diversify our holdings and reduce overall risk. Yet we already owned bonds for that purpose. Our Procter & Gamble bonds made sense to us. I’m pretty sure my children will brush their teeth tonight. But I don’t have a clue about that long-lumber, short-sugar trade. 
Did anyone at the table really understand what these hedge funds were doing? Should we be putting the retirement funds of Illinois state employees into investments that not a single trustee, consultant or staffer could explain?

Donor-advised funds are also a great way to give money to your favorite charity if you think their own investment

The article includes more clever advice:
... Donors who give appreciated assets get an added benefit: They avoid paying capital-gains taxes when they make the donation, and they get a deduction against their income taxes for the full value of the asset.
If you paid $50 for stock, now worth $100, give the stock to your favorite charity (Hoover!). The charity gets $100, you take $100 off your taxes, but you don't pay capital gains taxes on the $50. Essentially you get to take $100 plus the capital gains tax as a deduction.

It gets better though. Give a non-market asset to your favorite charity. You can see both you and the charity have every incentive to report fanciful values for the asset. If it's really worth $100, well, call it $200 for the IRS. The charity still gets $100 for free.

Now you can actually make money out of donations. Conservation easement syndications (here, here and most fun here are even better. Buy land cheap, declare a huge value, put the land in a conservation trust, promising not to build houses on it -- actual operating golf courses are ok, and too bad if sometime in 2050 building some houses is a good idea -- and deduct the high value against other income.
the former Millstone golf course outside Greenville, S.C. Closed back in 2006, it sat vacant for a decade...In 2015, the owner put the property up for sale, asking $5.8 million. When there were no takers, he cut the price to $5.4 million in 2016.
Later in 2016, however, a pair of promoters appeared. They gathered investors who purchased the same parcel at the market price and, with the help of a private appraiser, declared it to be worth $41 million, nearly eight times its purchase price. Why? Because with that new valuation and a bit of paperwork, the investors were suddenly able to claim a tax deduction of $4 for each $1 they invested. ..
...A preliminary IRS analysis of syndicated partnerships this summer showed investors claimed an average of $9 in tax deductions for every dollar they invest.
There are lots of ways to interpret all this. One can celebrate the creativity of the American tax lawyer and wealthy investor. Who said innovation has fled the US?

Obviously, I'm not such a fan. Even if you take a benign view -- the US likes to pass very high taxes for symbolic purposes, and then allows all sorts of shenanigans on the side so people don't actually have to pay the taxes -- much of the economic damage is done. Aside from the fact that marginal disincentives are high, the cost of all this stuff is not trivial either. From the first article
The funds linked to investment firms such as Fidelity and Vanguard typically charge administrative fees... The funds are often invested in vehicles managed by those firms and generate fees for the for-profit business.
And the lawyers who set up conservation trusts, and the lobbyists who keep them in the tax code, are all taking their cut too.

But even that is not the most annoying part. Now, on top of everything else, a wise taxpayer needs to set up a donor advised fund, sign a bunch of papers, and manage it each year. Already, perfectly normal citizens have to have trusts to manage estates, and hundreds of pages of tax forms each year. The needless complexity of life in the Republic of Paperwork is, to me, the most annoying part. We need a grand simplification of our public life. If this is what it leads to, the whole charitable deduction thing should get tossed overboard.

Wednesday, January 31, 2018

9 hour railway station

China builds a railway station in 9 hours (HT Marginal Revolution).

Yes, it's basically a propaganda video, but interesting nonetheless as a reflection on infrastructure.  The video does not say how long China spent on environmental review -- did it disturb wetlands, threaten various species, what's it's carbon footprint -- legal review -- is it paying prevalining union wages, was it bid with proper female and minority headed construction company set asides -- did it have community input, consistency with planning targets and so on. I doubt it was the oh, 10 years or so that takes in the US.

To be clear, I am not saying all that is useless. China has awful pollution,  and our reviews accomplish something.  China doesn't bother with the niceties of private property ownership, eminent domain proceedings, and legal challenges when they want to build a railway. These don't just triple or more the cost of projects, send vast sums of money to well-connected companies and lawyers and lobbyists, and delay projects for decades. But they also have that effect.

It's also interesting as a pin factory visit.  With that many people on a job, I would have thought they would be getting in each other's way. This video seems to deny the Q theory of investment! Some are standing, but a remarkable number are working hard. Of course, the video is edited.

When I watch US infrastructure projects, I see a lot of people standing around or "supervising" the one poor sob who is actually doing the work. That ratio seems a lot lower here.

There are a lot of machines.  The days of China substituting lots and lots of labor for capital are gone. The Chinese have taken Milton Friedman's advice. (On a visit to a dam, Friedman noticed people using shovels. He asked why they didn't use bulldozers. The answer was to give more people employment. Friedman responded, why then don't you make them use spoons?) This is not a new observation, but the video is a good reminder from afar.

Friday, January 26, 2018

News comments

The tariff and the wall were the big news this week, with some lessons for looming infrastructure.

The Tariff

30% on solar cells, 20-50% on washing machines. Since the ill effects of tariffs have been know for, oh, about 250 years, said again eloquently by the Wall Street Journal in Trump starts his trade war,  Let me try to offer some comments beyond the usual economist response -- comparative advantage, trade must balance, follow the money anything that goes overseas must come back, imported products are inputs too, solar cell installers need jobs too, blahdah blahdah blahdah.

Washing machines, a device unknown to the inside the beltway types, is how the rest of us clean clothes. So raising the price of washing machines is one more little sucker punch to people who wash their own clothes.

Solar panels are supposed to save the planet. Our government already subsidizes them heavily via tax deductions, credits, Solyndras, renewable mandates, and so on, with the purpose of lowering carbon emissions. If that is the purpose, then we want the cheapest panels around to compete with fossil fuels. If that means made in Malaysia, great. The planet does not care where they are made.

If the Chinese government wants to tax its citizens to send us artificially cheap solar panels, we should thank them for their generosity in helping us to save the planet. It's absolutely hilarious to see complaints that China is subsidizing its solar cell industry so merits retaliation, given how much subsidy they receive here.

Yet even Al Gore agrees that the tariff is a good idea and wants solar cells made in the US.

What's going on? I think there is a good lesson in political economy. Once a government starts subsidizing something, everyone lines up at the trough. If taxpayers are going to be on the hook, then every interest wants its share. So potentially sensible carbon policy ends up as one more boondoggle.

Related, this week I saw the brilliant post Solar panels cost twice as much to install in the US as in Australia. (HT marginal revolution.) The answer, as usual in what Mark Steyn calls the Republic of Paperwork, is the paperwork.

I loved the flowchart on what it takes to get solar installed. In particular, you see here a real person who has really done it. The rules just say ``get a permit'' but the actual process, laid out in the picture, takes many trips back and forth and negotiations with the permit granters, all on someone's paid time.

This is a lovely detailed example of a larger question -- just what is the cost of regulation? I've been having this back and forth with some liberal economist friends, who pooh pooh the idea that regulations cost a lot. And here the official paperwork act disclosures, pages of the federal register, and so on would not add up to much. Yet, it does add up, to double. And installing residential solar is pretty simple, and something governments say they want. If this example scales, than GDP is half what it could be with a simper regulatory system.

Back to tariffs. Just why is it so hard to grasp that tariffs are a bad idea? Well, it must be because it is hard, and illustrates perhaps why economics really is useful, and why "business experience" is not generally a good qualification for policy. Anything that reduces competition and drives prices up is good for an individual business. Business leaders know this. Take that business leader to Washington and he or she will quickly conclude that what's good for my business is good for yours. A tariff on everything! Reduce harmful competition everywhere! We call it the fallacy of composition. What is good for one business is not good for all businesses, because that one business is profiting at the expense of everyone else. Business or banking experience does not generalize to good policy.

(Update:) But it's not just the administration that is to blame. The trade law that the administration applies specifies that tariffs are to be imposed if  domestic companies are hurt by imports. That's an absurd blatantly protectionist standard. We have relied for years on the trust that  administrations would not be so stupid as to actually enforce the law as written."Well, if one comes along that is, perhaps it's time to rewrite the law. If the law said only that tariffs are imposed if american consumers are hurt by imports, or even the american economy as a whole is hurt by imports, much of this mischief would go away.

Congress can, and should fix this. Perhaps as with DACA, the Trump Administration actually executing the law as written by Congress will spur Congress to fix its absurd law. Get rid of the Jones act (all shipments to/from American ports on US built, operated, and staffed ships) while you're at it.

The Wall and infrastructure

A deal seems to be emerging, one that I advanced almost as a joke at faculty lunches. But it may happen. Give him his Wall, and get pretty much whatever you want in return.

From Trump's immigration offer
White House floated a proposal on Capitol Hill late Thursday that would offer legalization and a path to citizenship for some 800,000 so-called Dreamers in return for funding for President Trump’s wall at the Mexico-U.S. border and other changes to U.S. immigration law.
And arguments for taking the offer. From William A. Galston (One of WSJ's liberals)
In all, only 37% of Americans think adding a substantially expanded wall on the southern border is a good idea. But we have reached a point at which the sentiments of the majority are politically secondary. It is unimaginable that Mr. Trump will break faith with his supporters on this matter. Any deal, broad or narrow, will have to acknowledge this reality.
My view on this: 

Yes, the Wall is a bad idea on just about every policy-wonky (that's me) metric. What is it supposed to do? I guess, raise the wages of low-skilled american workers who compete with the kinds of immigrants who would cross a desert on foot illegally, and improve security, blocking the wave of Islamic terrorists who fly to Mexico, cross the border on foot, and stop to pick vegetables for a few years on the way to bombing things.  If you're worried about security, we currently spend $13 billion per year on border patrol, and $6 billion on the entire FBI. Another $25 billion on the border does not seem the crying need. (Though the FBI does seem to have time on its hands lately.) On either grounds, the wall is a colossal cost-benefit waste. 

But that is not the point. As Galston points out, the Wall is symbolic. President Trump campaigned on it, and wants very much to deliver some symbolic gesture to his supporters to say "I'm building the wall." Congressional democrats, centrist and never-Trump republicans can get pretty much whatever they want on policy if they will let the man have his symbolic victory. 

So that is the question for our time: Can our politicians let the other side have a purely symbolic victory, in exchange for a large policy victory? Or is denying the President a symbolic victory so important that no quiet policy victory is worth the price? 

My main new thought on this, which encourages me to agree with Galston -- take the deal -- is this: The Wall will never be built. 

I live in California, in which our governor, 8 years of the Obama administration, and the democratic super-marjority in the state legislature, has been devoted to building a high speed train. To my mind, it is a boondoggle equal to the wall, but ignore that -- the entire political power structure in California and the Federal government has been behind this thing for 10 years. And yet not one mile of the line yet exists. It took the Union pacific 4 years to build the transcontinental railroad from Sacramento to Utah, over the Donner pass, by hand. 

Such is infrastructure in the US today.

Can you imagine what will happen with the Wall, even if Congress appropriates $25 billion? It will instantly be in court. Start with environmental challenges. It will of course interrupt the migration path of the Eastern Arizona accelerati incredibilus. It will disrupt holy native lands and archeological sites. Mexicans are largely catholic, so suits will claim the wall is religious discrimination. Heck, infrastructure has to pass cost benefit tests, and good luck with that one.  The contracting was improperly done. State attorney generals busy suing the Trump administration will quickly add to this one.

As with solar cells, as with the second avenue subway, as with the high speed train, as with the Keystone pipeline, good luck building any infrastructure in America today -- and especially good luck building one that makes little sense and is a highly politicized hot potato.

If they gave the President all he wanted, tomorrow, this thing would not be out of court for decades, long after a democratic congress or administration kills it.

They can afford to give him a symbolic victory. If, well, they decide that they can afford politically to give him a symbolic victory. For that is all it will ever be. And frankly, even $25 billion of waste to fix immigration would not be a bad tradeoff. The waste to our country in the current immigration system is on the back of my envelope orders of magnitude greater than that.

Looking forward to infrastructure. 

As reported in the Wall Street Journal
U.S. Chamber of Commerce President Thomas Donohue last week was nearing the end of a speech urging Congress to rebuild the nation’s infrastructure when he offered another option: At least make it easier to build things when the money can be found.
“If we just fix the permitting thing this year, you would create an extraordinary enthusiasm about moving forward,” Mr. Donohue said,  
...Mr. Trump and his aides have cited studies suggesting that environmental review can often take a decade,  
 A Government Accountability Office study of the environmental review process in 2014 cited third-party estimates that reviews average 4.6 years. Outside experts say actual review times vary widely based on the scope of a project and other environmental factors.
If the average review time for, I guess, building a freeway cloverleaf, is 4.6 years, and often takes a decade, this makes my point -- don't worry about the wall!

The point of the article was that the Administration would like this to be reduced to two years. Good luck with that. The other point of the article is environmental groups lining up to fight any streamlining of the permitting process. Strategic delay rather than policy outcome is vital to them, apparently.

But the administration is right. If infrastructure is going to be built in the US, it strikes me that reforming the process for building infrastructure is the key. If home zoning and inspection requirements double the cost of residential solar cells, if prevailing wage, union work rules, and a hundred other impediments mean that subways cost billions of dollars per mile, many multiples of what they cost in France let alone China, and if permits take decades, and billions more of consultant and legal work, our problem with infrastructure is not finding the money to pay for it.

In the meantime, I offer a final suggestion to the Trump team: Offer to build a high speed train along the border instead! Just forget to put in any crossings.

(Update: I am just now reminded by a story on NPR that President Trump had, as a candidate, suggested coating the wall in solar cells. Truth is stranger than fiction.)

Friday, January 12, 2018

Right answer, wrong reason

Sometimes it is not good to get to the right answer for the wrong reasons. This thought comes to mind reading to recent WSJ articles, Walmart raises wages and Tax reform releases the bulls.
"Wal-Mart Stores Inc. said it would raise starting hourly pay to $11 for all its U.S. employees and distribute one-time bonuses, doling out some of the windfall it expects from the U.S. tax overhaul as it competes for store workers in a tight labor market." 
"Only 15 market days have passed since the Senate passed the tax bill, ensuring it would become law, and Wall Street analysts have already upgraded their consensus forward earnings for the S&P 500 by an unprecedented 4.6%. Is it any wonder that stocks have rallied?"
Two narratives compete for how corporate tax cuts might spur the economy: cashflows vs. incentives.  Washington and most pundits like to talk about cashflows, "trickle-down" if you will. Corporations (existing, large) don't have to give so much money to the government. So perhaps they will benevolently pass it on to their workers -- or perhaps political pressure is important to force them to this magnanimity.

Economists see the world through incentives. In this narrative, a lower corporate tax rate increases the incentive to invest, broadly construed -- to buy new investment goods, sure, but also to invest in worker skills, organizational improvements, new opportunities, and for new companies to spring up. That investment raises the productivity of labor and hence demand for labor. Competing to hire good workers, companies drive up wages. But companies no more voluntarily give workers bonuses out of extra cash than they voluntarily send money to the electric company on top of the bill.

National Fellows

Are you a young economist or other professor, and would you like to spend a year at Stanford with no teaching? The Hoover National Fellows program may be for you. Information and application instructions here. It's ideal for someone from a few years after PhD to a few years after tenure who wants a break to bring a research project to fruition.  Hoover prefers research with policy implications and people who will benefit from and contribute to the intellectual environment here.  Applications due Jan 30.

Tuesday, January 2, 2018

Property tax update

Every now again in writing a blog one puts down an idea that is not only wrong, but pretty obviously wrong if one had stopped to think about 10 minutes about it. So it is with the idea I floated on my last post that property taxes are progressive.

Morris Davis sends along the following data from the current population survey.

No, Martha (John) property taxes are not progressive, and they're not even flat, and not even in California where there is such a thing as a $10 million dollar house. (In other states you might be pressed to spend that much money even if you could.) People with lower incomes spend a larger fraction of income on housing, and so pay more property taxes as a function of income. Mo says this fact is not commonly recognized when assessing the progressivity of taxes.

SALT margins

I think most of the debate misses an important point about the state and local tax deduction -- incentives.

Suppose you are in the top, (roughly) 40% marginal federal tax bracket.  If you pay an extra $100 in state taxes, you deduct $100 from income, and pay $40 less in federal taxes. So, you really only pay $60 in state taxes. The federal government effectively transfers $40 to the state from taxpayers in other states.

That's a big incentive to raise money as deductible taxes from high-bracket tax payers! This incentive doesn't work if the state raises taxes from lower bracket taxpayers.

California's tax system, for example, seems to respond heartily to this incentive. California's income tax rate is highly progressive, topping out at 13.3%.  As reported in the Sacramento Bee
Nearly 90 percent of the money [income tax receipts]  comes from one-fifth of the taxpayers – those making $91,000...Forty-five percent of the state’s income tax money comes from the top 1 percent of filers – those with adjusted gross income of at least $501,000.
and, therefore, in the highest Federal tax bracket, and also likely to itemize deductions.

Friday, December 29, 2017


Thank you and happy new year to all my readers and commenters.

JCT distribution tables

Courtesy Greg Mankiw, the Joint Committee on Taxation distributional analysis of the new tax law.

Bottom line: No change. Income categories are paying almost exactly the same share of federal taxes as before. Millionaires actually pay a tiny bit larger share in the new bill.

Given the distributional hue and cry, frankly, it is a surprise to me just how tiny -- far below measurement errors -- the changes are.

One can argue whether this is the "right" measure of progressivity or redistribution, whether a tax cut should include a change in which income categories pay what share. But it summarizes the facts, which are stubborn things. Shares of federal taxes paid by income groups do not change. Millionaires get bigger dollar tax cuts exactly to the extent that they pay higher taxes. Period.

Note to those outside the beltway: The Joint Committee on Taxation is the committee set up by Congress to evaluate tax policy. Most criticism I've seen of its calculations lately come from the right.

MR wisdom

Best sentence award:
"It will not escape notice that New York buys subway construction the way all of America buys health care."
-Alex Tabarrok, Marginal Revolution, covering an excellent New York Times article on why subway construction in New York is so insanely expensive.

France -- supposedly bureaucratic, dirigiste, labor-protected France -- builds subways and high speed trains for far less than we pay. Something about the US government makes us singularly inefficient in public expenditures. Don't expect the French health care model to cost the same here either.

A prime candidate, in my view, is the US habit of federal financing plus state and local decision making. Local politicians who are spending national taxpayer money have very little incentive to reduce costs.

Thursday, December 28, 2017

Economists as Public Intellectuals

I ran across a video by my former Chicago Booth colleague Austan Goolsbee that prompts some reflection on the role of economists as public intellectuals. (In addition to my gentle scolding of Greg Mankiw in the last post.)

"Hi, I'm an actual economist (MIT PhD degree shown) 
and I promise you 
Donald Trump's tax plan is a scam. ... 
This tax cut was designed to help Johnny Marshmallow (Billionaire, with monopoly man image) ... 
President Trump believes that if you give more money to big corporations and billionaires that money will trickle down to you..."
Let us analyze the rhetoric of these amazing sentences carefully. 
"I'm an actual economist (MIT PhD degree shown)" 
This is an argument by authority, by credentialism. He, Austan, has a PhD from a Big Name institution. What follows is therefore a result of that special knowledge, that special insight, that special training, that actual economists have. He doesn't have to offer logic or fact, which you won't understand, and you aren't allowed to argue back with logic or fact, unless perhaps you too have a Big Name PhD.  What follows isn't just going to be Austan's personal opinions, it inherits the aura of the whole discipline. By implication, anyone who disagrees isn't an "actual economist."
"Donald Trump's tax plan is a scam"
This are the most interesting 7 words.

Mankiw on endowment taxes

Greg Mankiw wrote a New York Times column December 24 criticizing the university endowment tax. I disagree, not so much with the wisdom of the tax, but with the wisdom of writing such an article.

The tax is small -- 1.4% of endowment income. So if $100 of endowment earns 10%, or $10 of income, the university pays 14 cents. Still, with $38 billion of endowment like Harvard's, or $22 billion like Stanford's that adds up to some real money.

Greg writes that it is "hard to justify this policy." Universities invest in "human capital, which means educating our labor force" and "the knowledge that flows from basic research." Mainly, though, Greg's against the tax because the few elite universities with more than $500,000 endowment per student, (unlike the community colleges and state schools that actually do train the labor force)
"use their resources [to offer] need-blind, full-need admissions...."
"At Princeton [$24 billion] about 60 percent of undergraduates get financial aid. This aid covers the entire cost of tuition, room and board for students from families with income below $65,000 a year."
In sum, Greg feels that universities provide a public good, of refraining from charging tuition for low-income students, so should retain this subsidy. And subsidy it is. While I think all capital taxes should be zero for everyone, given that everyone else pays capital taxes, the fact that universities can borrow at tax-free rates, accept tax-exempt gifts, put the money into endowments which are run like funds-of-funds, hiring high-priced managers to send money to high-priced managers of hedge funds, private equity, venture capital, and real estate, and pay no tax on dividends, interest, capital gains, ever, amounts to quite a subsidy relative to everyone else. And it comes out of taxes that universities do not pay, which means everyone else pays more.

Lower rates, broaden base?

Does not every claimant on the public purse, anxious to preserve a tax deduction, claim that they provide a public good? The home builders, the mortgage bankers, and the real estate agents went apoplectic over limiting the deductibility of home mortgage interest. Because it was going to destroy the American Dream of Homeownership. Because building home equity is the tried and true, well, "engine of economic growth for the middle class!" Farmers demand agricultural subsidies to defend their storied way of life. Why, without the Family Farm, the fabric of American society is lost! The bankers demand immense leverage, deductibility of corporate interest, and a range of anti-competitive regulation because otherwise, who will lend to the middle class!  The solar cell and electric car manufacturers want tax credits and subsidies because they're saving the planet. And on we go.

Conservative, "Republican," free-market principles used to be to advocate for lower marginal tax rates, and a broader base, in which everyone gives up their little deduction or subsidy. (I use "Republican" as Greg uses it, so don't go all nuts in the comments about Republican failings to live up to these ideals.)

How can we credibly proclaim that we, universities, provide the true public good and deserve subsidies, but the rest of you get lost? Do we not look just a little hypocritical if when a tax reform is announced, we jump in line with the rest of them to demand our pork back?

Wednesday, December 27, 2017

Response to Williamson on taxes

Steve Williamson has an interesting new post on corporate taxes and investment, in which he claims that taxing corporate profits has no effect on investment.
What happens if the corporate tax rate goes up permanently, with the tax rate constant forever...? This has no effect on investment or on the firm's hiring decisions in any period. That is, if VB is before tax profits, then (1-t)VB = V, so maximizing VB is the same as maximizing V, and the tax rate is irrelevant, not only for investment decisions, but for the firm's hiring decision. In the aggregate, there is no effect on labor demand, and therefore no effect on wages. 
Basically, investment is an intertemporal decision for the firm. But the corporate tax rate affects per-period after-tax profits in exactly the same way in every period, so there is no effect on the after tax rate of return on investment the firm is facing. Therefore, the firm won't invest more with a lower corporate tax rate ...
Steve concludes
But, the tax bill is not about investment. The primary effect is redistribution. In the short run, the tax bill makes the rich richer and the poor poorer...
You can see there is a problem. If Steve is right, then why not a 99.999% capital tax rate? Per Steve, it won't distort any decisions, neither investment nor hiring nor starting companies, it will give a revenue bonanza for the government and it will transfer income efficiently. Surely if 99.999% corporate taxes had no disincentive effects, governments would have noticed? Surely not every single Republican is, as Steve implicitly charges, either lying through his teeth or an economic ignoramus when they state the goal of the tax cut is to spur investment, and thereby productivity and wages?

The Fiscal Theory of Monetary Policy

"Stepping on a Rake: the Fiscal Theory of Monetary Policy" is new paper, just published in the European Economic Review. This link gets you free access, but just for the next few days. After that, I can only post the last manuscript. (I held off sending this hoping the EER would fix the figure placement in the html version, but that didn't happen.)

The paper is about how the fiscal theory of the price level can describe monetary policy. Even without monetary, pricing, or financial frictions, the central bank can fix interest rates. In the presence of long-term debt higher interest rates lead to lower inflation for a while. Interest rate targets, forward guidance, and quantitative easing all work by the same mechanism. The paper also derives Chris Sims' "stepping on a rake" paper which makes that point, and integrates fiscal theory with a detailed new Keynesian model in continuous time.

Tuesday, December 26, 2017

The Buyback Fallacy

Many commenters on the tax bill repeat the worry that companies will just use tax savings to pay dividends or buy back shares rather than make new investments.

Savannah Guthrie, interviewing Paul Ryan on the Today Show, thought she had a real gotcha with
"What they [CEOS] are planning to do is stock buybacks, to line the pockets of shareholders."
(She then moved on to a question most guaranteed to produce retweets of partisan admirers, and least likely to produce an interesting answer,
"I'll ask you plainly, are you living in a fantasy world?"
NBC then wonders that it is charged with partisan bias.)

Peggy Noonan, in an otherwise thoughtful column, echoed the same worry:
"Big corporations can take the gift of the tax cut ... and do superficial, pleasing public relations sort of things, while really focusing on buying back stock and upping shareholder profits."
(Just how taking less of your money is a "gift" is a question for another day.)

So, having established that this is a bipartisan worry, let's put the fallacy to bed. It is the fallacy of composition, that actions of one company mirror actions of the economy as a whole. It is the fallacy of "paper investments" vs. "real investments." That distinction can apply to a company, but not to the whole economy.

What corporate cash is not. 
No, companies do not sit on vast swimming pools of gold coins, like Scrooge McDuck. One company's "cash" is a short term loan to another company, which the latter uses it to make real investments. Every asset (paper) is also a liability, backed by an investment. The charge fails to track the money.  One of the few things economists know how to do is always to ask, "OK, and then what do they do with the money?" Money is a veil, and real decisions are (to first order) independent of financial decisions. (I use italics to suggest some ways to remember these basic economic ideas.)