## Thursday, January 22, 2015

### Autopsy -- the Op-Ed

This was an Op-Ed in the Wall Street Journal December 22 2014. WSJ asks me not to post them for a month, so here it is now. I was trying for something upbeat, and to counter a recent spate of opeds on how ISLM is a great success and winning the war of ideas.

An Autopsy for the Keynesians

 Source: Wall Street Journal
This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

U.K. Chancellor of the Exchequer George Osborne wrote in these pages Dec. 14 that Keynesians wanting more spending and more borrowing “were wrong in the recovery, and they are wrong now.” The land of John Maynard Keynes and Adam Smith is going with Smith.

Why? In part, because even in economics, you can’t be wrong too many times in a row.

## Tuesday, January 13, 2015

### Asset Pricing Mooc

The new and improved online version of my PhD class "Asset Pricing Part 1" will open for business January 18.

You can learn more about the class and sign up for it on the Coursera website here. (Part 2, which follows this spring is here. Part 1 and 2 will be completely separate Coursera classes, so take what you want.)

The videos and quizzes have been useful for people who are not "taking" the class, or as supplementary materials for people teaching regular classes. I taught my PhD class by asking the students to watch the videos before coming to class, which allowed a higher level discussion. Feel free to use these resources any way you wish!

While we're at it, I maintain a section of my research website with extra materials for people using the Asset Pricing book in classes, here, and my teaching materials from MBA and PhD classes are here

To whet your appetite, here is the syllabus from the two classes.

Part 1 syllabus:
• Week 1: Stochastic Calculus Introduction and Review. dz, dt and all that.
• Week 2: Introduction and Overview. Challenging Facts and Basic Consumption-Based Model.
• Week 3:
• Classic issues in Finance
• Equilibrium, Contingent Claims, Risk-Neutral Probabilities.
• Week 4: State-Space Representation, Risk Sharing, Aggregation, Existence of a Discount Factor.
• Week 5: Mean-Variance Frontier, Beta Representations, Conditioning Information.
• Week 6: Factor Pricing Models -- CAPM, ICAPM and APT.
• Week 7: Econometrics of Asset Pricing and GMM.
• Final Exam
Part 2 syllabus:
• Week 1: Factor pricing models in action
• The Fama and French model
• Fund and performance evaluation.
• Week 2: Time series predictability, volatilty and bubbles.
• Week 3: Equity premium, macroeconomics and asset pricing.
• Week 4: Option Pricing.
• Week 5: Term structure models and facts.
• Week 6: Portfolio Theory.
• Final Exam

## Thursday, January 8, 2015

### Deflating Deflationary Fears

 Source: Charles Plosser
From a nice paper by Charles Plosser with that catchy title.  Yes, it's 10 years old, but the lesson is appropriate in today's hysteria. That dreaded deflationary spiral is always just around the corner.

## Wednesday, January 7, 2015

### Piketty Facts

Most Piketty commentary (like the Deridre McCloskey review I blogged earlier) focuses on the theory, r>g, and so on. After all, that's easy and you don't have to read hundreds of pages.

"Challenging the Empirical Contribution of Thomas Piketty's Capital in the 21st Century" by Phillip W. Magness and Robert P. Murphy is one of the first deep reviews of the facts that I have seen. I haven't read it yet, but the abstract looks promising:
Thomas Piketty's Capital in the 21st Century has been widely debated on theoretical grounds, yet continues to attract acclaim for its historically-infused data analysis. In this study we conduct a closer scrutiny of Piketty's empirics than has appeared thus far, focusing upon his treatment of the United States. We find evidence of pervasive errors of historical fact, opaque methodological choices, and the cherry-picking of sources to construct favorable patterns from ambiguous data. Additional evidence suggests that Piketty used a highly distortive data assumption from the Soviet Union to accentuate one of his main historical claims about global “capitalism” in the 20th century. Taken together, these problems suggest that Piketty’s highly praised and historically-driven empirical work may actually be the book’s greatest weakness.
Comments on the paper welcome. If I get a chance to read it I'll post some.

### Time use of the non-employed

 Source: New York Times
The decline in labor force participation means that a larger and larger fraction of the population, including many prime-age men, are not working and not actively looking for work.

What do they do all day? The New York Times has a lovely article answering that question.

I took a screenshot at left to advertise the post, but go to the Times where the graph is interactive.

Next question, where does the money come from?

Understanding the lives of people in this predicament seems to me a useful step to understanding the big decline in participation.

## Tuesday, January 6, 2015

### Strange Bedfellows

Jeff Sachs has written a very interesting Project Syndicate piece on Keynesian economics. It's phrased as a critique of Paul Krugman, but his message applies much more broadly. Krugman was mostly articulating fairly standard views on stimulus, "austerity'' and so forth. (We need a better word than "Keynesian'' for what Jeff calls "crude aggregate-demand management.'' But I don't have one handy.)

This is a good example for people outside economics (and quite a few inside) who think all economists line up on an easy right-left divide. If you expected Sachs to support the standard Keynesian consensus because he's "liberal," or to use his words, in favor of "progressive economics," you would be wrong. He looks at the facts, the forecasts, and the Krugman's curious rewriting of history in a "victory lap," and comes to his own conclusions.

Needless to say, I'm happy to find someone else making many of the basic points in my
Autopsy for Keynesian Economics (ungated version). I'm even more happy that someone of a "progressive" political orientation comes to the same conclusions that I do from a more libertarian orientation.  I'll be curious to see if Sachs comes in for the same sort of venomous personal attacks -- with essentially no attempt to argue the content -- as my piece attracted from the politicized lefty economics blogosphere. Do they treat "friends" more nicely, or "traitors" more harshly? We'll see.

On infrastructure, Sachs writes
To be clear, I believe that we do need more government spending as a share of GDP – for education, infrastructure, low-carbon energy, research and development, and family benefits for low-income families. But we should pay for this through higher taxes on high incomes and high net worth, a carbon tax, and future tolls collected on new infrastructure. We need the liberal conscience, but without the chronic budget deficits.
Here too, we can almost agree. We can agree on the principle that infrastructure spending is important, and should be evaluated on the basis whether its benefits exceed its costs, not on the "stimulative" powers of its spending. Then we can go back to evaluating whether all of these particular investments have benefits greater than costs, and whether those particular taxes merit their distortions.

## Monday, January 5, 2015

### Carbon Tax or Carbon Rights?

Larry Summers has a very nice Financial Times oped, "Let this be the year when we put a proper price on carbon" Greg Mankiw has also written extensively and eloquently in favor of a carbon tax, for example here.  Jeff Miron has some interesting skeptical thoughts, recently here.

I agree in principle.  But I have some important qualifications, and some suggestions for framing to broaden the appeal of the proposal substantially. I also think that individual rights may be better than a tax. What matters, really, is a carbon price, and there are different ways to bring that about.

## Saturday, January 3, 2015

### Interest-paying money is not inflationary

(With credible fiscal policy, of course.)  Another interesting case, from JP Koning's Blog "Moneyness"

RBNZ decided to 'flood' the system with balances to make things more fluid. This involved conducting open market purchases that bloated the monetary base (comprised of currency plus deposits) from around NZ$6 billion in mid-2006 to just under NZ$14 billion by December of that year. See chart below.
(Note that the RBNZ's problems began far before the credit crisis and were due entirely to the peculiar structure of the clearing system, not New Zealand's economy.)

Koning describes the lack of inflation as a result of the perceived "permanence" of the increased reserves. I think it comes from the fact that reserves pay interest -- as they do in New Zealand. Either way, the point is that banks and people are happy to sit on interest-paying money, in enormous quantities, just as they are on bonds.

### More Cash and Zero Bound

In my last post I started thinking about how options other than currency enforce a zero bound. Imagine there is no more currency, and the Fed tries to impose -5% interest rates. You put in a dollar, you get out 95 cents. What other ways are there to guarantee that if you put in a dollar you get back a dollar? (In my last post, I also pointed out that in each case rules or laws could be changed, but that the magintude of the required changes was pretty big.)

From Kenneth Garbade and Jamie McAndrews in a nice Liberty Street Economics blog post

• Certified check. Go to the bank, tell the bank to write you a \$10,000 certified check. Put it in your sock drawer. (More: "Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees.")
Or, inspired by that:

• Don't cash checks. Every 90 days, call up, say you lost the check, ask them to reissue it.
Clumsy. But as Ken and Jamie point out, it's very easy for a company to get started that does this, and offer fixed-value accounts to clients, beating the -5% at banks. Or, even in today's super-regulated environment, maybe banks could figure out to do this. After all, the Medici figured out in the 1400s to write offsetting bills of exchange to synthesize interest.

So, the project will mean changing the rules and laws governing checks, going back hundreds of years.

An earlier post by Todd Keister:

• Money market mutual funds.
Currently money market funds promise fixed value, and pay positive interest.  They are not set up to charge negative interest, or to allow capital losses. Maybe they should -- I've argued for floating NAV -- but they don't. The Fed kept the 0.25% rate on reserves precisely so banks and money market funds didn't have to reinvent themselves in ways that allow capital losses or negative rates.

Miles Kimball has also been writing in favor of negative nominal rates and thinking about the zero bound. One post is here

## Tuesday, December 30, 2014

### Cancel currency?

Ken Rogoff has  an interesting NBER Working paper "Costs and Benefits to Phasing Out Paper Currency."

Ken would like to get rid of paper currency in favor of all electronic transactions. I'm a big fan of low-cost electronic transactions using interest-paying electronic money. But I'm not ready to give up cash.

Ken has two basic points: The zero bound, and tax evasion / illegal economy.

### Ruble Trouble

On Russia, the fall of the Ruble.

This is an interesting event on which to test out our various frameworks for thinking about macroeconomics and monetary economics.

Theories

There are three basic perspectives on exchange rates.

1. Multiple equilibria. Lots of words are used here, "speculative attacks," "sudden stops," "hot money," "self-confirming equilibria" "self-fulfilling prophecies" "contagion" and so on. Basically, the exchange rate can go up or down on the whims of traders. There is often some news sparking or coordinating the bust.  Some of the mechanism is like bank runs, pointing to "illiquidity" rather than "insolvency" as the basic problem.

This has been a dominant paradigm since the early 1990s. I've been a bit suspicious both on the nebulousness of the economics (lots of buzzwords are always a bad sign), and since the analysis seems a bit reverse engineered to justify capital controls, currency controls, (i.e. expropriation of middle-class savers and poor currency-holders), IMF rescues, and lots of nannying by self-important institutions and their advisers who will monitor "imbalances," "control" who can buy or sell what, and so forth. But models are models and facts are facts.

2. Monetary. Exchange rates come from monetary events, and primarily the actions of central banks. For example, much of the analysis of the dollar strengthening relative to euro and yen attributes it to the idea that the US Fed has stopped QE and will soon raise rates, while the ECB and Japan seem about to start QE and keep rates low.

3. Fiscal theory. Exchange rates come fundamentally from expectations of future fiscal balance of governments; whether the governments will be able and willing to pay off their debts. If people see inflation or default coming, they bail out of the currency, which sends the price of the currency down. Inflation follows; immediately in the price of traded goods, more slowly in others.

Craig Burnside, Marty Eichenbaum and Sergio Rebelo's sequence of papers on currency crises, starting with  JPE "Prospecitve Deficits and the Asian Currency Crisis" (ungated drafts here) was big in my thinking on these issues. They showed how each crisis involved a big claim on future government deficits.  Prices fall, banks get in trouble, governments will bail out banks, so governments will be in trouble.  Inflation lowers real salaries of government workers. And so on.

The "future" part is important. Earlier work on crises noticed that current debts or deficits were seldom large, governments in crises often had surprisingly large foreign currency reserves, and there were no signs of sudden monetary loosening.  This earlier absence of a cause problem had led to much of the multiple-equilibrium literature. But money is like stock, and its value today depends on future "fundamentals."

Monetary and fiscal views are related. The question really is whether the central bank can stop an inflation and currency collapse by force of will, or whether it will have to cave in to fiscal pressures.

Most basically, a currency, like any asset, has a "fundamental" value, like a present value of dividends; it may have a "liquidity" value, like money; and it may have a "sunspot" or "multiple equilibrium value." The question is, which component is really at work in an event like this one -- or, realistically, how much of each? The money and fiscal views also much more clearly bring the currency into the picture.

So, as I read the stories of Russia's troubles, I'm thinking about which broad category of ideas best helps me to digest it. You can guess which one I think fits best. Yes, everyone likes to read the paper and see how it proves they were right all along. But at least being able to do that is the first step.

## Monday, December 22, 2014

### Inequality at WSJ -- the oped

This is a Wall Street Journal oped on inequality. With 30 days passed, I can post it here. It's a much edited version of my evolving "Why and How we Care About Inequality" essay.

What the ‘Inequality’ Warriors Really Want

Progressives decry inequality as the world’s most pressing economic problem. In its name, they urge much greater income and wealth taxation, especially of the reviled top 1% of earners, along with more government spending and controls—higher minimum wages, “living” wages, comparable worth directives, CEO pay caps, etc.

Inequality may be a symptom of economic problems. But why is inequality itself an economic problem? If some get rich and others get richer, who cares? If we all become poor equally, is that not a problem? Why not fix policies and problems that make it harder to earn more?

## Sunday, December 21, 2014

### Autopsy

Autopsy for Keynesian Economics. (I don't get to pick the titles BTW) A Wall Street Journal Oped. I'm trying for something cheery at Christmas, and a response to the many recent opeds that ISLM is just great and winning the battle of ideas.  As usual, the whole thing will be here in a month.
This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.
No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

Update: Hoover has an ungated version here;  Cato has an ungated version here.

## Saturday, December 20, 2014

Commenter Zack sent the following Paul Krugman links and quotes, which deserve promotion from the comments section.

"But deflation is a huge risk — and getting out of a deflationary trap is very, very hard. We truly are flirting with disaster."

"So we're really heading into Japanese-style deflation territory"
http://krugman.blogs.nytimes.com/2009/07/02/smells-like-deflation/

"So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend." http://krugman.blogs.nytimes.com/2009/01/10/risks-of-deflation-wonkish-but-important/

"But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising."
http://www.nytimes.com/2009/05/04/opinion/04krugman.html

"What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others."
http://krugman.blogs.nytimes.com/2010/07/11/trending-toward-deflation/

"Worst of all is the possibility that the economy will, as it did in the ’30s, end up stuck in a prolonged deflationary trap."

As we know, it didn't turn out that way. We have had positive inflation for 6 years.

Why does this matter? Normally, it doesn't and it shouldn't.

## Thursday, December 18, 2014

### Real or risk-neutral wolf?

Today's Torsten Slok chart. In yesterday's chart, we saw that the market forward curve keeps forecasting a recovery that never comes. Here, we see the same pattern, over much longer time period, in the survey of professional forecasters. They're always forecasting that interest rates will rise.

I think there are deep lessons from this chart. And not the simple "economists are always wrong," or even "economic forecasts are biased." The chart offers a nice warning about how we interpret surveys.

Expectations matter a lot to modern macroeconomics. But you can't directly see expectations. So many researchers have turned to surveys to measure what people say they "expect." And they find all sorts of weird things. People "expect" stock returns to be implausibly high in booms, and low in busts. Professional forecasters "expect" interest rates always to go up.

The trouble here, I think, is that we have forgotten what "expect" means to the average person.

## Wednesday, December 17, 2014

### 1994?

Torsten Slok at Deutsche Bank sends the graph, along with some musings on the eternal question: When (if?) interest rates rise, will it look like 1994, or like 2004? Will rates rise quickly, leading to a bath in long-term bonds? Or will rates rise slowly and predictability?

The graph shows you actual short term rates (red) and forward curves. As this lovely graph points out, the forward curve has been predicting rises in rates for years now. And it's been wrong over and over again. Economists all over have been forecasting a robust recovery too, and that hasn't happened either.

(To non-finance people: The forward rate is the rate you can lock in today to borrow in the future. So the forward curve ought to reflect where the market expects interest rates to go. If people expect rates to rise more than the forward curve, they rush to lock in now, which drives up the forward curve. Also, the forward curve is a cutoff between making and losing on long-term bonds. If interest rates rise following the forward curve, then long bonds and short bonds give the same return. If rates rise slower, long-term bondholders make more money. If rates rise faster, long bonds make less than short or even lose money. So, should you buy long term bonds? Compare your interest rate forecast to the last dashed line and decide.)

Torsten:
The chart .. makes you humble when it comes to the timing of the first rate hike.
Indeed.
But once the Fed starts hiking, they will likely raise rates faster than the market currently is anticipating. Think about it: The Fed has basically decided that they will only start hiking rates once there are signs of inflation.. If the economy is overheating, then raising the fed funds rate to 0.5% is not going to slow the economy down....To cool the economy down, the fed funds rate needs to be above the neutral fed funds rate, which we estimate to be 3.5%...to get inflation under control, the Fed will likely have to raise rates well above the neutral level, potentially above 5%...
So his scenario is, interest rates low and more good times for long term bonds until (if) inflation substantially exceeds 2%, then a big rout, as small rises will not do much quickly to dampen inflation. More like 1994.

An interesting view into the brains of bond traders:

## Monday, December 15, 2014

### Who is afraid of a little deflation? Op-Ed

This was a Wall Street Journal Op-Ed from a month ago. Now I can post the whole thing in case you missed it then.

Who is Afraid of a Little Deflation?

With European inflation declining to 0.3%, and U.S. inflation slowing, a specter now haunts the Western world. Deflation, the Economist recently proclaimed, is a “pernicious threat” and “the world’s biggest economic problem.” Christine Lagarde , managing director of the International Monetary Fund, called deflation an “ogre” that could “prove disastrous for the recovery.”

True, a sudden, large and sharp collapse in prices, such as occurred in the early 1920s and 1930s, would be a problem: Debtors might fail, some prices and wages might not adjust quickly enough. But these deflations resulted directly from financial panics, when central banks couldn’t or didn’t accommodate a sudden demand for money.

The worry today is a slow slide toward falling prices, maybe 1% to 2% annually, with perpetually near-zero short-term interest rates. This scenario would unfold alongside positive, if sluggish, growth, ample money and low credit spreads, with financial panic long passed. And slight deflation has advantages. Milton Friedman long ago recognized slight deflation as the “optimal” monetary policy, since people and businesses can hold lots of cash without worrying about it losing value. So why do people think deflation, by itself, is a big problem?

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Government Debt Management at the Zero Lower Bound is a very nice and interesting paper by Robin Greenwood, Sam Hanson, Josh Rudolph, and Larry Summers.

 Figure 1. Comparing Quantitative Easing and Treasury Maturity Extension, 2007–2014 ...the cumulative change in 10-year equivalents (scaled as a percentage of GDP) associated with the respective balance sheet policies undertaken by the Federal Reserve and the Treasury. Positive values increase the interest rate risk placed in public hands (Treasury policies), while negative values decrease it (typically Fed QE, but also Treasury maturity shortening in 2008–2009).

First point, what the Fed taketh away, the Treasury giveth. (Hence the title of this post). The Fed bought lots of long-term debt, with the idea that this would raise the price, lower the interest rate on the long-term debt, and thus stimulate the economy.

At the same time, however, the Treasury was selling lots of long-term debt. Interest rates are very low, and debts are high, so it's a great time to lock in low-rate financing. Homeowners and businesses are doing the same thing.

## Thursday, December 11, 2014

### Level, Slope and Curve for Stocks

"The Level, Slope and Curve Factor Model for Stocks" is an interesting and important empirical finance paper by Charles Clarke at the  University of Connecticut.

Charles uses the Fama-French (2008) variables to forecast stock returns, i. e.,  size, book to market, momentum, net issues, accruals, investment, and profitability. $Ret_{i,t+1} = \beta_0 + \beta_1 Size_{i,t} + \beta_2 BtM_{i,t} + \beta_3 Mom_{i,t} + \beta_4 zeroNS_{i,t} + \beta_5 NS_{i,t} + \beta_6 negACC_{i,t} +$ $+ \beta_7 posACC_{i,t} + \beta_8 dAtA_{i,t} + \beta_9 posROE_{i,t} + \beta_{10} negROE_{i,t} + e_{i,t+1}$ He forms 25 portfolios based on the predicted average return from this regression, from high to low expected returns.  Then, he finds the principal components of these 25 portfolio returns.

 Source: Charles Clarke

And the result is... hold your breath... Level, Slope and Curvature! The picture on the left plots the weights and loadings of the first three factors. The x axis are the 25 portfolios, ranked from the one with low average returns to 25 with high average return. The graph represents the weights -- how you combine each portfolio to form each factor in turn -- and also the loadings -- how much each portfolio return moves when the corresponding factor moves by one.

No surprise, the 3 factors explain almost all the variance of the 25 portfolios returns, and the three factors provide a factor pricing model with very low alphas; the APT works.