Thursday, November 27, 2008

We're All Keynesians Again

The whole point of Friedman and Schwarts' book was to blame the Great Depression on poor monetary management by the Federal Reserve.  Free markets work, without crisis, if only the government can not ruin everything.

Well, it looks like the pair provided necessary, rather than sufficient, conditions for avoiding the chaos resulting from massive deleveraging.  Substantial losses in asset values destroyed bank balances leading to a crisis in solvency, and a consequent loss in financial sector trust.  We don't have the liquidity problems that were present in the Depression--the Fed got that right this time--but it looks like the problems in both time periods are related to all sorts of other stuff.  As consumers get out of debt, they decide they want to retire with something, and stop spending, and then the economy crashes.  

This is a straightforward Keynesian stimulus that shouldn't be necessary anymore.  Cowen makes the argument that a fiscal expansion didn't help in the last Depression, but that's because FDR hampered his own stimulus with higher taxes.  I think it's hard to get away from the stimulus plans of Krugman and Larry "never saw a stimulas plan he didn't like" Summers.  

Wednesday, November 26, 2008

Send in Rainbow Six

Looks like my grandfather could be right in predicting that the Mumbai terrorists came from Pakistan via boats.  This was a pretty sophisticated attack, in line with LeT's growing reach.  The stated goal was to scuttle peace talks, but there's another pretty clear goal in terms of the coming elections in six states, most of which are a close BJP-Congress lineup.  The worst impact could be in Delhi, where, despite the fact that Sheila Dixit is surprisingly popular and competent, the UPA government has managed to both suffer a string of attacks and damage their Muslim base through suspicious police shootouts.  I think it's tough to imagine this going any other way than seeing the BJP back in office, with Advani as PM and Modi on his heels with a vision of a much more muscular Hindutva agenda.  Hopefully as they stay in power, they become captured by national interests and moderate a bit away from the Sangh Parivar in favor of a broader, conservative agenda that can actually capture half the national vote on a regular basis.  They dropped swadeshi easily enough; hopefully they can go from anti-Muslim to anti-Pakistan or anti-terrorism.  Otherwise there will be more terrorist attacks to come, and not all of them from abroad.  

India will survive.  Meanwhile, the idea of Pakistan is making less and less sense.  There is essentially a Punjabi core and a series of lawless, politically mobilized frontier areas.  Shaukat Aziz, a former Citi executive, did a great job at Finance Minister, but Pakistan has seen growth surges before, and this one looks to be ending the same as the previous ones with institutional collapse (though the lawyers' revolt was surprising and a testament to growing bourgeois sentiment).  They look to be in a serious financial crisis too (who isn't?) while the military state is keeping much of the mess together, and will probably intervene again sooner or later.  As Kaplan points out, Afghanistan and Pakistan are increasingly linked, and Obama has decided to double down in this part of the world.  

Tuesday, November 25, 2008

The State of Value Investing

I've written some stuff on why value investing isn't maybe the best thing in the world, and how Berkshire's S&P 500 equity puts are threatening the company. Felix Salmon makes a really obvious point I wish I thought up about these contracts. The idea is that money is worth different amounts in different periods of time, so by taking the tail risk that things go really bad, Berkshire faces an extraordinary loss: Things go really bad, and Berkshire has to pay out on the contract. And the probability of things going really bad is tough to tell from past data.

This is indicative of a broader issue with Berkshire and value investing. Berkshire the business specializes in taking exactly these sorts of extreme catastrophic risks. Value investing in general specializes in exactly those companies which go under in times of extreme stress. Value stocks do bad in a crisis, and this fact pushes up the premium for these stocks in good times (who wants to own something that is worth so much less exactly when you need money?). Only when there's a crisis do you see--as you do now with United Health, the rail companies, GE, American Express--how bad things can get.

This can still be a smart bet to make. Thomas Sargent has some interesting Bayesian calculations in which different actors share risk. Normal people trade away risk, while other agents take these risks and make out like bandits in good states. But it's a bet that makes use of a broader story: Stock markets are as close to information-efficient as you like, and the whole story of day-to-day fluctuations is driven by differing risk premia. It's very very difficult to make money picking and choosing stocks (More on this later...), but there is a role for smart managers to pick up different sets of risk exposure. In some extreme sense, there is no other way to make sense of investing.

Monday, November 24, 2008

The Coming Credit Failure of the US Government

The big news today is the plan to bail out Citigroup by the FDIC and Treasury. You can read all about this elsewhere. There are some broader points, though, which I haven't seen too much discussion.

There's a big question in my mind why the Citiempire went down to begin with. It's pretty easy to see why Bear Sterns and Lehman fell. Both were borrowing short to lend long with a great deal of leverage, so their entire business model depends on trust. With the stock market as a barometer of that, their tangible value starts being a function of the stock value, and when the stock goes down, people have less trust, so the stock is worth less, and so on. Morgan Stanley and Goldman Sachs avoided these problems by becoming associated with bank deposits which lowered the counterparty risk of dealing with these companies.

AIG's bust is pretty straightforward as well--bad risk managment related to CDOs and credit default swaps caused counterparties to demand huge payments as collateral, which AIG could not provide. Buffett's Berkshire is currently going through similar problems related to their investments in long-long term S&P index puts (who are the buyers?), for which Goldman apparently wants some collateral, and also concerns of losing investment-grade ratings for debt.

Citigroup is a tougher case. On the face of it, they have healthy free cash flows (not as nice as say Banco Santander's, but better than WaMu). Sure, many of their assets are toxic, and it's tough to figure out which ones are, but they certainly have the cash to handle day-to-day transactions in ways the Investment Banks could not. Insured deposits and lines of credit with the Fed give it a much stronger lifeline. Somehow, the crisis in confidence was enough to sink the company.

Brad DeLong's explanation is the best I've heard. Bad distributions on risk models, exploding risk premiums, and general bank concerns sank the company.

(One thing to keep in mind about bad risk modeling is state dependency. That is, money isn't worth as much in different states of the world (which is why no one will buy insurance against nuclear winter). Ideally, this would be a reason for banks to make sure they have enough to survive in times of crisis--as with Rajan's proposal of financial crisis insurance. That proposal is a pretty clever way of making sure banks have capital in times of need, without needing to tie up cash in boom times when agency problems (ie, Chuck Prince) are pushing to make quick cash with that money. Plenty of people call for more regulation in financial markets, seeing it as the same sort of quantity-based good as infrastructure or oil. Banks are very, very good at regulatory arbitrage and regulatory capture, so short of China or India style regulation, there will still be bank crises, and the more interesting stuff is how to design institutions which are incentive-compatible between regulators and banks.)

So it's tough to detail exactly what's wrong with Citibank. The general problem common to all the minor problems, however, relates to the basic structure of the company. Citi was conceived as a "global universal bank" where you go for all banking needs. The critics said that this would lead to all sorts of sprawl and size issues, and they were right. Citi was incapable of judging or handling risks, insulated by the notion that it was a "safe, big" bank. Pandit has tried to keep the broader model alive, but the collapse of his old Hedge Fund under Citi's care shows that it's difficult to integrate many business segments with different risk appetites under one roof. There's a lot of pressure now to sell off Citi into manageable pieces. This is a problem for Citi and also those "Citi-clones"--UBS maybe, perhaps even JPMorgan. Internationally, you have banks like ICICI. Some of these are really too big to fail, and are maybe even solvent. But they face severe management problems.

But whatever the problems with any of the too big to fail banks, the Treasury can print out enough money to keep them afloat longer. How much longer can they keep doing that? With long-term entitlements and debt spending up to tens of trillions, huge deficits and stimulus plans pushing those further, more and more bank guarantees and bailouts, how much longer can the government keep up their credit rating? Right now, they benefit from the flight to safety. Eventually, this will stop, as will continued purchases of Treasuries by foreign governments. Facing higher costs of capital would destroy the financing capacity of the Federal Government to be the ultimate IMF for the American economy, bail out firms, and would crimp monetary and fiscal tools to combat recessions. On top of all the other problems in ensuring normal governance with expensive rather than cheap debt.

Wednesday, November 19, 2008


For what it's worth, I tried one of those websites that gives a psychological profile from your blog, which coincides with my type from elsewhere.  Normally I would say this sort of thing is worthless, but if it returns the same score from different methods at least it's consistent.

Monday, November 17, 2008

The Death of Value Investing and Buy-And-Hold

Two strategies for dealing with investing that have held up over time are value investing and buying and holding.  Value Investors--exemplified by Buffett--buy things that are cheap and high quality (what is everyone else doing?), while the buy-and-hold people say it's useless to time the market or pick winners, and just buy some of everything whenever they can.  

Value Investing has a decent historical track record.  Cheap companies (many ways to measure this, just say their profits are large compared to the market valuation) do tend to perform well over time relative to the universe of picks.  The value mavens, and the field is growing, chalk this up to impatient markets.  

But the world of cheap stocks is cheap for a reason.  These companies are characterized by high leverage, are often cyclical, and have a high probability of going bankrupt.  Buying these companies is equivalent to taking on the risk that the entire economy won't crash, things will get better, and liquidity will flow again.  Which is completely fine; it's just that this risk premia delivers results exactly because of the low probability--perhaps even a probability so low you can't find it in historical data--that things may get really, really bad.  

I think we just saw one of those events.  If you look back at the track record of the value guys, they bought up cheap stuff earlier this decade and wound up doing pretty well.  That makes sense; the economy was in trouble some time ago, but liquidity, rising asset prices, and continued consumer spending propped up the levered, discretionary (cheap) portions of the market.  Then things crashed.  And then the value guys, if anything, were burned worse than most.  They mostly never saw how bad things could get--when your mindset is shaped by the Great Moderation and you think long-term, it's hard to--and so were pitching finance stocks, real estate, construction, even airlines, the whole way down.  It seems likely to me that, rather than being compensated for picking companies that were "psychologically" out of favor, value investors were instead compensated for bearing a "value" risk that paid off during the liquidity boom and hit a "black swan" as that funding died off and the risk embedded in low prices became evident.  

This is a very broad picture and doesn't capture everyone.  If Buffett read financial papers, he would no doubt refer to Piotroski's great paper, which shows that it's possible to discriminate between cheap stocks to find the ones with high quality.  He'd then argue that this the quality comonent matters as much as the cheap part.  I don't have much to say against that; the part of the paper I found most interesting was that within the class of poorly covered companies there are a few gems.  Still, with Buffett down as much as he is (and coming back through deals only he could get) the presence of accounting "quality" seems to cut out exactly when you need it.  

So maybe on a risk-adjusted basis, you can still find some good bargains.  Suppose that you can't.  What's the optimal strategy?  Many people resort to some sort of "buy and hold" idea, based on the historical trend that stocks go up about 10% a year.  Again, as with value investing, you have the problem that though there's a wealth of historical data, your true sample size is something much smaller because shifts in a few macroeconomic variables explain a lot of the changes in overall stock performance (and those variables are very historically contingent on all sorts of things).  Do we expect stocks to grow to infinity?  If the true risk-adjusted interest rate was really large, then a family could simply keep putting money away and grow arbitrarily rich.  Maybe this works for a few people but definitely not everybody.  Presumably embedded global political and economic risks crash wealth to zero every now and then.  Russian, Chinese, and German bonds were very popular about a century ago.  This is another way of saying that the equity premium, measuring the overperfomance of stocks relative to other investments, reflects actual risk which comes out at inopportune times.  

Another approach--interestingly, lining up with what Buffett has long said--is that stocks are like bonds.  That is, their returns are not distributed randomly, but can instead be reasonably predicted considering something like their dividends and price, much like how bonds are priced given their yield.  This makes sense from both a fundamental view--stocks are claims on the profits of a company--and an asset pricing view--the premium that investors are willing to pay for risk depends on broader circumstances.  Cochrane uses this to make the point that price volatility is not that big of a deal.  Another point is that--just as you don't go out and buy "bonds" regardless of the interest rate--you would do better to buy or sell in varying amounts depending on how cheap markets are overall.  Yeah, this is a lot similar to the value investing world.  But there are a few differences--one, you pick entire industries (or the market as a whole), not individual stocks.  Also, you don't depend on psychology for your returns, but rather on understanding risk premia at different times, for different asset classes.  You don't buy and hold "forever," but look at implied yield rates.

Here's what that would look like.  You take some stock of capital and divide it up into different asset types ("things"--real estate, commodities, materials, bonds--international equities by market cap, etc.) and you cycle money in and out of these asset types by judging aggregate valuation levels.  So you would have bought all sorts of equities (many emerging and small) several years ago, then commodities sometime in the last few years, then you would have shorted real estate, then equities (especially foreign), then commodites.  Any analysis you can do helps you make decisions.  Within asset types, you move out of expensive into cheap.  For all asset types, you buy quality.  Risk management is important; you hedge risks, including risks that assets start to move together, and volatility risk (out of the money puts).  

I realize I've just replicated a "hedge fund" but hopefully not all of them behave this way.  For one, a disturbingly large number of them turn out to be not that much into shorts.  The broader idea is that you don't claim any ability to "pick stocks," but rather you exploit different risk premia across different asset classes in a consistent manner.  As far as the individual asset components go, we may be in a world where the prices of many assets starts to link.  But even if you're playing only with one asset, timing long-short opportunities and remaining in quality should help you out.  

I'd have to backtest this with a more systematic approach.  May or may not "beat the market" but should get some returns while being explicit about the risk.  

I don't know why I'm so stupid as to write up every potentially profitable idea I have.  Hopefully no one reads this.  

Sunday, November 16, 2008

Teaching English

High Schools need to teach people few skills.  Give them some degree of numeracy, and teach people how to write.  Math is handled through subfields--Geometry, Algebra, Trigometry--which are fairly well divorced from the quantitative demands of a modern workplace.  Simple estimation, problem solving, data analysis, and computer skills (programming, modeling) seem much more important today, but are generally not taught.  

Writing is handled pretty poorly too.  Many people are very bad at this, even after spending as much as an eight of their total school career in English classes.  How does that happen?

Obviously it's going to be hard to teach people no matter what--especially as they get older, and given the poor quality of American teachers and the state of our knowledge of how people learn.  One thing that doesn't help is conflating "teach people how to write" with "teach people how to analyze literature." 

I've been trying to figure out why we spend thousands of hours on getting kids to understand Shakespeare, when teaching them to write and edit simple prose is so much more useful and also highly underprovided.  As far as I can figure out, this started on the University level in the late 19th century, as the German research model took over.  The justification for keeping disciplines became entirely dependent on research output, so English became a "science" just like any other, focused on textual analysis.  High Schools looked to Colleges for inspiration, and parents figured that as long as kids were reading and writing, they were doing well.  Plus you to satisfy that vague feeling that kids should read some English literature at some point for culture's sake.  

But this English racket doesn't make any sense.  Teaching writing primarily through the lens of literary criticism encourages a particular obscurantic style of writing and focuses on questionable methods of literary analysis at the expense of building basic skills.  If you go around online, you'll find many English teachers frustrated that they can't convey their love of literature to kids.  Tough.  None of them seem to question the whole notion of reading centuries old English literature to teach writing.  Fire the whole lot of them, kill the union, and hire the direct instruction people to improve the writing quality of high schoolers by a few standard deviations.  

Lies my Teacher Told Me

I was always told that getting a liberal arts degree would pay off in the long run in both psychic and monetary rewards.  Who knows about the psychic/intellectual rewards.  But I've always been skeptical about the monetary rewards.  Most data that's available shows that the quant fields--math, finance, econ--do much better than the soft disciplines for the first job (some of the skills premium for postgraduates was probably mispriced because of asset bubbles, excessive leverage, and poor risk models on the finance side--more on this later).  Again, the liberal arts partisans claim that this is unique to your first job, and that the liberal arts majors dominate over time.  This would actually be somewhat odd to see, as most people receive a similar, small annual increase every year regardless of major.  

Well, this is easy enough to check.  The government collects stats on the profile of around 8k graduates 10 years out of graduation.  As the chart shows, the math/quant/sciences dominate the liberal arts guys income-wise.   

Some weird stuff does happen in the distribution of income separated by major, shown left.  Engineers aren't as well represented as you might think at the top bracket given their high mean.  But the social and biological scientists dominate the humanities.  Psychology does abysmally, trailing even Education with .31% claiming an income in excess of $150,000 (2003 Dollars).  At the very least, this is good evidence that the liberal arts are not a great path to riches.  

The better question is whether this reflects knowledge learned in school, or whether majors serve to filter students along measures of intelligence and career preference.  Unfortunately, I can't correct for all potential problems as they don't release the full data, but I can look at some things anyway.  

First-I checked SAT/ACT grade variation by gender.  There's not too much resolution--I only have scored by quartiles, and many are missing---but this data would suggest a higher mean score for males as well as lower variance.  However, this group has already been preselected, so data at the bottom tail is unlikely to be perfectly representative.  Interestingly, this pattern is reversed for GPA: Females dominate the top end of GPA.  However, GPA is not as directly comparable between people, especially given the stark differnences in major choices by gender, and the differences in average GPA by major. Interestingly, given this difference, undergraduate GPA and test scores correlate.  The top quartile on the SAT/ACT had a 3.45 while the bottom received a 3.13. 

I also have SAT/ACT quartile by College Major.  Business majors don't do so great on standardized tests, but obviously make plenty of money.  The quant majors disproportionately pull in the top scorers.  But the Humanities, History, and Psychology do well enough test-wise.  But given another result from this data--that SAT/ACT predicts future income--it's clear that the liberal arts are underperformers in future earnings, taking intellectual ability before College into account.  

This isn't entirely definitive, and I'd like to run some real regressions here.  A big issue is personal preference for career--how much you make is a function of how much you want to work, and what you want to do as much as raw ability before or after College.  And obviously, there's more to college than becoming employable.  I really don't even know how much I could say from this data.  It's not clear what is contribution of a major to earnings outside of personal initiative and intellgience, or even to what degree College gives people skills or labels people as belong to various levels of quality.

Thursday, November 6, 2008

Real America

Here's a county level map of presidential voting in 2004:

Here's a similar map for this election:

Not that much changed, though Obama made incremental progress in many places. Here, however, is where McCain did better than Republicans in 2004. Arizona and Alaska make sense, and of course southern Lousiana lost a lot of black Democrats. But McCain made his pickups almost exclusively in a particular geography--the upland south.

This is a rough breakdown of that region. It's a pretty distinctive part of the South. Slavery was never big here; there is virtually a total complement between this and the following graph.

The share of African-Americans.

Similarly, this is also where Bill Clinton won his votes in the Democrat primary (purple is where he won > 65% of the vote). Hillary Clinton did very well here in those areas as well.

This gets at ethnic breakdown in this area. This is be a bit hard to read, but basically the plurality ethnic group reported to the census here is "American"--these people are Scotch-Irish who predominately identify by nationality. The regions where such groups are numerous map very strongly to those places where McCain/Palin grew the Republican vote share. Household incomes tend to be fairly low, with some of the biggest pockets of isolated poverty anywhere in the country.

Presumably this reflects the impact of adding Palin to the ticket. You have cultural identification by "real Americans," a strong evangelical turnout, and racism, though I suspect Condoleezza Rice or Colin Powell would do well here. Further South, record turnout of black voters pushed Obama's share upwards, while further North, social conservatism, broadly, is a smaller force.

This illustrates the point that the South is both "larger" and "smaller" than people think. The Deep South plantation economy was restricted to the far southern geographies where that was economically viable, while broader southern culture is shared by a larger community of Scotch-Irish that stretches into Ohio and Pennsylvania.

Politically, it doesn't seem to make a lot of sense in retrospect for Republicans to double down on this demographic. One of the post-election quotes from MN governor Pawlenty caught my attention. The original Sam's Club Republican was caught saying that his party needs to focus on attracting women, Hispanics, blacks, and young people. Well. What demographics was your party targeting to begin with?

The young vote doesn't bode well for them, as young people these days are fairly liberal on a range of economic and social issues. Some of this will obviously fade away over time, but the social liberal bit will probably stay; roughly, every generation moves out a step more liberal than the previous one and stays there. The cost of catering to the real Americans is felt in the plummeting support Republicans see among young voters, minority voters, and the educated. Obviously, these groups are pretty large and growing, while whole communities of Rockefeller Republicans are going extinct. The electoral benefits are pretty slim, as the bordering states were Republican anyway. The Republicans faced a very bad fundamental position and were probably going to lose barring some crisis. But McCain's decision to head even further right after winning the Republican nomination, target this crowd through a VP pick, and then run a campaign centered on inconsequential right-wing dogma points and attack ads did little to endear him to the broad swaths of American independents who swing randomly from party to party, and for whom McCain is actually fairly popular. It's enough to make you nostalgic for some Rovian tactics. At least he realized that you need more than half of the population to win, even if hubris over statistically dubious "political realignments" did them in.

Wednesday, November 5, 2008

Why Would You Want This Job?

Those of you who pall around universities are no doubt aware of the insanities of getting a job. Few people really know what they want to do, and so end up following whatever career bubble is big at the moment. Of course, the econ majors look at all sorts of highly unpleasant jobs with mediocre hourly wage. Private Equity is a big job opportunity here, and I think the following quote is priceless:

First Year #1: "Did you hear about the [big foreign bank] presentation yesterday?"
First Year #2: "No."
First Year #1: "This managing director is up in front of the podium answering a question about work-life b
alance someone asked, the junior guys are sitting in chairs on the stage behind him. Fifteen, maybe twenty seconds after the question one of the junior guys literally passes out and falls out of his chair onto the stage. They called the paramedics and everything. It was crazy."
First Year #2: "Is h
e ok?"
First Year #1: "Fine, apparently. Exhaustion. Just got off the plane from London, no sleep for a week because of a deal he was working. Right after the man
aging director just talked about how great the work-life balance is."
First Year #2: "They have a London office? Are they hiring for the Londo
n office?"

I wonder about this in the context of politics sometimes. The benefits of entering politics are obvious; Brooks has some good pieces on the massive ego involved. But, especially today, the costs are also apparent and sometimes you have to wonder why anyone would ever want to deal with certain problems.

Consider the problems facing the US Government. For one, the public debt has topped $10 trillion with no end in sight. This is not quite so horrible compared to other countries, but pretty bad nonetheless. This will be an enormous problem looking forward, as expenditures are headed steady upwards and revenues are so-so.
A huge problem that's going to hit the Obama Administration is something I've worked on a bit in my day job--the upcoming failure of Option ARM loans. These were really some of the worst structured products developed lately; the premise being that you can pay less than a normal loan balance because house prices only go up. Seriously. These people are going to wake up in 2010-2011 with loans resetting, balances well in excess of housing prices at the absolute bottom, and they're going to walk away from their homes in droves.

Below is a picture of the federal budget, and you can really see the impact of GWOT and the sprawling DHS on government spending on the defense side. Obama will most probably find it difficult to meaningfully cut this issue. He's stated that he'd like to add more soldiers, and the Democrat measure of doubling down in Afghanistan will probably be expensive as well, as that country is dying. Some sort of political compromise with the Taliban would probably be cheapest, but would also be hard to sell. It's almost certain that another crisis will emerge in the next four years;
Iran failing, further problems in Iraq (which, really, the US can't reasonably abandon responsibility for), Afghanistan, or ongoing problems in tribal Pakistan. One of the biggest issues with military spending is the unofficial agreement of military branches to split spending in equal ratios among the Air Force, Army, and Navy. This is horrible for all sorts of reasons, as the demands on the Army have never been higher, while there are really no peer competitors against the US Navy or Air Force. It's unlikely that we're going to see another Bill Clinton-style peace dividend.

The cost of health care is also expanding at insane rates. Of course, there are all sorts of great consequences of better health care. But the marginal dollar spent on health care has very little value added. Spending on healthcare varies dramatically around the country, and it's not clear that these variations explain different health outcomes. And, of course, health and lifestyle issues are more important to health than medicine. Doctors are essentially handing out different treatments for the same conditions with little concern for cost or efficiency. The evidence-based medicine movement sounds great, but will probably have little actual impact on lowering costs.

The rising cost of healthcare is leading to one of America's two entitlement problems; the exploding cost of Medicare/Medicaid. Obviously projecting straight-line out might not be the most reasonable estimate, but the government will have to take up more and more of the slack as private and employer insurance markets unravel. These programs alone are tens of trillions in unfunded liabilities; add to that several tens of trillions more for Social Security.

There are really two big ways of restraining health costs--consumer choice (as in Singapore) or government rationing, and Obama has really failed to endorse either. You can read this endorsal of Obama's health care plan, which does have some things going for it. But to imagine that a "technological revolution," or paying for results (which they do in Britain, if I'm not wrong, with the result that doctors game the system) will do anything about the trajectory of health care costs is silly. All sorts of health care systems work in other countries, but the likely path of American health care will likely follow Massachussets--a greater role for the state, more penalties on employers for not providing coverage, and higher costs. Maybe this is about what we should be doing; I just don't want to be the one to figure out how to pay for it. Payroll taxes to pay for social security and health spending is probably the worst way I could imagine to do so.

It's also shaping up how that fleecing the rich bit isn't a great response. It's unlikely to happen soon anyway, the country being in recession and all. But as the Federal Government depends largely on rich people for funding (and especially, post-2003 or so, on capital gains taxes), you have much less revenue when the ranks of the richest are decimated.

So there are long-term and short-term problems. The long-term ones are more severe, but America is perhaps better placed to deal with them than other countries. A culture of entrepreneurship, relatively free markets, etc etc all boost America's productivity with respect to zombie countries like Japan or Italy, which are looking at large swaths of industry which are globally uncompetitive, massive debts, large government involvement in the economy, and of course that looming demographic death spiral combined with xenophobia towards the immigrants that could otherwise save their economy.

The short-term really depends on events in the next four years. In one scenario, the economy dips, but recovers in time for Obama to be hailed as a Democratic tonic to the failed Bush-Kirk policies. In the other, things continue to get worse globally, finance takes its time coming back, and the recovery in the rest of the economy becomes jobless. The cost of foreign crises and domestic bailouts both wrecks the economy while derailing Obama's broader domestic agenda, which was basically premised on the notion that the big thing wrong with the economy was the excessive share of income going to the rich. Another energy crisis is also possible; is there really that much more oil production now than six months ago? Housing remains shot while the option ARM folks default as well.

What can the Federal Reserve possibly do? Interest rates are going to remain low for some time. Boosting the money supply--at a time when there is plenty of money waiting on the sidelines--will encourage further speculative bubbles and lead to an eventual crisis in inflation that can really only be solved by Vockler-style massive rate increases. The impact of interest rates in the upper teens will be not be good on a highly indebted consumer base suffering a bad recessing following a so-so decade, and even if this happens on more of the "upswing" portion of the recession. The European consumer base was never that strong, and at some point American consumers are going to have to start saving if they want to enjoy their (longer and longer) retirements. Where will the recovery come from? Of course, Chinese consumers appear to be using some of that cash they've been saving, and the government there also has plenty of cash, though there's plenty of pessimism in that part of the world too. But much of any sort of surplus sales there generate will presumably flow to corporate profits. After all, the factories are all there; excess rents will just be repatriated as manager compensation. Other emerging markets are facing all sorts of currency and sovereign debt crises, while the commodity producers aren't doing too great.

And once we purge the bubbles out of our system, what sort of "real" substantive employment is going to take place? Who could possibly be hiring in three to four years? Much of the job growth in the last eight years--such as it was--was driven by construction (real estate bubble) or finance (real estate and stock bubble). Of course, infrastructure and alternative energy are always mentioned. I suspect they will turn out to be new government boondoggles that further destroy the budget. William Bernstein makes the point that there's no real economic law that says that technology needs to improve jobs. After cars made horses obsolete, they died off by the millions. It's hard to guagethe demand for American unskilled labor the future, but it's hard to imagine a scenario in which it goes up that much; so presumably that whole sector of the country will kind of stagnate, clinging to their guns and so forth.

Again, a lot of this depends on timing. Best case scenario for Obama: Things start improving by the time 2012 rolls around. That really is a long time; it was hard in the 2002 recession or 1992 bust to think of things improving, but of course they did, because the fundamentals of the American economy were, and are, strong. Of course, neither of those times during a period of global problems and credit issues. But if things don't start to get better, I expect to see ads about the Obama-Kirk economy pull in a wave of populist, social conservatives into office.

Tuesday, November 4, 2008

The Great Depression and Now

There's an interesting pair of articles out there looking at the source of the Great Depression.  The usual Friedman story is that the Federal Reserve cut liquidity at a time when they should have raised the money supply, leading to a wave of bank crashes and other effects.  This interpretation is central to Bernanke's current handling of the crisis. (even though Anna Schwartz, Friedman's collaborator, sees the current crisis as coming from solvency problems, rather than liquidity.  John Cochrane, as well as the rest of the Chicago GSB, would probably agree with that assessment, and have been against the Treasury bailout plan for that reason.)  

The argument goes that long-term trends that improved corporate profits at the expense of consumption led to a structural crisis devastating the economy.  Corporate profits, in the face of weak consumer demand, was then fueled into speculative activities such as the stock market.  The stock collapse was made worse by these firms pulling out their investments, and long-term recovery was fueled by the gradual expansion of consumer demand through government supported efforts.  

The recourse to "shares" of income doesn't appear very causally important, as it ought to be the levels of consumption and corporate profits that matter, rather than their relative ratio--though it may be useful as a marker for those constituent changes.  But leaving aside the explanatory power of the consumption and corporate profit story with respect to the Great Depression, it doesn't seem like a great way to explain today's problems.  

One reason is that it misses consumer holdings of assets.  Many people before the Depression of course held stocks, and the collapse in asset value spurred additional saving.  Similar things are happening now, as consumers smoothed their consumption by relying on the increase in their home value (and stocks, to a lesser extent) to finance additional spending.  The drop in home and stock values are going to reverse the massive indebtedness of the average American household, and the resulting drop in spending will make it much harder to come out of the recession.   Certainly the share of corporate profits (in retrospect, inflated due to asset bubbles and leverage) to consumption has been rising.  But household consumption has also done well lately--the problem in fact being that consumption was too high, fueled by debt collateralized over overpriced assets.  

It's not clear either that stocks were overpriced because corporations faced weak consumer demand and instead blew profits on speculative investments.  Some may have, but by and large it appears that thrifty corporations saved cash, while consumers splurged.  

The broader picture, however, of weak consumer demand, and corporate profits chasing speculative investments with low rates of return do seem to be present in various Asian countries.  As James Surowiecki notes, the enduring cheapness of Japanese stocks is fueled by the depth of the fall from overpriced asset values in the 1980s, thrifty Japanese consumers, and bad corporations.  Return on equity is notoriously low in Japan, as companies rely on cheap debt funneled from sister companies to make value-destructive investment decisions.  It's really becoming apparent that Japanese corporate structure is not really capitalist (as someone pointed out, it's the only Communist country that has worked) but rather works to maximize the interests of corporate insiders.  

Another place where you are seeing something of this pattern play out is China.  Krugman some time ago was skeptical of the productivity of the Chinese economy, claiming that it was instead fueled through expanding inputs.  Since then, it's clear that labor productivity has played at least some role, but recently the picture is more mixed.  Consumption remains low as a portion of GDP; the bulk instead goes towards investment or (much smaller) exports.  A powerful case has been made that the Chinese economy is becoming less capitalist, rather than more.  

The argument goes that Chinese growth in the last few decades was dominated by small-medium enterprises, many of them local.  Growth recently has been capital intensive, and dominated by state-owned enterprises.  The banking system is filled by bad loans and provides easy credit to flailing politically-connected firms.  The most salient consequence is the wholescale devastation of the landscape from Beijing to Shanghai--commissar command of the economy results in undervaluing natural resources, which are cheaply converted as inputs.  Energy and water efficiency are horribly low, even comparative lto other countries.  

Speculative investments have also dominated the landscape.  Real estate was valued highly, as was the stock market.  Company investment in equities resulted in vicious circles (my company's value depends on the earnings of other companies, who are also invested in my company's stock...).  So large part of the recent boom is probably fictional, a relic of the hunger of state-owned-enterprise for overinvestment and speculation.  The image of capital investment--skyscrapers, factories--is impressive, but really not as relevant from a capitalist point of view as the return on investment.  Now, it turns out that a lot of this investment is worth less, while of course much of the export-oriented facilities is endangered.  Shifting to more domestic consumption is the obvious next step, and that's presumably the way things are going to head.  

It's hard to imagine the political consequences of necessary adjustments.  Everyone says "growth down into the single digits," but one hedge fund guy I've talked to expects a falling economy.  The long-term growth potential is clear, but recent and future growth is looking much more tenuous.  This is obviously a problem, given the lack of ways of political expression.  The Tibet riots came out of nowhere; doubtless others are mad about the falling stock market, health safety failures, a collapsing housing market, and looming economic issues.  

Saturday, November 1, 2008

Speaking of Tail Risks

What are the odds of an "unknown unknown" event pushing the price oil up a lot higher or lower?  If Bush decides to take down Iran before the new administration moves in, terrorists attack any number of oil bottlenecks, Venezuela or Russia or Nigeria implode, Central Asian pipelines get hit, Iran uses asymmetrical warfare in the Persian Gulf, or, alternatively, large economies shut down, Iraq decides to start pumping out a lot of oil.  Production-wise, on one hand you have large oil fields rapidly reaching the peak of their capacities, while the oil spike really sparked a lot of marginal producers to start projects.  I can see the short-term shocks going in either direction, and I could see the long-term price of oil moving lower (more substitutes, more production from marginal suppliers) or higher (fall in price of oil kills of new investments, so ageing fields don't get replaced).  To me, that suggests high price volatility of oil in either direction is a real possibility.  So go out and buy some out of the money derivatives?