Confessions of a Supply-Side Liberal

A Partisan Nonpartisan Blog

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Max Huppertz—The Decline in Labor Force Participation: Speed Bump, Hysteresis, or “I, Robot”?


Max Huppertz is a student in my "Monetary and Financial Theory" class and has his own Tumblr blog, Liberal Animation. Of all my current students, Max is the one whose writing reminds me most of Noah Smith’s style on Noahpinion. To get a full picture of Max’s sense of humor, you will have to go to his blog Liberal Animation, but the guest post below shows the depth of Max’s analysis. Max:


Evan Soltas had an interesting post about labor market tightness a couple of weeks ago. His main point is that, looking at the quits rate, you might think that labor markets are pretty tight right now. That might be a sign that, overall, there’s not a lot of unused economic capacity, or at least, not a lot of unused capacity that matters (more on that below). If you think that’s the case, you’d reach very different policy conclusions when it comes to monetary tightening than someone who thinks there’s still plenty of slack in the economy.

Quite a few people have given their 2 cents already. John Aziz makes a point about the potential benefits of overshooting: it might create jobs for some of the long-term unemployed.

Evan may have a good reason for disregarding the long-term unemployed. John’s proposal might be all we need. But if neither of the two is completely right, we may be in trouble.

Why does Evan think that the long-term unemployed don’t matter? He says that if they don’t compete with more active members of the labor force, they can’t hold back wage growth or interfere with employer/employee matching (because they won’t keep people from quitting a job they don’t like for one they enjoy). Which is a valid point.

But in the medium to long run, a drop in lower labor force participation seems like somewhat of an issue. And participation is down:


It seems to me that there are three possible reasons for this, and three scenarios how this could play out:

  1. The decrease in labor force participation is transitory. In that case Evan’s assessment is correct, although you could still argue that the possibility to overshoot is a risk worth taking, given its potential benefits.
  2. The decrease is more or less permanent, due to labor market hysteresis. In that case, overshooting alone might do the trick.
  3. The decrease is more or less permanent, and it’s a (labor!) demand trend. In that case, we might have a real issue on our hands.

1) Will it all be over soon?

Evan seems pretty convinced that the long-term unemployed “really can’t matter much in a macroeconomic sense”. I think that statement makes sense only if you assume that, in the long run, labor force participation will return to its pre-crisis level. Else, I would like to see an argument as to why we should ignore the fact that 3% of the total US labor force decided to take some time off. Changes of that magnitude are the ones that tend to matter little now, but a lot if they turn out to be persistent over several years’ time.

2) The UI forever (well, kinda…)

Just so we’re clear: economists have a somewhat peculiar interpretation of the word permanent. When I say that the drop in labor force participation might be permanent, I don’t really mean forever. I mean, “for around ten years or so”. Which is substantially longer than recovering from the recent crisis will take (hopefully, anyway), and thus covers a much longer time span than scenario one. So why might participation be depressed for a whole decade?

There are a few stories you could tell that might lead to scenario two. Maybe people lost a lot of human capital while they were unemployed, and have genuine trouble finding a job. Or maybe, employers regard long-term unemployment as a signal. Long-term unemployment might indicate that you’re not the kind of person people would want to employ. Granted, it might also mean you were just unlucky and got laid off at a time when it was really hard to find a new job. But so long as employers have plenty of ‘good’ applicants to choose from – people who aren’t sending out the long-term unemployment signal – they might be okay with rejecting you anyway.

I’m not sure how likely this scenario is, but if this is the one we’re in, definitely overshoot! Temporarily overheating the economy may raise inflation a little, but it would also mean more job openings and fewer people applying. Making job applicants scarce would provide an incentive for employers to take a closer look at the long-term unemployed, and to figure out whether what happened to them was just bad luck – or whether they’re actually bad apples.

3) Rise of the Robot Lords

What if the long run equilibrium level of employment is actually decreasing over time? Take a look at the bigger picture:


For a while now, there has been stagnation and quite a substantial drop in labor force participation, even before the dot-com bubble. If employers desperately needed these people, wouldn’t you expect them to raise wages and try to lure some of them back into the game?

I know this sounds a little like a sci-fi cliché, but if falling demand for labor due to increased mechanization were responsible for discouraging workers from even trying to find a job, overshooting will at best give a temporary boost to labor force participation. After that, we’re back to the downward trend.

The remedies for this kind of situation are very different from what we need to do in the other two cases. Increasing the general level of education would be a good idea (it generally is, but especially in this case).

Rethinking the social safety net would be another (this is probably worthy of a post of its own, but let me give you my intuition). Many of the labor-intensive industries of today might rethink their business model once robots become more cost-effective. What happens if mechanization puts us into a position where the vast majority of workers in classic manufacturing jobs (cars, steel) – and possibly also a fair few in the service sector (eventually, burger-flipping robots will be the norm) – are no longer needed? And when, at the same time, the new ‘employees’ – machines – won’t ever ask for pensions, or unemployment benefits? Well, it seems to me that indefinite unemployment insurance, or a guaranteed basic income, might not be so Utopian in this scenario.

Faced with this kind of affluence, society might well decide that the dangers of ‘paying people to be unemployed‘ are far outweighed by the benefits of getting much closer to what John Rawls would call a well-ordered society. And, especially in a highly educated society, I think we have reason to believe that people actually want to work, instead of being on the dole. As Jeffrey Smith nicely said (referring to Arno Duebel, a German who had been living off unemployment benefits for 36 years straight):

The actual mystery, though, is not the existence of someone like Arno, but rather, given the relative generosity of many European welfare states, their relative scarcity.

By the way, labor force participation isn’t just down for low-skill workers; this may be an issue that affects us all, even those with a college education (albeit to a lesser degree):


Like I said, this deserves a post of its own.

Humans good, robots bad?

I think that the third scenario is the one we want to be in. Any kind of job that a robot (or machine in general) can do better then a human – why not let it do it?

But it’s also the most difficult one to come to terms with, politically and ideologically. The left would need to give up part of its struggle for the ‘working class’, at least in the classical meaning of the word – factory workers, hard manual labor, that kind of thing. The right, on the other hand, might need to concede that in this kind of environment, maybe having a basic income won’t annihilate the US economy.

Issues like these would have to be dealt with during the next few years and decades. Or, who knows, maybe we are in scenario one, and Evan is right, or two, and John is right. But if not – and there are good reasons to believe this – we might want to start thinking about the implications.

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Robert Flood and Miles Kimball on the Status of the Efficient Markets Theory


Robert Flood is an economist famous for his study of asset bubbles. Links to many of his papers can be found here. 

My post "Robert Shiller: Against the Efficient Markets Theory" started a lively discussion on my Facebook wall (which is totally public). I added my discussion with Dennis Wolfe and a summing up by Richard Manning to "Robert Shiller: Against the Efficient Markets Theory" itself, but I thought the discussion with Robert Flood deserved its own post. See what you think:

Robert: This stuff is fun to talk about without a model, but finding one that works so you can use it for testing is harder. The stuff without a model says nothing about data so is nice for talk shows.

Miles: Any model we would write down at this point would be drastically wrong, so it would not be of much immediate practical value. What we need first is a suite of survey and experimental tools for measuring all the narrative forces that Bob Shiller is talking about.

Robert: As I have said, this is fun stuff. I just wish you’d get past the Efficient Markets thing. It’s undefined w/o a model and you do not want to talk about models - neither do I. The “stories organizing” notion is as good as anything else. I look forward to seeing where it goes. John Cochrane aside, the SDF approach looks like a dead end to me. It’s killing Macro and does not seem to do much for Finance.

Miles: There is no lack of efficient markets theory models that describe the way the world isn’t. Take your pick. In class today, I talked about the no-trade theorems, for example. In the real world, 95% of all trading volume cannot be explained if you insist that everyone has the same expectations.

Robert: Now you are talking. The issue you mention is a problem with Rep Agent - RA - not with EM. Indeed, having problems with RA gives an immediate research strategy - no RA - information dispersion, taste dispersion, life span dispersion, information discovery, transactions costs, rules of thumb….. In my view EM is not a hypothesis, it is an assumption about how people behave and not just in financial markets.

Miles: None of information dispersion, taste dispersion, life span dispersion, information discovery, transactions costs can possibly explain the volume we see. Only different people processing the available information differently can possibly yield the volume we see. Of your list, only “rules of thumb” is in this category, but in reality there are many people very actively processing the same information in different ways to come to different opinions. That is a failure of rational expectations. Without rational expectations, there is no efficient markets theory left, since the EMT logic runs from (approximately?) perfect competition in asset markets and (approximately?) rational expectations.

Robert: Agreed, volume is a real issue. I think it has something to do with the way we have structured compensation. Why is different processing of information a RE failure? People have very different experiences, different abilities and therefore different costs and therefore process things differently. The only failure is the failure by definition of RA. Forget econ for a moment. Look at politics. The dispersion of beliefs is, I think, much wider than the dispersion of information.

Miles: The assumption of rational expectations is the assumption of perfect information processing, given the information you have in front of you. There was a time half a century ago when economists thought that imperfect information and imperfect information processing were similar issues, but technical advances have made it clear that imperfect information can be dealt with by nice extensions of standard theory. Not so for imperfect information processing. Methodologically, that is a radical departure from standard theory, though a necessary one for many applications, since people in the real world are not infinitely intelligent and many real-world economic decisions are quite difficult computationally and conceptually—difficult enough to tax the abilities even of PhD economists, let alone people who don’t love solving optimization problems. I raised some of these issues in my post "The Unavoidability of Faith."

Robert: Sure. The Muth model, Lucas, Sargent, Sharp etc had free relevant information - including full information about the model generating outcomes and costless processing. So what? Expand the framework to include all sorts of costs and you have a bigger model, but that does not make people behave stupidly. The guys in the model will use their history (goodby Markov) to process things until they think (Bayes comes in here) it’s not worth processing more. (Oddly, this is Peter Garber’s completely incomprehensible thesis written under Lucas)

Miles: I agree that people do not generally behave stupidly. My point is that to this day, our standard technical tools depend crucially on them being infinitely intelligent. There is a reason Peter Garber’s thesis was not easy to understand. Dealing with imperfect information *processing* is a *much* bigger technical leap than dealing with imperfect information. This is one of the themes of my paper “Cognitive Economics” that I am giving as the keynote speech at the Japanese Economic Review Conference in Tokyo in August.

Robert: Ok. I am happy to agree on the NSS way of thinking ( NSS = Not So Stupid). In my view, that’s all EM or RE says. Remember where we came from - no expectations, static expectations, adaptive expectations.

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Pranav Krishnan: Fighting European Deflation with Negative Interest Rates


Pranav Krishnan is a student in my my "Monetary and Financial Theory" class. Pranav also has a blog that focuses on the finances of European football. Here is what Pranav has to say about eurozone monetary policy:


There were some positive signs around Europe, where it appeared that Spain’s unemployment rate had bottomed out in late 2013.

Perhaps talk of Europe’s recovery has come a little too early. While there were signs of positive growth in countries like Spain and Italy over the past few months, inflation was very low, and even more so inflation expectations.  David Roman of the Wall Street Journal wrote about a significant deflationary risk in Europe and how officials are expecting the European Central Bank to take the appropriate measures necessary to stem the tide. Josef Makuch, Slovenian Central Bank governor-rightly-feels that deflation could cause even more problems in the long term.

“Several [ECB] policy makers are ready to adopt nonstandard measures to prevent slipping into a deflationary environment,”

It appears that there might be more to this issue, than simply highlighting the risk of deflation.  The article was largely skimming the surface of what could become a wider problem later on.  Demosthenes Tambakis, a professor at the University of Cambridge, wrote for The Economist, outlining his opinion on why the Eurozone is at risk for deflation in further detail,  He points to very low inflation expectations across Europe and that alone increases a risk in deflation.  While he admitted that this risk shouldn’t rise so dramatically based on expectations alone, he does point out a few other institutional design elements that could contribute; Most notably, the European Central bank’s mandate, and the Zero Lower Bound.

The European Central Bank mandate is a bit pedantic in terms of legislature but it can play a role in the eyes of most economists.  The ECB, cites Tambakis, is committed to just below 2%, in contrast to say the Fed who wants to maintain a 2% average over time.  Tambakis believes that this causes an asymmetry which assures everyone that while they do not have to fear runaway inflation, they should worry when prices are too low because the ECB by design would be more reluctant to embark on expansionary monetary policy (increasing the money supply) than they are to contract.  While this point could make some sense in that the ECB might be unintentionally ‘guiding’ people to expecting less inflation in the medium-run and long-run, I would be surprised if this had a serious impact on inflation expectations.  Given the low levels of inflation in Europe, most economists and investors would likely expect lower levels to continue especially with the reduction in German growth rates.

The more likely argument seems to be the one about the Zero Lower Bound.  These risks are determined by the Shiller Index which predicts the long-run frequency of international stock market crashes.  Europe has faced two issues, in that they’ve suffered from the original financial crisis of 2008 and then the individual debt issues that each country faces. So, the natural reaction would be to cut interest rates to stimulate demand, but the Zero Lower Bound in Europe threatens to create a liquidity trap for the Eurozone.   In tandem with the dual mandate language set by the ECB, everyone already has very low expectations of inflation and the inability for countries to set monetary policy and stimulate demand individually threatens to worsen the situation for the Eurozone as a whole.

While there could be some legislation to create a more unified Europe fiscally and financially, the best thing the ECB can hope to do now is if they are going to be rigid about keeping inflation below 2% they should be more flexible about the Zero Lower Bound and allow the interest rate to hover in a broader range of negative interest rates.  The process will be rather painful because inflation expectations could plummet but in the long term, Europe could be better for it and escape the dangers of a long-term liquidity trap.

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Robert Shiller: Against the Efficient Markets Theory


On March 26, David Wessel published a very interesting interview with Bob Shiller, “Robert Shiller’s Nobel Knowledge." This interview gives a reasoned critique of the Efficient Markets Theory.

Ideal Informavores or Lovers of a Good Yarn? To begin with, Bob questions whether it is a reasonable approximation to assume that people acquire information avidly and process that information perfectly: 

The story about bubbles was that the markets appear random, but that’s only because markets respond to new information and new information is always unpredictable. It seemed to be almost like a mythology to me. The idea that people are so optimizing, so calculating and so ready to update their information, that’s true of maybe a tiny fraction of 1 percent of people. It’s not going to explain the whole market.

Instead, Bob argues that human beings are avid consumers and tellers of stories:

Psychologists have argued there is a narrative basis for much of the human thought process, that the human mind can store facts around narratives, stories with a beginning and an end that have an emotional resonance. You can still memorize numbers, of course, but you need stories. For example, the financial markets generate tons of numbers—dividends, prices, etc.—but they don’t mean anything to us. We need either a story or a theory, but stories come first.

Can You Earn Supernormal Returns? A failure of Efficient Markets Theory suggests that there should be some way to obtain above-normal returns. But Bob cautions that believing that you personally can earn above-normal returns in the stock market is a little like believing one can win American Idol: definitely true for someone, not likely to be true for you:

The question is often whether it’s possible for anyone to pick stocks, and I think it is. It’s a competitive game. It’s like some people can play in a chess tournament really well, but I’m not recommending you go into a chess tournament if you are not trained in that, or you will lose. So for most people, trying to pick among major investments might be a mistake because it’s an overpopulated market. It’s hard. You have to be realistic about how savvy you are. 

By contrast, if you want to try your hand at investing in a market where you have less competition as an investor, you have a better chance, with a lot of hard work:

But if you are thinking about buying real estate and renting it out, fixing it up and selling it, that’s the kind of market that’s less populated by experts. And for someone who knows the town, that’s doing business, I’m not going to tell someone not to do that.

Can Bob Shiller Earn Supernormal Returns? Bob does think that he can pick stocks. The key for him is to pick boring stocks:

Well, I actually think I’m smart enough to pick winners. I’ve always believed in value investing. Some stocks just get talked about, and people pay all sorts of attention to them, and everyone wants to invest in them, and they bid the price up and they are no longer a good buy. Other stocks, they are boring. There is no news about them—they are making toilet paper or something like that—and their price gets too low. So as a matter of routine, you buy low-priced stocks and sell high-priced stocks.

I think of “pick boring stocks that have a present value that can be easily calculated” (and of course only those that are undervalued according to that calculation) as Warren Buffett’s strategy as well. 

Can You Succeed at Contrarian Market Timing? The one thing I would add here to what Bob says is this about market timing. Some of Bob’s work, some of it joint with John Campbell, suggests that contrarian market-timing can be a good idea. In particular, their work suggests increasing one’s stock holdings when the price/dividend ratio is low and reducing one’s stock holdings when the price/dividend ratio is high. (Bob has also used the ratio of price to cyclically adjusted earnings or smoothed earnings as a way of gauging if the market is high and likely to fall or low and likely to rise.) I believe this works and try to do it myself. But it is hard to do without a contrarian personality. What makes the market too high is that some story is making people optimistic about the market—a story that is likely to infect you as well; what makes the market too low is that some story is making people pessimistic about the market—again a story likely to infect you as well. So doing any market timing subjects you to the danger of succumbing to the stories out there that, because most other people are succumbing to them at the same time, will make you likely to buy high and sell low. It is only if you naturally like stories other people don’t like and dislike stories that they like that you can be a contrarian investor without great intellectual and emotional self-discipline. 

Update: There were many great comments on the Facebook version of this post. The discussion with Robert Flood I am making into the post for Friday, April 18. Let me put the key elements of my discussion with Dennis Wolfe and Richard Manning here:

Dennis Wolfe:  Miles – enjoyed both your post on Saturday and this one – and I tend to believe both, especially Shiller’s points. Have you seen the whitepaper “Capital Idea: The active advantage can help investors pursue better outcomes”? The paper was published late last year by The American Funds to make a their case for active investing over passive investing. Their paper presents strong evidence that some investment managers have a proven model and track record of persistent above average results over rolling periods of time. John Rekenthaler (The Rekenthaler Report), a researcher at Morningstar, published results of a similar study last summer comparing American Funds with Vanguard index funds (The Wrong Side of History; The Horse Race) with similar conclusions. After considering Shiller’s thoughts and the evidence outlined by American Funds and Rekenthaler, I am much more persuaded against the efficient markets theory. I’d be interested in your thoughts.

Miles: The theory is pretty clear that if there is any departure from the efficient markets theory, most people (or people holding a majority of the risk-tolerance weighted money) have to be getting it wrong. Thus, believing that the efficient markets theory is not right makes me *more* skeptical of active investing. When most investors are getting it wrong, one would have to be doing something unusual to be getting it right.


Thank you, Miles. Active management, the argument goes, is unable to outpace a respective index because of the efficient-market hypothesis.

From the Capital Group whitepaper:

Those who adhere to that theory contend, in brief, that all information is reflected in a firm’s share price, making it impossible to beat the market consistently. But much of the literature in favor of index investing uses “the average active manager” to make the point. And indeed, in aggregate, U.S. equity active managers have not consistently outpaced the Standard & Poor’s 500 Composite Index. …

We believe this is a flawed way to frame the issue, akin to concluding that because the
average person cannot dunk a basketball, no one can dunk a basketball. Obviously,
some are playing at a higher level, and using the average to characterize an entire
industry obscures the fact that there are investment managers that have consistently
added value over a variety of market cycles,

Both studies I referred to in my earlier post demonstrate there are investment managers that have consistently added value over a variety of rolling time periods and market cycles - that is more than talk show chatter. I think it’s important to focus on the qualities associated with success like the contrarian and fundamental value points discussed by Robert Shiller but also including low fees, experience and global research.

While I certainly believe someone like you or Robert Shiller are capable of consistent success, I am skeptical the average person can consistently produce above average results on their own, especially since the average professional investment manager apparently does not (at least after fees). However, I don’t believe that proves the efficient market theory. When there is evidence investment managers that focus on disciplined qualities of success do consistently produce above average results after taxes and fees, then I believe the efficient market theory is hollow. And, If they do it, an average investor can still indirectly succeed by adopting their model by using their funds.

Miles: I am more drawn to the fact that since so many people invest so much money through professionally managed funds, most people putting their money in the hands of professionals must also be doing it wrong, so letting a professional handle one’s funds is no panacea. And that is before paying significant fees, which makes the mistake much worse. The advantage of putting money in low-fee index funds (my Fidelity Spartan accounts have a 0.1% annual fee) is that there is a bound on how far wrong one can go if one comes as close as possibility to holding the universe of accessible risky paper assets in proportion to market capitalizations. The only way to do better than holding a broad set of low-fee index funds is to do things that most investors don’t do when they try to go beyond that. And most investors are more like most investors than they think.  

Dennis: Miles, thank you, again, I appreciate your honest, objective thinking on this and the comments of Robert Flood. I must admit It is more difficult for me to completely understand this issue from economist’s point of view without that background. As a practicing CPA and now CFP, I often think about this practical issue for my clients and want to learn as much as I can, including how to sort through the intense marketing claims from both sides that cloud it. Since moving to the full time practice of financial planning about 14 years ago, I have been most influenced by the principles and work of Benjamin Graham, Burton Malkiel and Charles Ellis. My experience is few investment firms put clients’ interests central to their process and approach. I believe most are simply “commercial” and this is the main reason people are attracted to low cost index funds - not because of the efficient markets theory. In other words, I believe some people will (perhaps should) accept a C rather than seek an A or B when doubt or lack of trust exists. Despite the trust issues that exist in the financial services industry, I believe we should not ignore those firms whose processes consistently produce above average results, after fees and taxes, over rolling periods of time and market cycles. They do exist. However, where doubt exists and as a hedge, I am also also inclined to sometimes use low cost index funds or ETFs for myself and for clients.

A few other thoughts: I generally believe equity markets are more efficient in the U.S. than outside the U.S. - and the evidence is appears overwhelming in that space by objectively examining results. I also believe markets are more efficient for large companies over small and mid-size companies where quality proprietary research seems to yield comparatively better results. And finally, to Shiller’s point, I also believe inefficiency exists because most of us are attracted to interesting stories over “boring” stories. In summary, I continue to be persuaded there is room (given the right process that also puts an investor’s interest central) to produce consistent above average results over time. At the same time, I agree with you that most investors (including me) are more like most investors than we want to admit.

Richard Manning Whether Schiller or others believe the market is technically efficient or not on a moment by moment basis the practical advice for the vast majority is the same: buy and hold a diversified portfolio. No? So why the fuss?

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John Stuart Mill: Strong Feelings Strongly Controlled by a Conscientious Will


"Strong Feelings Make Me Stronger" by thezgi

Although I have been Associate Chair for Administration and Director of our Master of Applied Economics Program, I am saved from some of the more onerous leadership and decision-making roles within my department because I am considered a bit unpredictable and a bit too much outside valued boxes. (There is also a tendency to consider someone who has a generally has a positive outlook on people and situations as a less serious person.) In On Liberty, Chapter III: “Of Individuality, as One of the Elements of Well-Being,” paragraph 16, John Stuart Mill extols the virtues of being, in modern slang, a bit of a “loose cannon" and a bit of an "Energizer Bunny": 

As is usually the case with ideals which exclude one-half of what is desirable, the present standard of approbation produces only an inferior imitation of the other half. Instead of great energies guided by vigorous reason, and strong feelings strongly controlled by a conscientious will, its result is weak feelings and weak energies, which therefore can be kept in outward conformity to rule without any strength either of will or of reason. Already energetic characters on any large scale are becoming merely traditional. There is now scarcely any outlet for energy in this country except business. The energy expended in this may still be regarded as considerable. What little is left from that employment, is expended on some hobby; which may be a useful, even a philanthropic hobby, but is always some one thing, and generally a thing of small dimensions. The greatness of England is now all collective: individually small, we only appear capable of anything great by our habit of combining; and with this our moral and religious philanthropists are perfectly contented. But it was men of another stamp than this that made England what it has been; and men of another stamp will be needed to prevent its decline.


Update: On the Facebook version of this post, David Yves offers this comment:

“Do not fear to be eccentric in opinion, for every opinion now accepted was once eccentric.” -Bertrand Russell. If only we didn’t have to fear.

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Dimitry Slavin: U.S. Stocks Are Not in a Bubble and Here’s Why


I am quite skeptical of attempts to predict where the stock market overall will go, beyond looking at something like the price/dividend ratio or cyclically adjusted price/earnings ratio a la John Campbell and Robert Shiller, and recognizing moments of market overreaction to geopolitical events. But among those who nevertheless attempt (perhaps foolhardily) to predict, I want to put my "Monetary and Financial Theory" student Dimitriy Slavin in contention. (You can see his Flickr page here, and his LinkedIn page here.) What Dmitriy says sounds at least as sensible to me as others who claim to be able to predict what the market will do—including those with outsized reputations. I’d be interested to hear what people think of his analysis:



If you take a look at the S&P 500 Stock Index for the past twenty years, you will notice a clear cyclical nature to it- it seems to undergo a cycle about every seven years, with a roughly 5 year period of growth and then a two year period of decline. Five and a half years out of the Great Financial Crisis with the Fed rolling back QE and the S&P index reaching an all time high, some investors are worried that U.S. stocks may be in yet another bubble. In my next two posts, I am going to argue that this is not the case…at least for now.

This weekend I read two interesting documents that have convinced me that it is unlikely we will see a dramatic fall in the S&P anytime soon: JP Morgan’s latest edition ofQuarterly Perspectives and BlackRock’s 2014 Investment Outlook. I will split up my argument into three pieces: (1) Peaks in Stock Prices Vs. Peaks in the Output Gap, (2) Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits, (3) The EV/EBITDA to VIX ratio.

1.    Peaks in Stock Prices Vs. Peaks in the Output Gap

One thing that has characterized past asset bubbles is that they generally tend to coincide with peaks in the economic cycle. As we’ve discussed in class, an economy can’t operate above full capacity for long periods of time, so at some point output must fall. In the past, these falls in economic output have occurred at roughly the same time when the stock market fell:


But as you can see by the graph above, the present case is quite different from the past. The output gap is nowhere near a peak right now, and most would agree that the U.S. economy is still in recovery mode from the financial crisis. This recovery has taken much longer than past recoveries from recessions, and has been characterized by slow initial growth, rising incomes, and slowly falling debt burdens. This slow growth coupled with the current negative output gap is a good sign that the U.S. stock market is not on the cusp of another asset bubble.

2.    Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits

One thing that characterizes practically all asset bubbles is an unjustified surge in stock prices. What I mean by ‘unjustified’ is that people begin to ignore fundamental analysis and start buying up stocks simply because their price is rising, much like what happened during the Tulip-Bulb Craze we read about in Malkiel’s Random Walk Down Wall Street. In contrast, the recent rise in stock price has not been unjustified because stock prices have been rising along with corporate profits:


This positive trend gives credence to the argument that investors are not simply building ‘Castles In the Air,’ and rather are basing their investments in sound fundamental analysis. Something to watch out for though is the growth rate of corporate profits versus that of stock prices. I would argue that it is somewhat worrisome that the growth rate in profits for the past three years has been smaller than that of stock prices, and could potentially be a sign that the U.S. stock market will be overvalued in the future. For now though, the difference in growth rates is both tolerable and reasonable.

Taking a look at the left side of the graphic above, we also see that the length of the current bull run is just below the average of past bull runs, yet its return has been slightly higher than average. Roughly average returns + a typical duration time further justify the point that the current bull run on U.S. stocks is not forming an asset bubble.

3.    The EV/EBITDA to VIX ratio

The final part of my argument has to do with a common market indicator- the EV/EBITDA ratio- a tool that gives a measures of US corporate valuations, leverage, and investor complacency by dividing enterprise value (EV) by earnings before interest, taxes, depreciation, and amortization (EBITDA). This ratio is then divided by the stock market volatility index in order to measure investor complacency.


BlackRock’s 2014 Investment Outlook provides a solid interpretation of the above graph:

The ratio of the [the EV/EBITDA and the volatility index] is the key. High valuations combined with low volatility can make for a lethal mix. This market gauge sounded the alarm well before the financial crisis…[Today,] valuations are roughly in line with their two-decade average (and leverage is lower). Yet volatility is hovering just above two-decade lows. The result: The market gauge stands well above its long-term average,
but is far short of its pre-crisis highs.

The main point the above graph and discussion make is that although we may be seeing early signs of the formation of an asset bubble, it is not expected to form in the imminent future. It also gives further weight to the argument that corporate earnings need to start rising faster if the economy is to avoid a bubble in the future because a rise in earnings would drive the EV/EBITDA to VIX ratio down (assuming volatility stays low).

In summary, I have laid out a three-pronged argument for why I think the U.S. stock market is not experiencing an asset bubble. A wide output gap, a close correlation between earnings growth and stock price growth, and a reasonably small EV/EBITDA ratio tells me that the U.S. economy is not on the cusp of another bubble. Furthermore, I am generally in agreement with Ray Dalio’s claims (mentioned in some of my previous posts, here and here; the first post examines the long term debt cycle and the second elaborates on the last stage of the cycle- the reflationary period) when he asserts that we are currently in the reflationary period of the long-term debt cycle. Consequently, I expect the economy to make a full recovery in the next couple of years: QE tapering will continue, interest rates will rise slowly but steadily, and both corporate earnings and income growth rates will rise, further dispelling doubts of a possible bubble. With all this in mind though, I think it’s important to keep a close watch on the indicators I discussed throughout this post because they provide a good summary for the state of the U.S. stock market.

Update: Robert Flood notes on Facebook:

Just for the record, the Tulip Bulb Craze (1636) was for fixed-date forward bulb prices not spot. I’m not sure what bubbles you are talking about here - no definition - but I’m real sure you are not studying one in some fixed-date forward/futures price.

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Christina Romer: After A Financial Crisis, Economic Disaster Is Not Inevitable--Bonnie Kavoussi Reports

Bonnie Kavoussi worked for Huffington Post before coming to the Master of Applied Economics program at the University of Michigan that I wrote about last week. Bonnie now has her own blog, where Bonnie reports on Christina Romer’s very interesting talk at the University of Michigan on Tuesday (including an embedded video of the talk). The bottom line is that both of Carmen Reinhart and Ken Rogoff’s big claims in the last few years have been called into serious question:

  • Along with many others (many of whom we link  to in our follow-up column here), Yichuan Wang and I found no evidence in Reinhart and Rogoff’s data to support their claim that higher national debt lowers the rate of economic growth.
  • As Bonnie reports, and as I can verify from my own attendance at the talk, Christina Romer and David Romer question, on solid grounds, Reinhart and Rogoff’s claim that financial crises lead with high probability to a relatively intractable, long-lasting economic downturn.  

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Mormon Hell Tweets

Yesterday I posted my favorite song from the musical “The Book of Mormon”: the very moving "Sal Tlay Ka Siti." The title of the storified tweets linked from the title above is inspired by another, much campier, song from “The Book of Mormon”: "Spooky Mormon Hell Dreams." The tweets themselves are about Noah Smith’s guest post "Mom in Hell."

By the way, it is worth listening to the song “Sal Tlay Ka Siti” here and then reading "Mom in Hell" again with “Hell” replaced with “desperate poverty abroad” and “Heaven” replaced by “America.”

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