Corbett Schmitz: Should Social Security Switch to a Defined Contribution Plan?

Corbett Schmitz

Corbett Schmitz

This is a guest post by my “Monetary and Financial Theory” student Corbett Schmitz. Corbett’s answer is “Yes.” Corbett argues his case well.

One issue Corbett does not address is the effect of a shift to a defined contribution plan on the amount of redistribution in social security. There, it is important to recognize that social security has much less redistribution in it than most people assume. Except at the very bottom, what redistribution seems to be there in the size of the benefit check is offset to a surprisingly large percentage by the fact that richer people tend to live longer, and therefore tend to draw on Social Security for a longer time. 

Just recently, I had the opportunity to have dinner with my dad. Given our mutual interests, our conversation naturally drifted towards finance. My dad playfully joked how excited he is to start receiving pension checks in just a few years. Even though these checks will be small, I responded jealously; when I start working this fall, there will be no pension program waiting.

This shift away from pension programs is not unique to my father and me. Over the last 40 years, many employers have switched away from pension retirement plans (more generally called defined benefit (DB) plans), for defined contribution (DC) plans (like 401K’s). Under DB plans, employers pay a predetermined amount of cash to former employees after those employees reach retirement age. Under DC plans, employers set aside a certain amount of money each year to assist employees in developing a retirement savings account. As the graph below shows, the shift away from DB plans to DC plans has been staggering. Since 1979, for employees lucky enough to have corporate-sponsored retirement plans, enrollment in DB plans has dropped 57% while enrollment in DC plans has grown 55%.

This transition to DC plans is largely due to an increase in life expectancy rendering DB plans unsustainable (ie: as people live longer they collect benefits longer, increasing the onus placed on firms and requiring progressively more cash to fund DB plans). This year, the Society of Actuaries released new life expectancies for the first time since 2000. In the last 14 years, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase.  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion. After this revision, these liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and doing so is no easy task. Considering that life expectancy is expected to grow further, it’s not surprising that firms are switching to DC plans from DB, as doing so helps reduce total liabilities. Specifically, the switch to DC from DB helps reduce liabilities by shifting investment risk away from firms and to retirees. Under a DB plan, firms are responsible for paying a set amount of retirement income in the future. To generate this future outflow, firms invest cash now, hoping it will grow enough to fund the promised pension payments. Unfortunately, very few firms invest enough to meet the entire defined benefit payment, as most firms assume unrealistically high returns when making investments. Doing so causes many firms to drastically underfund their DB plans, generating enormous liabilities (with potentially crippling consequences) in the process. In contrast, a DC plan is much more sustainable because it does not promise any future cash payments, and therefore does not create any liabilities. Rather, a DC plan only requires firms to presently invest cash on behalf of its employees, with the future retiree bearing the investment risk.

Does this mean that the switch from DB to DC is a bad thing for retirees? After research, I believe it’s a wash. That said, I did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB. A study by Dartmouth College found that the typical DC 401K-retirement plan, “provides an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”

If you check my sources, however, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs. But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last ten years, DB benefits have only outperformed DC plans by 0.86%. Furthermore, most of this underperformance is due to a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will be similar under both optionsHowever, I am largely in favor of DC plans because they eliminate the liabilities associated with DB payments. So how is this conclusion relevant to social security? Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions could help solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033. However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058). Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DC plan. While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.” For example, if social security tax is currently 10% of income, I propose it should be reduced to 5% of income in, let’s say, ten years. In those ten years, the social security withholding should grow to 5% of income. Eventually, social security tax should fall to 0% of income and be replaced entirely by the withholding (Personally, because I think savings is so important, I think that this withholding should ultimately represent a higher percentage of income than social security tax ever has or will).

Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis. Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan. As individuals continue to work, instead of paying taxes to fund social security, they will pay withholdings to help fund their own retirement.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe, well-diversified indexes (like a global fund). If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money. On average, even professional money mangers cannot outperform indexes that track the aggregate market). Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

My proposed plan has some similarities to George W. Bush’s proposal of private savings accounts in early 2000. Under the most successful of Bush’s privatization proposals, taxpayers could divert 4% of taxable wages or a maximum of $1000 from FICA payments to fund personally managed retirement accounts. These contributions would not replace, but rather would offset, social security’s existing DB payments. Workers would then have the option to invest their private accounts in 5 different funds.

The key difference between my proposal and Bush’s proposal is the long-term implications for social security. Bush’s proposal aimed to prolong, not eliminate, the insolvency date of social security by offsetting social security’s DB payments with some DC payments. In contrast, my plan proposes a gradual but complete transition of social security from a DB plan to a DC plan, thereby rendering insolvency irrelevant.

While my plan is not perfect, I believe it effectively addresses the sustainability of social security by gradually eliminating government-paid DB benefits. Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxable income with government-mandated savings. I believe this system, by eliminating the liabilities related to DB retirement plans, is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy. As always, I welcome any and all suggestions as we collectively try to address the issue of social security sustainability.

Update by Miles: I had a Twitter exchange with Andrew Burton about financing the transition, where I was thinking of the capital budgeting principles you can see in “Capital Budgeting, the Powerpoint File.” In addition, Gary Burtless gives some great comments on the Facebook version of this post.

Gary Burtless: First off, I think Mr. Schmitz is wrong about this: “This transition to DC plans is largely due to an increase in life expectancy rendering DB plans unsustainable.” The shift was due instead to (#1) ERISA’s requirement that employers fund their DB plans and pay for insurance in the event the employer entered bankruptcy with an underfunded plan; and (#2) Employers’ recognition of the risks they were taking on by guaranteeing future annuities with risky assets (60% equities). The rise in longevity has been underway for 100 years, and there have been no surprises since the early 1980s, when the phase-out of DB plans got underway.

Second, I think Mr. Schmitz is probably wrong about the potential welfare gain from converting Social Security from a DB to a DC plan. Rising longevity is essentially irrelevant in thinking about this question. I suspect the great majority of working citizens prefer DB to DC pensions, because they believe their retirement incomes will be more predictable (and they like that predictability). While individual employers, including private, municipal, and county government employers, cannot guarantee future DB pensions, the U.S. government can (at least up to a limit) given its ability to tax residents, few of whom are likely to move out of the country to avoid this tax. In other words, whereas it may be hard for the overwhelming majority of individual employers to guarantee future DB pensions without backing that guarantee with very, very safe (and low return) assets, it is easier and more credible for our national government to do the same thing. In light of the fact that workers seem to prefer DB over DC-style pensions, why shouldn’t rational citizens support national provision of such pensions? I think polling evidence supports the idea that U.S. citizens strongly favor continuation of Social Security as it currently exists, that is, as a DB plan, even if they have to pay higher payroll taxes to maintain the system. My guess is that converting the system to a DC plan, and reducing the assurance of a (semi-) guaranteed flow of future benefits, would reduce rather than increase worker and citizen welfare.

My answer there is this: “The government definitely has a comparative advantage in providing annuities, but it could do so in a market way.” What I have in mind is that on its liability side, in addition to Treasury Bill’s, the US Sovereign Wealth Fund I advocate should provide a variety of different kinds of annuities at prices that give the taxpayers implicitly providing those annuities a fair shake. See

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.

Update:Willem Buiter writes on the Facebook version of this post:

Willem H. Buiter:Efficient Markets Theory is an obvious empirical failure. Unfortunately, the alternative is a swamp of mutually contradictory but non-refutable (i.e non-scientific - long live Popper) anecdotes.

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.

Dennis: 

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?

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:

blog.supplysideliberal.com tumblr_inline_n3wbefD5FF1r57lmx.png

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.

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.  

Meet the Fed's New Intellectual Powerhouse

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Here is a link to my 47th column on Quartz: “Meet the Fed’s new intellectual powerhouse.”

I have two related columns not directly linked in this piece: “Monetary Policy and Financial Stability” and my discussion of Janet Yellen’s views: “Janet Yellen is Hardly a Dove: She Knows the US Economy Needs Some Unemployment.”

What I say in the column about how a low elasticity of intertemporal substitution affects how the Fed should respond to risk premia is informed by the discussion I gave of a paper of Mike Woodford and Vasco Curdia at a Bank of Japan conference (which I mentioned and linked to here.) Claudia Sahm, Matthew Shapiro and I are working on literature review of empirical work on the elasticity of intertemporal substitution for our paper on that topic. I will have more to say on that in the future. 

Update: I wrote this column (which is about much more than Jeremy Stein himself) just in time. On April 3, 2014, Jeremy Stein announced he was resigning from the Fed. But we might see him again in the future in high government office.

Zane Salem: How to Boost US Exports

Zane Salem

Zane Salem

I like my student Zane Salem’s post because it applies the principles I talk about in my post “International Finance: A Primer” and the related tools I talk about in my “Monetary and Financial Theory” class, particularly this “International Finance” Powerpoint file. The policy perspective is distinctively his. I am not signing on to all of it, but starting with sound theory makes what he says coherent in a way in a way most commentators who talk about trade are not.

Note that a Twitter thread disputes Zane’s claim of a positive correlation between net exports and GDP. I think when Zane said “GDP is directly correlated with the country’s net exports" he simply meant that net exports is a component of aggregate demand. But "directly correlated” has a different technical meaning. The overall correlation between net exports and GDP depends on many other causal forces in addition to the effect of net exports on GDP as a component of aggregate demand. 

Here is what Zane has to say:

Last December’s export data revealed the United State’s trade deficit sunk deeper than expected. This was caused by both an increase in its imports and decrease in its exports. Since GDP is directly correlated with the country’s net exports, the recovering US economy will keep taking dents if this is not turned around.

Background for Improving Exports

The current administration has worked at improving exports numbers since the recession. This was done by attempting to remove trade barriers with other countries and by offering financial assistance with ease of information. While the data suggests there have been some successes, numbers are not where they could be. A subsidy or tax break in any way, shape, or form doesn’t provide a suitable solution for this problem the short run.

That being said, I see two possible ways to improve a country’s exports:

  • Invest in assets abroad
  • Protect intellectual property abroad

A most effective way to increase exports is by having a relatively weak currency. This makes a country’s goods/services look relatively cheaper and thus a worthwhile purchase to others. By applying the basic principles of international finance we covered in lecture, I’ve devised an algorithm to create a relatively weaker currency and thus more attractive prices for being imported. This could be applied to the United States or any other country.

Investment in Foreign Assets

  1. Invest in foreign funds – (ideally assets with HIGH rates of return)
  2. In exchange for their intentional IOUs, they receive unintentional IOUs (US dollars)
  3. The bouncing around unintentional IOUS (US dollars) overseas leads to an increase in the purchasing of our exports (from their perspective our goods look cheaper and they have dollars to exchange)
  4. In addition to the return on the investment, NX increases for the US

The reason this works is because of the currency exchange that takes place after the initial investment. The unintentional US dollars that foreign countries incur will be used to purchase goods and services from the US, effectively making the investment an exchange of assets for goods and services. The shortcoming here is that this algorithm requires a simplified model. And, in addition to large number of unconsidered factors, this method is susceptible to high taxes/fees that foreign funds could charge foreign investors. Its implementation could potentially be a controversial political gesture as well.

But we have seen small examples of this. For instance, the Czech republic, staying clear of the Euro-zone, can be seen as doing something similar to this strategy to boost its exports. By investing abroad, they have been able to increase their exports. We have also seen examples with larger impacts, specially from China. China invests huge sums in US and Japanese funds, and in return the US and Japan imports a large number of Chinese goods.

In fact, Japan has recently really been on the suffering end of this strategy, with their net exports have seeing a downturn due to this paradigm. China (along with the US), seeking higher returns on investments, invest in Japan. Logically, Japan increases its imports of Chinese goods and services. In fact, foreign direct investment (FDI) skyrocketed last month from China to Japan:

“The rise in outbound FDI in January was led by a 500 percent jump in investment in Japan, the ministry said without elaborating.”

Trading Economics (and Fed) shows data on Japan’s balance of trade over the past year (see below). Notice how after China’s 500% investment jump in January, leads to a heavy drop in Japan’s balance of trade that same month:

So things do look troubling in Japan. A good question you might be asking yourself: is the US being affected by this too? The short answer is yes. Even as the world’s richest country, we rank 2nd to China in exports as of 2012 (latest data). In fact, it makes plenty of sense that China is ranked 1st in exports.

Intellectual Property Protection

So this strategy seems like a trouble inducing arms race for lower interest rates across many countries. Is there anything else the US or other countries could do to improve its exports? Yes, especially for the US! The United States could protect its IP abroad. It certainly does have a lot of unique valuable exports that other countries demand. Some high demand products come from the entertainment (movies, music, etc) and technology industry (machinery, electronics, etc). But both of these products don’t get their fair share of purchases because of heavy media pirating and patented designs being exploited or stolen (ex: iPhone). Enforcing piracy and protection at home and especially abroad has been a difficult challenge that the country is still trying to resolve. This is an area that I think deserves more attention.

While all of this would help us recover from the economic downturn and have a healthy GDP, we would be doing a disservice to the “victim” countries by competing with their local businesses (shifting the supply curve upward) and enforcing protection of IP. If performing such actions cripples another nation’s economy, this has negative moral and political repercussions that shouldn’t be taken lightly. I think its important to realize what could be done to provide solutions, not necessarily to impulsively act upon them.

Quartz #45—>Actually, There Was Some Real Policy in Obama's Speech

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Link to the Column on Quartz

Here is the full text of my 45th Quartz column, “Actually, there was some real policy in Obama’s speech,” now brought home to supplysideliberal.com. It was first published on January 29, 2014. Links to all my other columns can be found here.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© January 29, 2014: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2015. All rights reserved.

In National Review Online, Ramesh Ponnuru described last night’s State of the Union speech as “… a laundry list of mostly dinky initiatives, and as such a return to Clinton’s style of State of the Union addresses.” I agree with the comparison to Bill Clinton’s appeal to the country’s political center, but Ponnuru’s dismissal of the new initiatives the president mentioned as “dinky” is short-sighted.

In the storm and fury of the political gridiron, the thing to watch is where the line of scrimmage is. And it is precisely initiatives that seem “dinky” because they might have bipartisan support that best show where the political and policy consensus is moving. Here are the hints I gleaned from the text of the State of the Union that policy and politics might be moving in a helpful direction.

  • The president invoked Michelle Obama’s campaign against childhood obesity as something uncontroversial. But this is actually part of what could be a big shift toward viewing obesity to an important degree as a social problem to be addressed as communities instead of solely as a personal problem.
  • The president pushed greater funding for basic research, saying: “Congress should undo the damage done by last year’s cuts to basic research so we can unleash the next great American discovery.” Although neither party has ever been against support for basic research, budget pressures often get in the way. And limits on the length of State of the Union addresses very often mean that science only gets mentioned when it touches on political bones of contention such as stem-cell research or global warming. So it matters that support for basic research got this level of prominence in the State of the Union address. In the long run, more funding for the basic research could have a much greater effect on economic growth than most of the other economicpolicies debated in Congress.
  • The president had kind words for natural gas and among “renewables” only mentions solar energy. This marks a shift toward a vision of coping with global warming that can actually work: Noah Smith’s vision of using natural gas while we phase out coal and improving solar power until solar power finally replaces most natural gas use as well. It is wishful thinking to think that other forms of renewable energy such as wind power will ever take care of a much bigger share of our energy needs than they do now, but solar power is a different matter entirely. Ramez Naam’s Scientific American blog post “Smaller, cheaper, faster: Does Moore’s law apply to solar cells“ says it all. (Don’t miss his most striking graph, the sixth one in the post.)
  • The president emphasized the economic benefits of immigration. I wish he would go even further, as I urged immediately after his reelection in my column, “Obama could really help the US economy by pushing for more legal immigration.” The key thing is to emphasize increasing legal immigration, in a way designed to maximally help our economy. If the rate of legal immigration is raised enough, then the issue of “amnesty” for undocumented immigrants doesn’t have to be raised: if the line is moving fast enough, it is more reasonable to ask those here against our laws to go to the back of the line. The other way to help politically detoxify many immigration issues is to reduce the short-run partisan impact of more legal immigration by agreeing that while it will be much easier to become a permanent legal resident,citizenship with its attendant voting rights and consequent responsibility to help steer our nation in the right direction is something that comes after many years of living in America and absorbing American values. Indeed, I think it would be perfectly reasonable to stipulate that it should take 18 years after getting a green card before becoming a citizen and getting the right to vote—just as it takes 18 years after being born in America to have the right to vote.
  • With his push for pre-kindergarten education at one end and expanded access to community colleges at the other end, Obama has recognized that we need to increase the quantity as well as the quality of education in America. This is all well and good, but these initiatives are focusing on the most costly ways of increasing the quantity of education. The truly cost-effective way of delivering more education is to expand the school day and school year. (I lay out how to do this within existing school budgets in “Magic Ingredient 1: More K-12 School.”)
  • Finally, the president promises to create new forms of retirement savings accounts (the one idea that Ramesh Ponnuru thought was promising in the State of the Union speech). Though this specific initiative is only a baby step, the idea that we should work toward making it easier from a paperwork point of view for people to start saving for retirement than to not start saving for retirement is an idea whose time has come. And it is much more important than people realize. In a way that takes some serious economic theory to explain, increasing the saving rate by making it administratively easier to start saving effects not only people’s financial security during retirement, but also aids American competitiveness internationally, by making it possible to invest out of American saving instead of having to invest out of China’s saving.

Put together, the things that Barack Obama thought were relatively uncontroversial to propose in his State of the Union speech give me hope that key aspects of US economic policy might be moving in a positive direction, even while other aspects of economic policy stay sadly mired in partisan brawls. I am an optimist about our nation’s future because I believe that, in fits and starts, good ideas that are not too strongly identified with one party or the other tend to make their way into policy eventually. Political combat is noisy, while political cooperation is quiet. But quiet progress counts for a lot. And glimmers of hope are better than having no hope at all.

Roger Farmer and Miles Kimball on the Value of Sovereign Wealth Funds for Economic Stabilization

Roger Farmer

Roger Farmer

As macroeconomic theorists, Roger Farmer and I have very different perspectives, but we have both come the conclusion that advanced economies should create institutions that treat sovereign wealth funds as a tool of economic stabilization. Sovereign wealth funds are already routine for governments that have more paper assets than liabilities. The new idea is that it is worthwhile for governments to borrow if necessary to finance sovereign wealth funds as a tool of economic stabilization. Here is my brief appeal for a US sovereign wealth fund in “Off the Rails: How to Get the Recovery Back on Track”:

Establishing a US Sovereign Wealth Fund to do the purchasing of long-term and risky assets would give the Fed room to maneuver in monetary policy, and restrict its job to steering the economy rather than making controversial portfolio investment decisions. And a US Sovereign Wealth Fund could stand as a bulwark against wild swings in financial markets.

The same argument holds for the UK or any other large advanced economy. 

In his academic research, Roger Farmer focuses on models with multiple rational-expectations equilibria, and takes that perspective in discussing his prescription for dealing with financial instability. By contrast, along with Robert Shiller and George Akerlof, I tend to think of genuine financial instability as arising from irrational swings in expectations with no firm foundation in fundamentals. Despite this stark theoretical difference, our policy views about sovereign wealth funds as agents of economic stabilization are remarkably similar. (This is not just my assessment: Roger was actually the first one to notice the similarity of our policy views some months back, and we have corresponded since then.)

Yesterday’s post by Matthew C. Klein, “Buy $3 Trillion in Stocks. What Could Go Wrong?” is a good source of links to others who are talking about a US sovereign wealth fund. I think what follows answers some of  the objections that Matthew raises. In particular, the institutional architecture for a sovereign wealth fund must be very carefully designed, and should be more like the way central banks are set up than the way current government investment funds are designed. And Roger solves the problem of how to vote shares for what the government owns.

Let me lay out references and quotations for the key elements of our argument.

1. Purchases of Long-Term and Risky Assets Work to Stimulate the Economy, Even When Short-Term Rates are at the Zero Lower Bound, But Such Purchases Deserve a New Institutional Framework

This is the gist of the argument in my first column on this issue:

Several other posts detail my thoughts on setting up such an institution:

Roger calls such an insitution a “fiscal authority,” while I call it simply a “sovereign wealth fund,” even though it would have key new features relative to existing sovereign wealth funds. But our essential idea is the same. Here is the relevant passage Roger’s John Flemming Memorial Lecture, given at the Bank of England on 16 October 2013: “Qualitative easing: a new tool for the stabilisation of financial markets” (pdf):

The institution that I would like to promote is a fiscal

authority, with the remit to actively manage the maturity

structure and risk composition of assets held by the public.

This authority would continue the policy of qualitative easing, adopted in the recent crisis, and by actively trading a portfolio of long and short-term assets it would act to stabilise swings in asset prices. I will show that asset price instability is a major cause of periods of high and protracted unemployment, and I will argue that by varying the maturity and risk composition of government debt, we can control large asset price fluctuations, and prevent future financial crises from wreaking economic havoc on all of our lives.

It is clear from other passages that Roger intends the sovereign wealth fund to deal with risky private sector assets as well.  In the design of how such an institution would handle stock holdings, Roger solved one problem I was stumped by: how to avoid government interference in the private sector by the way the sovereign wealth fund votes the shares of stock it owns. Exchange traded funds provide the solution. Here is the relevant passage from Jason Douglas's Wall Street Journal blog post about Roger’s proposal “How to Stop Financial Panics? Say Hello to Qualitative Easing”: 

In an interview, Mr. Farmer said he isn’t advocating government agencies buy individual stocks in such operations. Buying a stock index through a fund might be a less controversial approach, he said. He added international cooperation between such these qualitative-easing institutions would also be highly desirable.

Roger’s lecture at the Bank of England gives an extended defense of the efficacy of government purchases of long-term and risky assets. Roger uses the term “Qualitative Easing” whenever QE is done as a “twist” without increasing the money supply:

Following the 2008 financial crisis, central banks throughout the world engaged in an unprecedented set of new and unconventional policies. I would like to draw upon a distinction that was made by Willem Buiter, a former member of the Monetary Policy Committee, between quantitative and qualitative easing (Buiter (2008)). When I refer to quantitative easing I mean a large asset purchase by a central bank, paid for by printing money. By qualitative easing, I mean a change in the asset composition of the central bank. (2) Both policies were used in the current crisis, and both policies were, in my view, successful.

But when short-term rates are at zero, either way the oomph from QE comes the purchases of the long-term and risky-assets, not from whether that is done by issuing money or by issuing short-term safe bonds, so I am content to lump both quantitative and qualitative easing together as QE. Here are some things I have written on QE that I especially recommend:

2. Central Banks Should Not Be Too Quick to Worry about Financial Instability as a Result of Central Bank Action

Roger explains how QE works in this way: 

If confidence is low, the private sector places a low value on existing buildings and machines. Low confidence induces low wealth. Low wealth causes low aggregate demand, and low aggregate demand induces a high-unemployment equilibrium in which the lack of confidence becomes self-fulfilling. Qualitative easing works to combat this vicious cycle by increasing the value of wealth as governments absorb the risks that private agents are unwilling to bear.

I would say “partially self-fulfilling” rather than “self-fulfilling,” but otherwise this is very much like what I write in my column

There I argue that monetary policy has to work either through raising wealth or by making it possible for people to borrow who couldn’t borrow before. If increases in wealth due to monetary policy and people who couldn’t borrow before becoming able to borrow are always seen as dangerous financial instability, then there is no room for monetary policy to do its job during a serious recession without someone complaining of dangerous financial instability.

3. A Sovereign Wealth Fund Can Reduce Financial Instability by Countercyclical Investment Policies

Here is the case I make: 

For the case Roger makes, let me start with what Jason Douglas says in his article about Roger’s plan, “How to Stop Financial Panics? Say Hello to Qualitative Easing”:

How can governments stop financial panics wrecking their economies? A paper published by the Bank of England on Friday proposes a radical solution: a new breed of central bank-like institutions that buy and sell assets to prevent destabilizing swings in prices.

Mr. Farmer writes that financial crises are a frequent occurrence and often hurt citizens not yet born, never mind those who have to live through them. Citing evidence from past stock market crashes and the more-recent fallout from the subprime housing collapse in the U.S., Mr. Farmer argues that asset market volatility wreaks havoc in the real world. Some people will pay twice as much for a home than a neighbor who purchased theirs only a few years earlier. School leavers seeking work in a recession may earn far less throughout their lives than near-contemporaries lucky enough to have found a job in a boom. Mass unemployment frequently follows financial collapse.

His solution: “qualitative easing,” and new institutions to implement it.

Here is Roger himself, in his lecture at the Bank of England:

The efficient markets hypothesis has two parts that are often confused. The first, ‘no free lunch’, argues that without insider information, it is not possible to make excess profits by buying and selling stocks, bonds or derivatives. That idea is backed up by extensive research and is a pretty good characterisation of the way the world works.

The second, ‘the price is right’, asserts that financial markets allocate capital efficiently in the sense that there is no intervention by government that could improve the welfare of one person without making someone else worse off. That idea is false. Although there is no free lunch, the price is not right. In fact, the price is wrong most of the time.

The crisis was caused by inefficient financial markets that led to a fear that financial assets were overvalued. When businessmen and women are afraid, they stop investing in the real economy. Lack of confidence is reflected in low and volatile asset values. Investors become afraid that stocks, and the values of the machines and factories that back those stocks, may fall further. Fear feeds on itself, and the prediction that stocks will lose value becomes self-fulfilling. …

In my view, the policy of qualitative easing should be retained as a permanent component and new tool for the stabilisation of financial markets. Initially it was considered a radical step for central banks to control interest rates. The use of interest rate control to stabilise prices has proven to be effective and should be continued. But one instrument, the interest rate, is not sufficient to successfully hit two targets. …  The remedy is to design an institution, modelled on the modern central bank, with both the authority and the tools to stabilise aggregate fluctuations in the stock market.

Since the inception of central banking in the 17th century, it has taken us 350 years to evolve institutions that have proved to be successful at managing inflation. The path has not been easy and we have made many missteps. It is my hope that the development of institutions that can mitigate the effects of financial crises on persistent and long-term unemployment will be a much swifter process than the 350 years that it took to develop the modern central bank.

A Final Thought: High Equity (Capital) Requirements as the Key to Minimizing the Harm from Remaining Financial Instability

A sovereign wealth fund, investing in a contrarian way, can reduce financial instability. But there is likely to be some financial instability remaining. The harm from this remaining financial instability can be reduced dramatically by high equity requirements. What do I mean by dramatically? The Financial Crisis of 2008 is the kind of thing that happens as a result of financial shocks when equity financing is only about 3% of the relevant asset class–mortgage-backed securities in this case. The crash of the internet stock bubble in 1999-2001 is the much less damaging kind of thing that happens as a result of financial shocks when equity financing is more than half of the relevant asset class.

I don’t know Roger’s views on this, and it is something that became clear to me only after much of what I have written on sovereign wealth funds. But I feel passionately about the importance of high equity requirements, which seem highly relevant to the topic of this post. So let me lay out here some of what I have written on high equity requirements as a way to protect the economy from the worst effects of financial shocks:

On the topic of equity requirements, my views are very close to those of Anat Admati and Martin Hellwig, which you can see at their website on this issue:

http://bankersnewclothes.com/

The Volcker Rule

Former Fed Chairman Paul Volcker suggested what has come to be called the Volcker Rule.

I am with Anat Admati and Martin Hellwig in strongly preferring tougher equity requirements on the liability side of the balance sheet that make sure banks and other financial firms are investing their own shareholder’s money to tight restrictions on the asset side like the Volcker rule. But given where the discussion is, I think the Volcker rule is a net plus. The Volcker rule can always be loosened later in exchange for higher equity requirements. The stronger the liability-side rules (high equity or “capital” requirements) the more financial firms can innovate on the asset side without putting the economy in danger, or putting taxpayers on the hook. The value of that innovation is one reason I think equity requirements are so much superior. Of course, there have to be *some* asset-side rules, but they only have to rule out quite extreme positions if the equity requirement is at 50%, as I recommended here:

Anat Admati, Martin Hellwig and John Cochrane on Bank Capital Requirements.

The reason common equity is such a good funding mechanism for financial stability is that stock prices go up and down all the time and no one is likely to be deceived by a claim that stocks are totally safe. By contrast, almost all forms of debt have built into them some relatively sudden transition from looking fairly safe to looking very scary when things go south. Stocks don’t have that sudden transition because they always look at least a little scary.

Quartz #35—>Get Real: Robert Shiller’s Nobel Should Help the World Improve Imperfect Financial Markets

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Link to the Column on Quartz

Here is the full text of my 35th Quartz column, “Get Real: Robert Shiller’s Nobel should help the world accept (and improve) imperfect financial markets,” now brought home to supplysideliberal.com. It was first published on October 16, 2013. Links to all my other columns can be found here.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© October 16, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2015. All rights reserved.

With the world still suffering from the 2008 financial crisis, it is good to see Nobel prizes going to three economists who have set the bar for analyzing how stock prices and other asset prices move in the real world: Eugene Fama, Robert Shiller, and Lars Hansen. Eugene Fama is best known for setting the benchmark for how financial markets would work in a world of perfect efficiency. Robert Shiller pointed out that financial markets look much less efficient at the macroeconomic scale of financial market booms and busts than they do at the microeconomic level of prices for individual stocks. And Lars Hansen developed the statistical techniques that have served as the touchstone for arbitrating between competing views of financial markets.

In many respects the “popular science” account of the work of Fama, Hansen and Shiller, given by the official Nobel prize website, is excellent. But its understated tone does not fully convey the drama of Fama and Shiller painting two diametrically opposed pictures of financial markets. (Nor the beauty and the clarity of Hansen’s way of thinking about the statistical issues in refereeing between these opposing views—but that would be too much to expect in a popular science treatment.) Fama’s picture of financial markets is Panglossian: all is for the best in the best of all possible worlds. In Shiller’s picture, financial markets are much more chaotic. As Berkeley economics professor and well-known blogger Brad DeLong puts it:

Financial markets are supposed to tell the real economy the value of providing for the future—of taking resources today and using them nor just for consumption or current enjoyment but in building up technologies, factories, buildings, and companies that will produce value for the future. And Shiller has, more than anyone else, argued economists into admitting that financial markets are not very good at this job.

Shiller’s view of financial markets that are swept up in successive excesses of optimism and pessimism allowed him to sound a warning of both the crash of the dot-com bubble in 2000 and the collapse of the house price bubble that interacted with high levels of leverage by big banks to bring down the world economy—to depths it still hasn’t recovered from.

Even when they don’t fully believe that all is for the best in the best of all possible worlds, the imaginations of most economists are captivated by the image of perfect markets, of which Eugene Fama’s Efficient Markets Theory provides an excellent example. The bad part about economists being riveted by the image of perfect markets is that they sometimes mistake this image for reality. The good part is that this image provides a wonderful picture of how things could be—a vision of a world in which (in addition to the routine work of facilitating transactions) financial markets gracefully do the work of:

  • information acquisition and processing,
  • getting funds from those who want to save to firms and individuals who need to borrow, and
  • sharing risks, so that the only risks people face are their share of the risks the world economy as a whole faces—except for entrepreneurs, who need to face additional risks in order to be motivated to do whatever they can to make their businesses successful.

One way to see how far the world is from fully efficient financial markets is that perfect markets would function so frictionlessly that the financial sector itself would earn income that was only a tiny fraction of GDP, where in the real world, “finance and insurance” earn something like 8% of GDP (see 1 and 2,) with many hedge fund managers joining Warren Buffett on Forbes’ list of billionaires.

One reason the financial sector accounts for such a big chunk of GDP may be that information acquisition and processing is much harder in the real world than in pristine economic models. After all, there is a strong tradition in economics for treating information processing (as distinct from information acquisition) as if it came for free. That is, look inside the fantasy world of almost all economic models, and you will see that everyone inside has an infinite IQ, at least for thinking about economic and financial decisions!

In the real world, being able to think carefully about financial markets is a rare and precious skill. But it is worse than that. Those smart enough to work at high levels in the financial sector are also smart enough to see the angles for taking advantage of regular investors and taxpayers, should they be so inclined. Indeed, two of the most important forces driving events in financial markets are the quest for plausible, but faulty stories about how the financial markets work that can fool legislators and regulators on the one hand and stories that can fool regular investors. A great deal of money made by those in the financial sector rides on convincing people that actively managed mutual funds do better that plain vanilla index funds—something that is demonstrably false on average, at least. And a surprisingly large amount of money is made by nudging regular investors to buy high-fee plain vanilla index funds as opposed to low-fee plain vanilla index funds. (There is a reason why, for my retirement savings account, I had to drill down to the third or fourth webpage for each mutual fund before I could see what fees it charges.) Even those relatively sophisticated investors who can qualify to put their money into hedge funds have been fooled by the hedge funds into paying not only management fees that typically run about 2% per year, but also “performance fees” averaging about 20% of the upside when the hedge fund does well, with the investor taking the full hit when the hedge fund does badly. So one crucial requisite for financial markets to do what they should be doing is for regular investors to know enough to notice when financial operators are taking them for a ride (which as it stands, is most of the time, at least to the tune of the bulk of fees paid) and when they are getting a decent deal.

For getting funds from those who want to save to those who need to borrow, the biggest wrench in the works of the financial system right now is that the government is soaking up most of the saving. The obvious part of this is budget deficits, which at least have the positive effect of providing stimulus for the economy in the short run. The less obvious part is that the US Federal Reserve is paying 0.25% to banks with accounts at the Fed and 0% on green pieces of paper when, after risk adjustment, many borrowers (who would start a business, build a factory, buy equipment, do R&D, pay for an education, or buy a house, car or washing machine) can only afford negative interest rates. (See “America’s huge mistake on monetary policy: How negative interest rates could have stopped the Great Recession in its tracks.”)

Yet, the departure from financial utopia that I find the most heart wrenching is the failure of real-world financial markets to share risks in the way they do in our theories. If financial markets worked as they should:

  • There would be no reason for the people in a banana republic to suffer when banana prices unexpectedly went down—that contingency would have been insured just as routinely as our houses have fire insurance,
  • There would be no reason for people to suffer if house prices unexpectedly went down in particular metropolitan areas more than elsewhere, since home price insurance built into mortgages would automatically adjust the size of the mortgage,
  • There would be no reason for people to suffer if the industry they worked in did unexpectedly badly, since that possibility would be fully hedged.

Some of these things don’t happen because people don’t understand financial markets well enough. But some don’t happen because the financial markets have not developed enough to offer certain kinds of insurance. All three winners this year richly deserve to be Nobel laureates. I tweeted the day before the announcement in favor of Robert Shiller because he, more than anyone else, has been trying to make financial markets live up to this vision of risk sharing. It not just that this is a big theme in the books he has written. Shiller has also patented new types of financial assets to enhance risk sharing and helped create the Case-Shiller home-price index as a foundation on which home-price insurance contracts could be based. Shiller’s vision of risk sharing is far from being a reality, but one day, maybe it will be. If that day comes, the world will look back on Robert Shiller as much more than a Nobel-Prize-winning economist. As Brad DeLong says of Shiller: “Pay attention to him.”

Banks Now (2008) and Then (1929)

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The Hellhound of Wall Street: How Ferdinand Pecora’s Investigation of the Great Crash Forever Changed American Finance

James Grant’s October 2010 review of Michael Perino’s book The Hellhound of Wall Street is titled “Out for Blood: A Portrait of the prosecutor charged with investigating the 1929 crash.” Trying to distinguish between size of shock and ability to withstand a shock of a given size, James Grant contrasts the stability of banks back then compared to banks now:

For 10 days in March 1933, Pecora’s investigatory target was Charles E. Mitchell, chief executive of National City Bank, later to become Citigroup. “Sunshine Charley,” as Mitchell was mockingly known after his fall from grace, came pre-convicted, but his bank was a pillar of strength. Today, in the wake of the serial bailouts of 2008-09, Mitchell’s managerial achievement seems almost mythical. From the 1929 peak to the 1933 depths, nominal GDP fell by 45.6%—the American economy was virtually sawed in half. By contrast, during our late, Great Recession, nominal GDP dropped by only 3.1%. Yet this comparatively minor perturbation sent Citigroup into the arms of the federal government to the tune of $45 billion in TARP funds and wholesale FDIC guarantees of the bank’s tattered mortgage portfolio.

National City did accept a $50 million federal investment in 1934, after Mitchell resigned. However—and herein lies the difference—the bank’s solvency didn’t hinge on that cash infusion. Many banks did fail in the Depression, of course. But from today’s perspective the wonder is that so many didn’t.

There is a moral to this story. We have better monetary policy now than at the beginning of the Great Depression. And we know enough to know that to save the economy we need to bail banks out, if they would otherwise drag the economy with them. But what we have not yet learned is that to keep banks from needing to be bailed out, the key is to have much higher equity requirements than those contemplated today, even under the heading of financial reform.

Here is how I frame the issue in my column “How to Avoid Another Nasdaq Meltdown: Slow It Down (to Only 20 Times Per Second)”:

In academic finance, concerns about high-frequency trading go under the heading of “market microstructure” issues. There are other bigger problems in finance at the macroeconomic level that I have talked about morethanonce [3 different links]. The best reason to fix unfairness—or even perceived unfairness—in market microstructure is so people aren’t distracted from noticing how those in the financial industry use low levels of equity financing (often misleadingly called capital) to shift risks onto the backs of taxpayers and rewards into their own pockets. In quantum mechanics, electrons can “tunnel” from one side of a barrier to another. Using massive borrowing to ensure later government bailouts, the financial industry has perfected an even more amazing form of tunneling: the art of tunneling money from the government so that the profits appear on their balance sheets and in their pockets long before the money disappears from the US Treasury in bailouts. By comparison with this financial quantum tunneling of money from the US taxpayer that has been a mainstay of the financial industry, high-frequency trading profits of a few billion dollars a year are small change.

And here is the question I posed in my column “Three Big Questions for Larry Summers, Janet Yellen, or Anyone Else Who Wants to Head the Fed”:

What do you think of what Anat Admati and Martin Hellwig have to say about financial regulation in their book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It? Their argument comes down to this: despite all of the efforts of bankers and the rest of the financial industry to obscure the issues, it all comes down to making sure banks are taking risks with their own money—that is, funds provided by stockholders—rather than with taxpayers’ or depositors’ money. For that purpose, there is no good substitute to requiring that a large share of the funds banks and other financial firms work with come from stockholders. (For follow-up questions on financial regulation, Admati and Hellwig have an invaluable cheatsheet.)

That is a question I now pose to all of you. I give my answer here and here.

Quartz #32—>Talk Ain't Cheap: You Should Expect Overreaction When the Fed Makes a Mess of Explaining Its Plans

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Link to the Column on Quartz

Here is the full text of my 31st Quartz column, “You should expect panic when the Fed makes a mess of explaining its plans," now brought home to supplysideliberal.com. It was first published on September 19, 2013. Links to all my other columns can be found here.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© September 19, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2015. All rights reserved.

Back in June, Ben Bernanke told the press:

If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of [asset] purchases later this year.

That sentence was interpreted as signaling a tightening of the path of monetary policy, and rocked markets around the world. Bernanke and other members of the US Federal Reserve’s monetary policy committee made great efforts to fight that perception of tighter policy intentions, but it is only with yesterday’s announcement that

… the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its [asset] purchases

the markets have been convinced that the Fed intends to continue to use the “quantitative easing” provided by buying long-term government bonds and mortgage-backed assets to stimulate the economy until things look better.

I agree with Justin Wolfers, writing in Bloomberg, that the way Bernanke talked in June about “tapering” off asset purchases was a serious mistake, only partly rectified by the Fed’s announcement today. But the real fault lies with an approach to monetary policy that relies so heavily on communicating the Fed’s future intentions.

Monetary policy’s dependence on what the Fed calls “communications” is problematic because members of the Fed’s monetary policy committee don’t even agree on what war they are fighting. Some view the battle as one of fighting back from a close call with the possibility of another Great Depression. Janet Yellen, the clear frontrunner to succeed Ben Bernanke now that Larry Summers has bowed out, is in this camp. Some just want to make sure monetary policy doesn’t contribute to another financial crisis. Still others worry about avoiding the inflationary mistakes of the 1970s. It is hard for a many-headed beast to signal a clear direction.

Secondly, the Fed’s approach of talk therapy is problematic because it is hard to communicate a monetary policy that is strongly stimulative now but will be less stimulative in the future. As I discussed in a previous column and in the presentation I have been giving to central banks around the world, adjusting short-term interest rates has an almost unique ability to get the timing of monetary policy right. Unfortunately, the US government’s unlimited guarantee that people can earn at least a zero interest rate by holding massive quantities of paper currency stands in the way of simply lowering short-term interest rates. Without being able to cut short-term rates, the two choices left are (a) stimulative both now and later or (b) not-so-stimulative either now or later. Since the appropriate level of monetary stimulus now and a year or two from now are likely to be different, it is easy to see how the Fed’s thinking—and the market’s interpretation of the Fed’s thinking—could oscillate between focusing on getting the right level of monetary stimulus now, and getting the right level of monetary stimulus later.

My own recommendations for the Fed are no secret:

  1. Eliminate the zero-lower bound on nominal interest rates—or at least begin making the case to Congress for that authority.
  2. Develop a more rule-based approach to monetary policy focused on the level of nominal GDP in which (aside from urgent crises like that in late 2008) the role of “judgment calls” would be limited primarily to judgments about the highest level of output consistent with avoiding a permanent increase in inflation. Such an approach would allow the Fed to speak with a more unified voice despite disagreements among members of the monetary policy committee.
  3. Deal with financial stability by raising equity requirements for banks and other financial firms rather than thinking that tight monetary policy is the key to financial stability.