Quartz #62—>How Increasing Retirement Saving Could Give America More Balanced Trade

Link to the Column on Quartz

Here is the full text of my 62d Quartz column, “The TPP would be great for America if Americans had been saving for retirement,” now brought home to supplysideliberal.com. It was first published on May 14, 2015. Links to all my other columns can be found here.

In the column, I write:

Using back-of-the-envelope calculations based on the effects estimated in this research, they agreed that requiring all firms to automatically enroll all employees in a 401(k) with a default contribution rate of 8% could increase the national saving rate on the order of 2 or 3 percent of GDP.

Here is a rough idea of the kind of simple calculation that could back that claim up:

• Suppose current 401(k)’s give only one-quarter or less of the amount of saving if everyone had an 8% contribution rate–partly because many people aren’t covered at all. Then if no one opted out, the new regulation would add 6% to saving as a fraction of labor income. Multiply that by 2/3 for labor’s share, that is 4% more of GDP if no one opted out. Then the opt-out assumption is that 25% to 50% of people opt out.

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:

© May 14, 2015: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2017. All rights reserved.

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It is no accident that US president Barack Obama asked for fast track trade promotion authority after he had faced his last election. Free trade is good for economic growth. Economic theory predicts that the value to consumers, workers and owners of firms gained from free trade outweighs the value lost. So why do so many politicians see free trade as toxic politically?

One reason rightfully given for the political toxicity of free trade is that the concentrated losers from free trade are more obvious, more vocal, and better organized than the widely dispersed winners from free trade. During recessions, another factor in the opposition to free trade is that people blame trade for what is primarily a failure of monetary policy or a failure of financial stability policy. When the poor in other countries are out of mind, a concern about the effect of free trade on the poor in one’s own country can be a reason to oppose free trade. And one can cogently worry that free trade might adversely affect sectors of the economy that start out being stunted by product market and labor market distortions more than the sectors of the economy that would be helped by free trade (one of the few things that can overturn the theoretical prediction that the value gained from free trade outweighs the value lost).

Yet despite all these factors, I wonder if many who think of themselves as opposing free trade are really opposed to trade deficits. Let me speak as if the home country at issue is the US, but a similar question can be asked for many countries. How many people would be against free trade if it were balanced trade in which people and firms in other countries buy just as much from Americans as Americans buy from them?

If trade were balanced, it would mean that every dollar of imports would be balanced by a dollar of exports. Intuitively, freer trade means that people in the US can do more of what they are best at and less of what they are worst at—but with this subtlety: in producing goods and services people in the US are better at almost everything than people in other countries. So to have balanced trade, out of all the things people in the US are better at, some at the bottom of the list of US advantage (whether in ability to produce quantity or to produce quality) have to be imported in order to give people in other countries the US dollars they need to buy the things near the top of the list of US absolute advantage.

All of this gets thrown off when trade is not balanced. How can that happen? To simplify, when Americans buy Chinese goods with borrowed Chinese yuan, while the Chinese people and the Chinese government save the US dollars they get instead of spending them on American goods, and Americans follow the same pattern with many other countries, then the US will run a trade deficit. Running a chronic trade deficit results in less employment in a way that goes beyond the business cycle.

What is the remedy for unbalanced trade? It isn’t trade restrictions. Regardless of trade restrictions, as long as Americans are borrowing more from other countries than they are borrowing from us, the simple fact that they are directly or indirectly (when doing the foreign exchange transaction) handing Americans their currency when they lend guarantees that one way or another Americans will end up spending more on foreign goods and services than the other way around. Thus, the equation is that if you borrow from foreigners, you will buy more from foreigners than they will from you. (I explain this principle more on my blog.)

For a country running a trade deficit as the US is, given open financial markets, the only way to get to more balanced trade is for the American people, American firms or the US government to save more, or for Americans to shift their net financial investments toward lending to foreigners.

It might seem that it would be hard to raise the US saving rate given the limited success of past attempts. But the conjunction of psychology and economics has identified a powerful and underappreciated lever for raising saving, waiting to be used. In remarkable research initiated by Brigitte Madrian (now a professor at Harvard’s Kennedy school) and continued with the help of many coauthors, it has been found that when people are automatically enrolled in 401(k)’s, they save a lot more than when they have to actively set up 401(k) contributions themselves. Some people opt out of doing that extra saving, but many don’t.

I talked to Madrian and David Laibson, the incoming chair of Harvard’s Economics Department (who has worked with her on studying the effects of automatic enrollment) on the sidelines of a Consumer Financial Protection Bureau research conference last week. Using back-of-the-envelope calculations based on the effects estimated in this research, they agreed that requiring all firms to automatically enroll all employees in a 401(k) with a default contribution rate of 8% could increase the national saving rate on the order of 2 or 3 percent of GDP.

The regulation I am talking about would not require any change to the rate at which firms match their employee’s contributions. One of the biggest benefits would be helping people arrive at retirement well prepared financially. But it would also have a major effect on the US trade balance. If the US ran smaller trade deficits, employment would go up beyond any particular business cycle. If Americans were saving too much and had too many available jobs tempting them to work too much, that wouldn’t be a good thing for them. But right now, in this economy, more jobs and more savings are appropriate, so it would help them.

Automatic enrollment in retirement savings plans is so powerful that some economists will worry that its spread will help exacerbate a global glut of saving. But if paper currency policy gets out of the way of the appropriate interest rate adjustments, financial markets will find the appropriate equilibrium. They will balance the supply and demand for saving, and companies will realize the extent to which an abundance of saving makes available the funds they need to dream big by creating new markets and technologies that the future of America depends on.

The Arbitrage Pricing Theory as a Noise Trader Model

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The Arbitrage Pricing Theory or APT is not only one of the most basic theories of finance, it is one of the theories that is closest to being true. The theory itself gives a reason the APT is so close to being true: because it depends primarily on the principles of arbitrage and diversification being applied by some investors. So the APT is robust to large numbers of investors with a huge amount of investable wealth behind them being irrational–the “noise traders” of the post’s title–as long as there is a remnant of rational investors who also command a significant amount of investable wealth. 

In this post, I want to explain what I see in the APT at the level I do finance in my undergraduate “Monetary and Financial Theory” class. In particular, I am assuming the level of knowledge in my handout “Notes on the Capital Asset Pricing Model.” You can see another take on the APT in the Wikipedia article on Arbitrage Pricing Theory, and I would be glad for recommendations for other links to especially accessible and well-written treatments of the APT. 

To simplify, I am thinking about real returns over a short period of time, coming out of the usual jagged path of prices without sudden jumps. And I am leaving aside issues of intertemporal hedging so that everyone’s objective boils down to a function of only the mean and variance of the overall portfolio returns over that short span of time. (Key issues this leaves out are intertemporal hedging, which Matthew Shapiro, Tyler Shumway and Jing Zhang talk about as the issue of appropriate numeraire for each age by risk tolerance group by which to evaluate returns in our paper “Portfolio Rebalancing in General Equilibrium” and integration of human capital into portfolios.)   

The returns for different assets often covary, either positively or negatively. Some of this return variation and covariation might be due to the actions of the noise traders. Indeed, the returns due to variation in the required return for risky assets are a good candidate for noise-trader-induced return variation and covariation. 

If the way the return of each asset varies is thought of as a vector, then two assets that covary positively–that is, move together to some extent–can be thought of as vectors with an acute angle (of less then 90 degrees) between them. Two assets that covary negatively can be thought of as two vectors with an obtuse angle (of greater than 90 degrees) between them. Two assets that are uncorrelated can be thought of as two vectors that are orthogonal to one another–that is, two vectors that have a right angle of 90 degrees between them. From this point of view, all the variation and covariation of all of the assets out there can be thought of as an ellipsoid with many, many dimensions. 

To give you a little of the picture of what an ellipsoid in many dimensions is like, let me quote in full the text of my post “My Proudest Moment as a Student in Ph.D. Classes”: 

Ellipsoids, which are more or less a watermelon shape, are important in econometrics. In my Ph.D. Econometrics class at Harvard, Dale Jorgenson explained the effect of linear constraints by saying that slicing a plane through an ellipsoid would be like slicing a watermelon. Slices of a 3-dimensional ellipse–a watermelon–are in the shape of a 2-dimensional ellipse–a watermelon slice. Dale’s analogy of watermelons and watermelon slices inspired me to exclaim that slicing a 4-dimensional ellipsoid with a hyperplane would get you a whole watermelon! 

No matter how many dimensions are in play, except in rare cases of equal lengths, there will be one major axis (usually at a slant) along which the ellipsoid representing all the asset returns is the longest. In the APT, this represents the “first factor” or most important way in which the universe of assets covaries. Then, among all the directions at right angles to that, the longest axis is the “second factor” and so on. When the covariances of the returns are analyzed, it turns out that after a few factors (each at right angles to all the previous factors), the ellipsoid is pretty thin in all the directions at right angles to the first few factors.

Suppose that each of these factors is made into a hedge fund or mutual fund. If we go through all the factors, even the minor ones, and make them each into a hedge fund or mutual fund, these hedge funds and mutual funds (hereafter “hedge funds”) will cover all the bases and make any position possible that was possible with the full set of assets.

Imagine that there is a set of rational investors who all agree on these covariances and on the mean excess returns that each asset earns above the safe rate. These investors may differ in their risk aversion. I am going to leave aside any rational investors who are ever limited from short-selling or from borrowing to take a more than 100% position in risky assets overall, and focus on a core group of rational investors who are never limited in those ways.

Asset Demand by the Unconstrained Rational Investors 

Each unconstrained rational investor k will want to choose a share in each of the factor funds obeying the following equation:

share of wealth in factor fund i 

= risk tolerance of k * mean excess return of i / variance of i 

Here, risk tolerance is just a name for 1/relative risk aversion. Risk tolerance turns out to be a very useful concept because risk tolerance averages across people as a simple wealth-weighted mean, while risk aversion correspondingly averages across people as a more complex harmonic average. To see this note that 

total holdings of factor fund i by all unconstrained rational investors =

sum over unconstrained rational k of wealth of k * risk tolerance of k 

* mean excess return of i / variance of i.

It is convenient to define aggregate risk tolerance of unconstrained rational investors by 

aggregate risk tolerance of unconstrained rational investors

= sum over unconstrained rational k of 

(wealth of k / total wealth of core rational investors) * risk tolerance of k.

Then dividing the equation just before that by the total wealth of all unconstrained rational investors, 

share of the wealth of all unconstrained rational investor in factor fund i 

= aggregate risk tolerance of unconstrained rational investors  

* (mean excess return of i / variance of i). 

Setting Supply Equal to Demand

Think of the supply of each asset left over for the unconstrained rational investors as if it were exogenous. At any rate, however endogenous that is, since someone must hold all the assets that exist, whatever assets are left over for the unconstrained rational investors must be held by them as a group. I will represent the key aspects of the supply of assets left over for the unconstrained rational investors by the shares of the various factor funds in the total pile of wealth that the unconstrained rational investors as a group hold. 

It is natural to define the aggregate risk aversion of the unconstrained rational investors as 1 / aggregate risk tolerance of unconstrained rational investors. Given that definition, after setting the shares in the supply left over for the unconstrained rational investors to the share on the demand side for the unconstrained rational investors, a little algebra gives a formula for the mean excess return of factor fund i when the 

mean excess return of i 

= aggregate risk tolerance of unconstrained rational investors 

* variance of i 

* share of i in what is left over for unconstrained rational investors.

The interesting thing about this equation is that it has the key asset pricing prediction for the APT: that the mean excess return is almost zero for a minor factor (e.g. the 23d factor) for which the factor fund has almost no variance after the diversification implicit in forming the i-th factor fund. 

Among factors that have some variance even after diversification, the mean excess return will be higher when the unconstrained rational investors are asked to hold a lot of it–as well as, of course, factors that have a high variance. 

The Covariance with the Unconstrained Rational Investors’ Portfolio

Consider an unconstrained rational investor k. Let the risk aversion of investor k be Ak. Call the excess return of this investor’s whole chosen portfolio (including whatever safe assets it contains) yk. Let h be the amount of any asset with excess return x more or less than what investor k actually chooses. By the definition of h as a perturbation, the optimal level of h is 0. That is:

h* = 0.

Because of the simplifying assumptions (including continuous time), the investor maximizes a mean-variance expression:

{max over h} E ( yk + hx) - (Ak/2) Var( yk+ hx).

Using a little statistical algebra, including expanding the variance as one would the square of a sum, this optimization problem becomes

{max over h} E (yk) + h E(x) - (Ak/2) Var( yk) - h Ak Cov(yk,x) - (h2/2) Ak Var(x).

(h2 here is just h squared.) As a function of h, this is a smooth parabolic hill. The easiest way to find the top of the hill–the optimal value of h or h*–is to use the fact that the top of a smooth hill has a zero slope. Taking the derivative with respect to h and writing that it is zero at h*, 

E(x) - Ak Cov(yk,x) - h* Ak Var(x) = 0.

But because h* was a disturbance or perturbation away from what the rational investor chose to do, h*=0. Thus, after a tiny bit of rearrangement: 

E(x) = Ak Cov(yk,x)

or

( E(x) / Ak ) = Cov(yk,x).

If zk is the fraction of all the wealth of unconstrained rational investors held by investor k, then 

sum over unconstrained rational k of [zk ( E(x) / Ak )]

= sum over unconstrained rational k of [zk Cov(yk,x)].

This boils down to the very interesting equation

aggregate risk tolerance of unconstrained rational investors * E(x)

= Cov(y,x),

where y is the excess return of the aggregate portfolio (including any safe assets) of all unconstrained rational investors put together. Equivalently, for any asset with excess return x,

E(x) = aggregate risk aversion of unconstrained rational investors * Cov(y,x).

That is, with supply equated to demand, the excess return of any asset must be proportional to the covariance of that asset with excess return of the pile of assets that have been left over for the unconstrained rational investors. This is true even if most investors are noise traders, as long as there is a core group of unconstrained rational investors. The constant of proportionality is the aggregate risk aversion of those rational investors. 

The Capital Asset Pricing Model

The Capital Asset Pricing Model–or CAPM–is the special case of the APT in which all investors are unconstrained rational investors. Then the assets left over for the unconstrained rational investors is simply the universe of all assets (including any safe assets), and the mean excess return of any asset is proportional to the covariance of that asset with the portfolio composed of the universe of all assets. And the constant of proportionality is equal to the aggregate risk aversion of all investors. 

One nice thing about this proposition is that if there are some households that avoid risky assets, but all investors who do invest in risky assets are rational, then all risky investors are rational, and the logic above implies that the CAPM will still hold (since the covariances only depend on the risky assets), except that the constant of proportionality is their aggregate risk tolerance only if the safe assets held by the households that (perhaps irrationally) do not invest in risky assets are excluded.

Note that if investors cannot see through the government veil so that Ricardian equivalence and Wallace equivalence totally fail, then the unconstrained rational investors would be simply the private investors and the covariance that matters is with the portfolio of private investors and the aggregate risk tolerance is that of the private investors. 

Note on the Integration of Human Capital and Houses into the Rational Investors’ Portfolio

If the unconstrained rational investors integrate human capital into their portfolio decisions, that complicates things. One simple way to modify the propositions above to finesse that issue is to focus on unconstrained, rational, retired investors and to treat their social security wealth as a safe asset.

Their houses should be included in the aggregate portfolio of these investors, however, with the caveat that because of the frictions making it difficult to get a little more or a little less house, the covariance condition may not apply to the houses themselves, though it should apply to other more easily variable assets with the covariance including, in part, the covariance with those houses.

Intertemporal hedging is then one of the biggest remaining issues.

Note that even if everyone is rational, focusing on the covariance of an asset with the aggregate portfolio of retired investors could be helpful in order to avoid concerns about human capital.

Yichuan Wang: Stocks for the Long Run—Still a Wild Ride

I am delighted to be able to host another guest post by Yichuan Wang. Yichuan has appeared on “Confessions of a Supply-Side Liberal” in many capacities (as you can see by typing “Yichuan” into the search box down low on my sidebar), but this time it is as a student in my “Monetary and Financial Theory” class. This is the 13th student guest post this semester.You can see the rest here.

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I use simulations of stock market histories to show how long run investing is much more risky than is commonly believed. I show that:Long run average stock returns are a poor judge of how safe stocks are over longer runsReasonable levels of risk aversion can generate scenarios in which stocks deliver the same long run expected utility.Let’s first set up the simulation. Below is a stock price index for the United States from FRED. Stocks tend to trend upwards in the long run, and even when things go down in say 2002, they tend to go back up afterwards. This history makes it look like in the long run, you’re guaranteed to make money.

But as a first approximation, returns in one year should tell you nothing about returns in the next. After all, if you knew returns next year were going to be all of a sudden higher, you would have bought today! Formally, this means that returns can be approximated as being independent over time. So let’s try an experiment. In the data above, the average return in a given year was 7.5% with a standard deviation of 13 percent. Let’s generate returns that follow independent normal distributions with those properties, run it for 40 years, multiply all the returns, and see what stock prices look like:

And so even when returns from year to year are random, you still see “trends”. After the fast run up in the red line, there’s a “natural” pop of a bubble around year 34! But after a few years, you recover again. Hence this model of independent returns is plausible both from an economic theory perspective, and the graphs also look reasonable.

I generate 1000 such paths, and then they start looking like the plot below. Each black line represents some alternative history of the world in which returns every year had a mean of 7.5% and a standard deviation of 13%.

Now that we’ve run the simulation, we can see some interesting phenomenon:

1. Cumulated stock returns can be huge! In some of the best histories, you’ve increased your wealth by a factor of 100 over the course of 40 years. On the other hand, a 2% annually compounded bond would have only put you at a factor of 2.
2. But most of the final returns aren’t that high. Hence when we say that you can expect to earn a lot from holding stocks for 40 years, much of that expectation is being driven by the extreme right tail of extremely high returns.
3. In contrast to the Malkiel graph on the variance of average returns declining over time, it’s clear that the variance of total returns increases over time — the graphs get farther apart! And when you retire, you care about how much wealth you have left over at the end, not some accounting number about how much on average you earned over the past 40 years. In other words, it’s the variance in total returns, not average returns, that matters. Therefore long run average returns are a poor judge of the riskiness of long term investing.

Let’s turn to the second claim. Stocks usually beat bonds handily. But what happens in the nightmare scenarios in which they underperform?

To evaluate these scenarios, we need to plug in the cumulated returns into some kind of utility function. To make it easy, I consider two utility functions — CRRA utility with a risk aversion of 2† and log utility — and then as a comparison I plot just the raw total return. The key part about the utility functions is that there is diminishing marginal utility — a 1 million dollar loss hurts a lot, whereas a million dollar gain isn’t nearly as salient. This means that people are averse to risky gambles such as the stock market, but are still willing to make the bets if they think it will raise expected utility.

Below are the 1000 paths of utility and cumulated returns. The leftmost panel is just the plot of raw cumulated returns from above. The middle plot is what those returns would mean for log utility, and then the right plot is what utility looks like with a risk aversion coefficient of 2. The red line in each plot is a benchmark for what final total return or utility would look like if you instead invested at a risk free rate of 2%.

These charts show two things:

1. No matter your utility function, the probability of stocks outperforming bonds is the same. Roughly the same number of black lines are below the red line in each plot.
2. But when the black lines go below the red line when risk aversion is higher (see far right), the results are catastrophic.

Any measure of risk needs to both take into account the probability of losses and the magnitude of those losses. So as a benchmark risk measure, let’s compare the expected utility of investing in stocks relative to bonds:

Average stock returns trounce bond returns. But once you raise the risk aversion coefficient to 2, the expected utility from bonds is higher than expected utility from stocks. This is because stocks sometimes do really bad, and those scenarios hurt a lot.

Risk adjusted stock returns in this simple model are no safer than a 2% bond yield, and looking at average annual returns tells you little about how much risk there is in stock investing. The motivation for long run investing must be deeper than the higher returns to stocks, but that will have to be saved for a future post.

† I use risk aversion of two because it’s considered as an upper bound based on labor supply data, and although more extreme values come from the asset pricing literature, the more extreme values just reinforce the point that risk aversion matters.

Paul Krugman: Wall Street’s Revenge →

Paul Krugman’s piece linked above is nice bit of political economy, both for its succinct description of the layout of interest groups in our politics and for its warning about how the financial industry is trying to weaken the guardrails against the financial instability that could lead to future bailouts. Given its recent track record, the financial industry should not be trusted to write its own regulations, but it has enough money to buy many legislators. 

On this theme, in “Odious Wealth: The Outrage is Not So Much Over Inequality but All the Dubious Ways the Rich Got Richer” I write in praise of vulture capitalism, but what the financial industry wants is another matter:

Among excessive rewards caused by the government, bailouts without increases in equity requirements big enough to prevent future bailouts are especially unfair. But actions by the government to protect the profits and business models of firms already in place by standing in the way of firms doing new things in new ways can in the long run be just as damaging.  And in the digital age, copyright law is long overdue for reevaluation.

In “How to Avoid Another Nasdaq Meltdown: Slow Down Trading (to Only 20 Times Per Second)” I write:

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 more than once. 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.

Of course, the real authorities on these issues are Anat Admati and Martin Hellwig, who wrote The Bankers’ New Clothes. They are the ones who should be writing regulations for the financial industry, not the industry itself. You can see a brief summary of their argument in “Anat Admati, Martin Hellwig and John Cochrane on Bank Capital Requirements.”

Quartz #59—>Swiss Pioneers! The Swiss as the Vanguard for Negative Interest Rates

Link to the Column on Quartz

Here is the full text of my 59th Quartz column, “Swiss pioneers! What unpegging the franc from the euro means for the US dollar,” brought home to supplysideliberal.com. It was first published on January 16, 2015. Links to all my other columns can be found here.

This column is a follow-up to “The Swiss National Bank Means Business with Its Negative Rates." Thanks to Mark Fontana for letting me know in real time about the Swiss National Bank’s actions. Note that since I wrote this column, Denmark’s central bank has lowered its certificate of deposit rate to -.75%. I doubt they would have done that at this point without the example of the Swiss National Bank in going down to -.75% for the interest on reserves.   

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 16, 2015: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2017. All rights reserved.

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The Swiss National Bank’s dismantling of its ceiling on the value of the Swiss franc yesterday stunned the financial world. Jim Armitage and Russell Lynch of the Independent called the ensuing jump up in the value of the Swiss franc an earthquake; Social media called it “Francogeddon;” while the CEO of Swatch, Nick Hayek, called it “a tsunami for the export industry and for tourism, and finally for the entire country.” Thomas Jordan, the head of the Swiss National Bank, explained, “If you decide to exit such a policy, you have to take the markets by surprise.”

At points during the day yesterday, the Swiss franc was as much as 39% more expensive relative to the euro and the US dollar than it had been the day before. Exchange rate movements have yet to settle down, but seem to be headed for something closer to a 15%-25% increase in the value of the Swiss franc.

In my Dec. 19, 2014 column “The Swiss are now at a negative interest rate due to the Russian ruble collapse” I made three predictions. On one, I was spectacularly wrong. On the second, I was exactly on target. As for the third, its time has not yet come, but will.

When I wrote “no one should underestimate the Swiss National Bank when it says that it will do whatever it takes to keep its exchange rate at 0.833 euros per Swiss franc” I badly underestimated the speed of events. On top of the continuing crisis of the Russian ruble, the financial markets’ belief that the ECB will soon begin serious quantitative easing to lower yields in the eurozone is now also steering investors toward Swiss assets. And buying Swiss assets requires buying Swiss francs. So there is a scramble to get hold of Swiss francs, even at a premium.

The Swiss National Bank decided it was a fool’s game to fight this: keeping the ceiling on the Swiss franc’s price longer would have meant the Swiss National Bank taking bigger losses. As it is, the Swiss National Bank lost on the order of 60 billion Swiss francs (equivalent to about $68 billion in US dollars) when yesterday’s exchange rate movements made its foreign asset holdings worth that much less in terms of Swiss francs.

But events have borne out my second prediction: that the Swiss National Bank would move toward deeper negative interest rates. The SNB’s new interest rate for banks keeping money in an account at the SNB is now down to -0.75 % per year. That is three-quarters of a percent below zero. By comparison, the European Central Bank is still at -0.2% per year, or only a fifth of a percent below zero.

My third prediction was that the Swiss National Bank is prepared, if needed, to push interest rates lower still—beyond the -0.75% they are at now. In a bit of hyperbole, Hans Guenther-Redeker said in a Bloomberg interview that if the Swiss National Bank pushed interest rates down to -2%, “You have to make a bank depositor to pay for the services of the bank—or for the luxury of having a deposit with the bank. That is going to turn capitalism upside down.” Swiss National Bank interest rates at -2% now look much more likely to happen. If the Swiss National Bank does lower interest rates to -2%, capitalism will adjust, and the Swiss economy will get stimulus it badly needs.

Besides lowering interest rates, the other main option the Swiss National Bank has to keep the Swiss economy from sputtering is to push the Swiss franc down relative to the US dollar, now that the SNB has given up pushing the Swiss franc down so hard relative to the euro. But it will have to buy huge amounts of dollar assets to have much of an effect on the Swiss franc/dollar exchange rate if it doesn’t use interest rate cuts to help make the Swiss franc cheaper relative to the US dollar.

I am betting that, going forward, interest rate policy will be the linchpin for the Swiss National Bank rather than exchange rate interventions. What the Swiss National Bank knows that many financial market observers have not yet figured out is this: other than an economy that starts to boom and risk overheating from lower interest rates, there is no limit to how far a central bank can cut interest rates, as long as it cuts the interest rate on paper currency along with other interest rates.

As I explained to an attentive audience at the Swiss National Bank on July 15, 2014, in a negative interest rate environment, all that is needed to bring the rate of return on paper currency down in line with the other interest rates a central bank controls is to introduce, and for a time gradually increase, the size of a paper currency deposit fee when private banks come to deposit paper currency at the cash window of the central bank. Then, once a robust economy leads to positive interest rates again, the paper currency deposit fee at the central bank’s cash window can be gradually reduced back to zero, until the next time that negative interest rates are needed to keep the economy on track. (You can find all the details here.)

Although lowering the paper currency interest rate in tandem with other interest rates avoids the massive paper currency storage that would otherwise be a serious side effect of deep negative rates, there is no question that negative interest rates will require many detailed adjustments in how banks and other financial firms conduct their business. Like it or not, Swiss banks and the rest of the Swiss financial industry may be forced to lead the way in figuring out these adjustments, just as the Swiss National Bank is leading the way in figuring out how to conduct negative interest rate policy. The Swiss are eminently qualified for that pioneering role. The rest of the world would be well-advised to watch closely.

Quartz #56—>The Swiss National Bank Means Business with Its Negative Rates

Link to the Column on Quartz

Here is the full text of my 56th Quartz column, “The Swiss are now at a negative interest rate due to the Russian ruble collapse,” brought home to supplysideliberal.com. It was first published on December 19, 2014. Links to all my other columns can be found here.

I kept something closer to my working title as the title above. This column is in honor of all the amazing people I met at the Swiss National Bank. 

At this writing, this is my 7th most popular column ever, edging out “The National Security Case for Raising the Gasoline Tax Right Now” for that spot.  You can see a list of my most popular columns here.

Paul Krugman links to this column as a news source in his column “Switzerland and the Inflation Hawks.” The link is on the words “charging banks.” 

I knew I needed a big update to this column when I saw that the Swiss National Bank abandoned the ceiling on the value of the Swiss franc. So I wrote another whole column:

Swiss Pioneers! The Swiss as the Vanguard for Negative Interest Rates

I recommend reading that immediately after you read this column. 

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:

© December 19, 2014: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2017. All rights reserved.

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The initials “SNB” for the Switzerland’s central bank, the “Swiss National Bank” are about to become just as familiar as the initials ECB for the European Central Bank. Today, the SNB announced it would cut interest rates for banks that keep large amounts of money at the SNB to -.25%. Yes – a negative interest rate.

The SNB’s negative interest rate surprise is bigger news than it seems. Switzerland has strong reasons to turn to new monetary policy tools. The lackluster economic growth Switzerland has had since the Financial Crisis in late 2008–visible in the graph of Switzerland’s real GDP in the chart above–has brought inflation down until now it hovers around zero, as shown in the graph below:

The Swiss economy is heavily dependent on exports to the eurozone, which hasn’t fared well lately. And the Swiss economy has had troubles of its own. This past September, BBC News ran the headline “Swiss economy fails to grow as EU stagnates,”  accompanied by this quotation from Maxime Botteron Credit Suisse’s Maxime Botterton:

The trend in exports is not a big surprise. Trade data so far already pointed to a rather weak contribution of exports. What is a bit more surprising is the weak investment spending, especially in the construction sector.

Let me explain why the slowness of Swiss exports matters: Thomas Jordan, the head of the SNB, said during Thursday’s press conference that asset markets have been spooked by the fall of the Russian ruble and are looking for a safe haven. Switzerland has a long history of being just such a safe haven: during times of crisis, money flows in. So the ruble crisis is putting upward pressure on how many euros it costs to buy a Swiss franc, because more investors are trying to buy francs. A more expensive Swiss franc will make Swiss exports even more expensive, making it even harder to sell things produced in Switzerland to the rest of the world. The SNB is determined, therefore, to do whatever it takes to keep the Swiss franc from ever costing more than .833 euros.

The main tool the central bank has had for preventing the Swiss franc from appreciating is buying up enough foreign assets with Swiss francs to guarantee there are enough Swiss francs available in the world for anyone to buy one for .833 euros. The trouble with relying on that approach alone is that Switzerland winds up with a lot of foreign assets that are less safe than Swiss assets would be (especially when the effect of possible future exchange rate changes on those foreign assets are taken into account).

The world is used to positive interest rates: a borrower pays a lender for the use of money. Negative interest rates mean that the lender has to pay the borrower to keep money safe. Negative interest rates are a way for Switzerland to get paid for the safety it provides in a financially dangerous world. Then, if Switzerland ends up with risky foreign assets while foreigners end up with safe Swiss assets, at least Switzerland is getting paid for the difference between the safe assets it provides and the riskier assets it is buying.

The most remarkable thing SNB chief Thomas Jordan added to his initial remarks was the statement that despite already having a -.25% interest rate compared to the ECB’s higher -.2% rate, the SNB is prepared to go even further. As James Shotter and Alice Ross reported in the Financial Times

Mr Jordan said the SNB was prepared to take further steps to protect the minimum exchange rate if needed, including pushing rates deeper into negative territory and lowering the threshold above which the negative rates were charged.

The other hint that the SNB is prepared to go further was in its statement that its band for the Libor interest rate now goes all the way down to -.75 %.

A good question to ask now would be: Why is the SNB confident that it can go down to deeper negative rates? Most central banks are afraid that if they cut their target rates or interest rates on reserves too far into negative territory, people will start piling up paper currency, which may be inconvenient to store, but otherwise pays an interest rate of 0%, which might start looking very good, compared to, say -.75%.

The answer, which most observers don’t realize, is that the SNB can actually inflict a negative interest rate on paper currency as well. In a principle that the underappreciated polymath (art and cultural historian, Biblical scholar and monetary theorist) Robert Eisler groped towards back in 1932, there’s an easy way to exact a negative interest rate: Charge customers an exchange rate between paper currency and money in the bank. More recent economists, notably Willem Buiter (now Chief Economist of Citigroup) further elaborated on this idea.

On July 15, 2014, I gave a presentation at the SNB explaining how to use a fee on paper currency deposited at the SNB by private banks to generate a negative interest rate on paper currency. This was a variant on Robert Eisler’s approach. To generate a negative paper currency interest rate, the paper currency deposit fee has to gradually increase in size. But as soon as interest rates are positive again, the paper currency deposit fee can gradually shrink in size until it finally disappears, and things go back to the way things work now. So the SNB has the idea of a paper currency deposit fee to implement negative interest rates on paper currency in its back pocket.

There is a world of difference between a central bank that cuts some of its interest rates, but keeps its paper currency interest rate at zero and a central bank that cuts all of its interest rates, including the paper currency interest rate. If a central bank cuts all of its interest rates, including that paper rate, negative interest rates are a much fiercer animal.

As a professor who teaches for a living, I care most about whether students learn things in the end. But I can’t help but notice the difference between quick learners and slow learners. When it comes to how to do negative interest rates right, the people at the SNB are some of the quickest learners I’ve seen.

The bottom line is that no one should underestimate the Swiss National Bank when it says that it will do whatever it takes to keep its exchange rate at .833 euros per Swiss franc – even if it requires boldly cutting its interest rates to a depth no central bank has gone to before.

Jonathan Zimmermann—Swiss Franc Shock: Time to Take Advantage of Return Policies

Link to Jonathan Zimmermann’s LinkedIn profile

I am very pleased to kick off another season of guest posts from students in my Monetary and Financial Theory class. In this class, every student is required to write 3 blog posts every week. Each of the 40 students chooses 5 over the semester to submit to me, out of which I pick some of the best as guest posts here. (My teaching assistant, Ryoko Sato last year and Adam Larson this year, reads and comments on all of them, 120 a week!)

You can see links to all of the student guest posts from last year here. 

In this guest post, Jonathan Zimmermann is definitely thinking like an economist in the wake of the Swiss franc shock. Note that CHF is the symbol for Swiss francs, and SNB is the abbreviation for “Swiss National Bank.” Here is Jonathan:

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In the space of a few minutes, after the decision of the SNB to remove the floor on the EUR/CHF exchange rate, the cost of one Euro in terms of Swiss francs decreased from 1.2 to 0.86. The exchange rate eventually started to stabilize around the 1:1 parity rate, but as I write the Swiss franc is still more volatile than ever.

The repercussions of this decision are gigantic, and many brokers already announced hundreds of millions of losses. As a Swiss national however, I also notice the more direct (and easier to understand) repercussions of this shock. Indeed, most of my revenues and assets being directly indexed to the value of the Swiss franc, my purchasing power for international goods instantly increased by more than 20%.

Of course, our first reaction, we Swiss, is to think “Waouh! I’m rich, everything is cheap now!” Since the prices are likely to readjust progressively in a way or another, we will probably try to buy as many goods as possible from the rest of the world. As for the rest of the world, they will try to buy as few products from Switzerland as possible.

But we also regret everything we bought the previous day: if we had waited a bit more, they would have been much less expensive. And here is where it is interesting: it is actually possible to get some of your money back. Today, more than ever, return policies are powerful free “put options”.

In many physical and online shops, it is possible to return an item up to a few months after having bought it, to get your money back or a credit in the shop. Some stores are more flexible than others, and some even allow you to return an already used item without having to explain the reasons. Let’s say you received a new TV for Christmas last month that cost 1000CHF in Switzerland and was sold for 850 euros in the Eurozone (i.e. more or less the same price with the old exchange rate) only a few kilometers further. Today, by simply returning your TV to the store, changing the Swiss francs you received in euros and re-buying the same model of TV in France, you just earned 150 Swiss francs without losing anything other than time (and a bit of integrity). This is almost a pure form of arbitrage.

But even better: you could use a similar strategy on items you bought in another country, if you paid in Swiss francs with a Swiss credit card. Amazon’s policy, for example, is to refund you in your local currency at the same rate used when you placed the order! Let’s say you bought a pair of shoes last month for $200 (on the US website, but this would work in any country), paying in Swiss francs through the Amazon currency converter when the dollar was at 1.05. If you ask for a refund, Amazon will credit you 210CHF, and if you buy this same pair of shoes again it will now only cost you 180CHF ($200 at the current exchange rate of 0.9 CHF per USD). Amazon does not accept returns on already used items, but since there is no difference between the item you bought last month and the one you can order now, you can simply buy a new pair of shoes and return it as if it was the old one (so you don’t even need to still physically possess the item you purchased in the first place). Here again, without leaving your house you can make an arbitrage gain of 30CHF on a simple pair of shoes.

Of course, the strategy I just described is probably everything but moral, and I wouldn’t advise using it unless you are a huge fan of smoky-tactics-to-spare-a-few-dollars-and-make-you-feel-like-a-smart-guy. I didn’t use this strategy, and I don’t intend to, but I think it is interesting to be aware of and understand this unusual strategy that has never been more efficient than today.

Cognitive Economics

The image above is a computer simulation of the branching architecture of the dendrites of pyramidal neurons from the Wikipedia article on “Mind.”

Here is a link to an ungated copy of my paper "Cognitive Economics" as it appears in the Japanese Economics Review. By special arrangement with the Japanese Economics Review, this paper is in the public domain. The presentation I gave at the Japanese Economic Review conference for this conference volume is here. 

This paper is written in the same style as my more academic blog posts. So I count it as a major blog post as well as an NBER Working Paper. It just happens to be a blog post that you need to follow a link to see in full. (And sadly, like the typical blog post, despite diligent efforts, a few typos have crept through. The number and severity of typos I find will have to reach a certain critical threshold before I put the NBER staff to the work of putting together a new version. Please let me know if you find a typo)  

Let me give you a bit of a preview, in the form of an outline with one or more key quotations from each section and subsection:

I. Introduction

• … research in “Cognitive Economics” has already been underway for a long time. But as a participant in this subfield, it seems to me that research in this area has been growing in recent years.

II. Defining Cognitive Economics

• Cognitive Economics is defined as the economics of what is in people’s minds. In practical terms, this means that cognitive economics is characterized by its use of a distinctive kind of data. This includes data on expectations, hypothetical choices, cognitive ability, and expressed attitudes.

• The name “Cognitive Economics” might initially sound as if it might be yet another synonym for Behavioral Economics … The most obvious difference is that Cognitive Economics is narrower. Behavioral Economics addresses a huge range of issues and cuts across all of the data types listed above, while Cognitive Economics focuses primarily on innovative kinds of survey data … Second, important pieces of Cognitive Economics are inspired by the internal dynamic of economics rather than by psychology.

• … there is an obvious complementarity between Cognitive Economics and Behavioral Economics. Although it is possible to consider nonstandard theories of human behavior on the basis of standard data on market decisions alone, freeing up economic theory from traditional assumptions tends to increase the number of free parameters. There is a great value to additional data that can help pin down these additional free parameters.

• … let me give my opinion on existing research and future directions in Cognitive Economics, organized around three themes: using data on hypothetical choices and mental contents (1) to identify individual heterogeneity, (2) to revisit welfare economics and (3) to study finite cognition.

III. Identifying Individual Heterogeneity

• Heterogeneity across individuals in preferences and cognitive ability is not at all controversial. But data limitations have often forced economists to assume uniformity. Here the kind of data discussed above can do a lot to allow economists to capture some of the heterogeneity that exists.

IV. Revisiting Welfare Economics

• The use of self-reported happiness to study welfare issues illustrates a key methodological issue in Cognitive Economics. Whenever a new measure is used, its relationship to standard concepts of economic theory is at issue.

• It is possible, however, that happiness data could have a tight relationship to preferences even if the level of happiness does not. In particular, to explain the data, Kimball and Willis (2006) suggest that a large component of self-reported happiness depends on recent innovations in lifetime utility. Whenever people receive good news about lifetime utility, self-reported happiness temporarily spikes up; whenever people receive bad news about lifetime utility, self-reported happiness temporarily dips down. If true, this means that while it is questionable to use the level of happiness to infer preferences, the dynamics of happiness are informative about preferences and so can be used to inform welfare economics.

V.  Studying Finite Cognition

• Moreover, to avoid the judgment Herbert Simon’s phrase “bounded rationality” can inadvertently suggest, I will refer instead to “finite cognition.”[3] Finite cognition means something more than just imperfect information—it means finite intelligence, imperfect information processing, and decision-making that is costly.

• [3] Often, the inadvertent judgment suggested by “bounded rationality” is quite inappropriate. For example, if decision-making is actually costly, which is more “rational,” to choose in a way that takes into account the costliness of decision-making or to pretend that decision-making has zero cost? If one’s intelligence is actually finite, which is more rational, taking into account the limits on one’s intelligence, or pretending that one’s thinking power is unlimited? There is certainly a sense in which knowing and adjusting to one’s own limitations can often be the height of “rationality.”

• finite cognition implies that even in the absence of externalities, welfare can often be improved by economic education, setting up appropriate default choices for people, or providing disinterested, credible advice. By contrast, explanations of puzzling behavior on the basis of individuals maximizing exotic preferences imply (if true) that welfare improvements must come in the standard way from addressing externalities, or in the case of inconsistent preferences, by taking sides in an internal conflict. Once puzzling behavior that is difficult to explain on the basis of standard economic theory is identified, it is hard to think of a more important question than whether people behave that way because they want to, or simply because they are confused.

A. The Reality of Finite and Scarce Cognition.

• Although the inadequacies of our current tools can make it hard to study finite cognition theoretically, the claim that human intelligence is finite–and that finite intelligence matters for economic life—scarce cognition—is not really controversial.[4]

• [4] There are many problems that are too hard for even very high levels of intelligence. For example, one of the problems with Bayesian updating is that, strictly speaking, it involves putting a positive probability on a much greater than astronomically huge set of possibilities. Various strategies of economizing on information processing are always essential in practice. Even the existence of a utility function itself is, in a sense, a technique of economizing on information transfer and processing. If evolution could process an infinite amount of information, and the genetic code could transmit an infinite amount of information, we could be endowed with decision rules embracing essentially all contingencies instead of mere objective functions and calculation capabilities.

B. Difficulties in Studying Finite Cognition with Standard Theoretical Tools.  

• One key reason it is not easy using our standard theoretical tools to model finite cognition is the “infinite regress” problem emphasized by John Conlisk (1996). The infinite regress problem afflicts models that assume a cost of computation or other decision-making cost. The problem is that figuring out how much time to spend in making a decision is almost always a strictly harder decision than the original decision.

• Costs to decision-making are a natural enough assumption for economists that a substantial percentage of all applied economic theory papers might include them, if it were not for the infinite regress problem. Finessing the infinite regress problem somehow is essential if economists are to develop effective theoretical tools for studying finite cognition. There are several feasible strategies for getting around the infinite regress problem—every one of which requires breaking at least one inhibition shared by many economists.

1. Least transgressive are models in which an agent sits down once in a long while to think very carefully about how carefully to think about decisions of a frequently encountered type.

2. A second strategy is to give up on modeling finite cognition directly and use models of limited information transmission capacity as a way of getting agents to make more imperfect decisions. In other words, one can accept the fact that our standard tools require constrained optimization with its implication of infinite intelligence somewhere in the model, but handicap agents in the model by giving them a “thick skull” that is very inefficient at transmitting information to the infinitely intelligent decision-maker within (that is, the perfect constrained optimizer within).

3. A third feasible strategy is in the spirit of what the complexity theorists call “agent-based modeling. … This type of modeling substitutes the problem of agents that have unrealistically subhuman intelligence for the problem we have been focusing on of agents that have unrealistically superhuman intelligence. Despite this lack of realism, the results can be very instructive because the failure of realism is in the opposite direction from what economists are used to.

4. I would like to focus on a fourth strategy for getting around the infinite regress problem–one that seems to me less commonly used: modeling economic actors as doing constrained optimization in relation to a simpler economic model than the model treated as true in the analysis. This simpler economic modeled treated as true by the agent can be called a “folk theory.“ … A folk theory should not be confused with the Folk Theorem of repeated game theory. I am talking about folk economics in the same sense as the well established ideas of “folk psychology,” “folk physics” and “folk biology.”

C. Modeling Unawareness Requires a Subjective State Space for the Economic Actor Distinct from the True State Space.

• Dekel, Lipman and Rustichini (1998) argue for relaxing what they call the “real states” assumption as follows:

• In standard state-space models, states play two distinct roles: they are the analyst’s descriptions of ways the world might be and they are also the agent’s descriptions of ways the world might be. If the agent is unaware of some possibility, though, ‘his’ states should be less complete than the analyst’s. In particular, the propositions the agent is unaware of should not ‘appear in’ the states he perceives.

• Departures from the real states assumption would allow agents to have a different model of the economic situation in their minds than the maintained assumptions the analyst is using to model the situation of those very agents.

• Note that if someone is successfully taught a more sophisticated model, this would involve an expansion in the individual’s subjective state space. If positive probabilities were accorded to the newly added states, this must necessarily involve a departure from Bayesian updating. Presumably it is also possible for people to “see the light” even without being explicitly taught. For example, the agent might be driven to entertain an expanded model if the probability of observed events conditional on the initial folk model ever appeared sufficiently low. We all recognize the practical importance of expansions in one’s subjective state space when in scientific contexts we say “Asking the right question is half the battle.”

D. Using Folk Theories to Model Finite Cognition: A Portfolio Choice Example. 

• Clearly, the desirable properties for a modeled folk theory are quite different from the desirable properties for a theory proposed as a good approximation of reality. A folk theory need not be logically consistent at a deep level. Indeed, in representing reality, it may be a positive virtue for a folk theory to have logical inconsistencies of a form similar to the logical inconsistencies real people might have in their views of the world. Other than (a) descriptive accuracy as a reasonable representation of how people actually view the world, for theoretical purposes the key desirable properties for a modeled folk theory are (b) providing a clear prediction for how the people holding that folk theory will behave in various circumstances and © representing clearly what the people holding the folk theory are confused about and what they do understand. In terms discussed in Richard Herrnstein (1997)–particular in the chapters with Drazen Prelec–a folk theory should at least implicitly model the accounting framework that an agent uses, in addition to the objective function. Because it need not be logically consistent at a deep level, the argument for a folk theory can involve (correct reasoning about) logical leaps and plausible, though fallacious reasoning.

• In reality, I am confident that people’s thinking about portfolio choice varies from person to person with a wild profusion of different kinds of misunderstanding. In most other contexts as well—at least where there is some complexity–any model that assumes everyone’s folk theory is of the same type is likely to be false. Realizing that people don’t always have the same mental model of a situation as the economist studying that situation is the first step toward facing the motley truth about people’s folk theories.

VI. Conclusion

• Economic research using more and more direct data about what is in people’s minds is flourishing. But much more can be done. Fostering continued progress in this area of Cognitive Economics calls for three inputs. First, new theoretical tools for dealing with finite cognition need to be developed, and existing theoretical tools sharpened. Second, welfare economics needs to be toughened up for the rugged landscape revealed by peering into people’s minds. Third, the statement “The data are endogenous” needs to become not only an econometrician’s warning but also a motto reminding economists that new surveys can be designed and new data of many kinds can be collected to answer pressing questions.

Robert Flood and Company on Bubbles | A Facebook Convo →

I am delighted when my Facebook page becomes the site for serious economic discussion. Here is a great example. 

Miscellaneous Notes about Facebook and Tumblr: A reminder to everyone: my Facebook page is totally public.

By the way, I put links to all of my blog posts on my Facebook page. So anyone who wants to follow my blog on Facebook can do that. At this point, I routinely accept friend requests from everyone who seems human (as opposed to a bot).

“ASSET BUBBLES

In a 1985 paper, [Jean Tirole] offered three conditions needed to create a bubble: durability, scarcity and common beliefs. ‘The possibility of creating too much’ of an asset ‘may prevent bubbles,’ he wrote. ‘The scarcity requirement explains why, at first sight, bubbles often affect assets that for historical reasons cannot be reproduced.’”

– Nick Timiraos and Charles Duxbury, in the Wall Street Journal article “5 Contributions to Economics from Nobel Winner Jean Tirole”

How and Why to Avoid Mixing Monetary Policy and Fiscal Policy

Link to image source: “Reconvo: The Blacklist S2 Ep. 1 Lord Baltimore”

When Raymond Reddington (played by James Spader) burns a pile of US paper currency in the second season opening of “The Blacklist,” he is giving a gift to the Federal Reserve (the “Fed”), and through the Fed, to the US government. To see this, notice that right after the US paper money is burned, the Fed can ask the US Mint to print an equal amount of paper currency for its vaults, and other than the cost of the paper and ink themselves, get the same result as if Raymond Reddington had given the paper currency directly to the Fed. This would be income to the Fed, and unless the Fed increased its expenses, would ultimately be added to the check that the Fed sends to the US Treasury every year.  

Similarly, if the Fed mails money to every US citizen, instead of using the money it creates to buy US Treasury bills, as it usually does, then the US Treasury ends up selling those bonds to someone else and the US government ends up owing that amount to someone else who won't ultimately send the interest it earns back to the US Treasury as the Fed does. 

Indeed, if the Fed mails every citizen money–a so-called “helicopter drop”–it is equivalent to the Fed doing its usual thing of buying US Treasury bills, plus the US Treasury issuing treasury bills to finance sending money to every citizen. The reason treating a helicopter drop as the combination of these two operations is useful is that the first (the Fed buying US Treasury bills) is the normal way that the Fed changes interest rates (when the zero lower bound doesn’t get in the way), while the second (the US Treasury selling bonds to finance sending money to every citizen) brings in all the complexity of fiscal policy. In the present, it takes money from those who buy the new bonds (who presumably like to save) and gives it to all the citizens (among whom there are some who like to spend). From a long-run perspective, having the US Treasury sell bonds to finance sending money to every citizen takes money from future taxpayers, in proportion to who would be asked to pay extra future taxes, to spread it out relatively evenly to citizens now. So there is redistribution. And the overall amount of redistribution that takes place through fiscal policy is an object of fierce debate between the major political parties.

I think the debate about how much redistribution should take place should be carried out in as open and transparent a way as possible. But if there are to be any obfuscations in this area, leave the Fed out of those obfuscations! If you think it is a good idea to mail money to every citizen, let the US Treasury do it; then no one will mistake what is going on, and the argument can be in the open.   

Now, when the economy needs stimulus, and monetary policy is seriously constrained in a way that can’t be helped, mailing a credit card to every citizen with a $2000 line of credit as I have advocated is somewhere between regular fiscal policy and regular monetary policy, and might be appropriate to put under the Fed’s jurisdiction. Such a policy strives not to redistribute, though it unavoidably does to some degree when some fraction of people fail to repay the loan from the government. 

In addition to thinking that arguments about redistribution should be out in the open (as they are on my blog), I think it is important that the Fed be shielded from politics as much as possible in order to allow it to do its job of economic stabilization (keeping output at the natural level as that natural level shifts around in response to technological progress, and keeping the price level steady). That is why I argued in my column “Why the US Needs Its Own Sovereign Wealth Fund” that instead of having the Fed engaged in “quantitative easing,” buying anything other than 3-month Treasury bills should be left to another, new government agency:

… isn’t it a bit much to expect the Fed to both choose the right amount of stimulus for the economy and decide which financial investments are the most likely to turn a profit for a government that faces remarkably low borrowing costs?

Why not create a separate government agency to run a US sovereign wealth fund? Then the Fed can stick to what it does best—keeping the economy on track—while the sovereign wealth fund takes the political heat, gives the Fed running room, and concentrates on making a profit that can reduce our national debt.

I collected links to other posts I have written about sovereign wealth funds as an instrument of economic policy here. 

Through Roger Farmer, who also endorses sovereign wealth funds as an instrument of economic policy, I heard about Mark Blythe and Eric Lonergan’s plan, heartily endorsed by Matt Miller, to either (a) mail money to consumers, or (b) earn returns through the central bank acting as a sovereign wealth fund and then send the funds earned out to people: 

Central banks could issue debt and use the proceeds to invest in a global equity index, a bundle of diverse investments with a value that rises and falls with the market, which they could hold in sovereign wealth funds. The Bank of England, the European Central Bank, and the Federal Reserve already own assets in excess of 20 percent of their countries’ GDPs, so there is no reason why they could not invest those assets in global equities on behalf of their citizens. After around 15 years, the funds could distribute their equity holdings to the lowest-earning 80 percent of taxpayers. The payments could be made to tax-exempt individual savings accounts, and governments could place simple constraints on how the capital could be used.

Of these two ideas, I think the second, (b) is better. The money for redistribution is coming not from raising taxes but from having the government do risk bearing it is actually rewarded for, instead of through implicit risk guarantees that benefit private, often wealthy individuals.

However,

1. I think it is much better institutionally to separate the sovereign wealth fund from the central bank. A sovereign wealth fund, though immensely valuable, is inherently controversial. The Fed and other central banks face enough controversy even when they don’t act as sovereign wealth funds. They don’t need the added political burden.
2. Although I like the idea of new revenue that doesn’t come from taxes being used for some form of redistribution, it is not clear to me that sending people money is the best form of redistribution. There should be a vigorous debate about the most effective ways to lift up the poor for a given amount of money used. This is the issue I have with basic income proposals as well. Are they really the most effective ways to help the poor per dollar spent? (For example, see 1 and 2.) 

Still, I am glad to see the idea of a sovereign wealth fund gain traction–not only

• as a way to stabilize the financial cycle–which would continue to exist even if the Fed completely tamed the business cycle, other than those fluctuations that are an appropriate response to technology and other real shocks–but also
• as an alternative way to add to government revenue on average without resort to taxes.

Notice that in the background I have a particular view on the rational level of risk aversion, which I plan to defend in a future post–though it is always hard to find time to write major, relatively technical posts.

I also want to be clear in saying that, after eliminating the zero lower bound (as it should), a central bank should only raise the amount of revenue that is consistent with maintaining zero inflation in the unit of account (except for a bare minimum of hard-to-avoid short-run fluctuations in inflation). In particular, inflation is a very costly way to renege on the promises a government makes when it issues bonds. That seems like a bad idea to me.

The Wall Street Journal Editorial Board Comes Out for a Straight 15% Equity Requirement

Carmen Segarra’s secret tapes from inside the New York Fed prompted a Wall Street Journal editorial about financial regulation. (You can jump over the paywall by googling the title: “Regulatory Capture 101: Impressionable journalists finally meet George Stigler.”)    Here is one key passage:

The journalists have also found evidence in Ms. Segarra’s recordings that even after the financial crisis and the supposed reforms of the Dodd-Frank law, the New York Fed remained a bureaucratic agency resistant to new ideas and hostile to strong-willed, independent-minded employees. In government?

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Enter George Stigler, who published his famous essay “The Theory of Economic Regulation” in the spring 1971 issue of the Bell Journal of Economics and Management Science. The University of Chicago economist reported empirical data from various markets and concluded that “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.”

But what is most striking is the Wall Street Journal's endorsement of a simple 15% equity requirement:

Once one understands the inevitability of regulatory capture, the logical policy response is to enact simple laws that can’t be gamed by the biggest firms and their captive bureaucrats. This means repealing most of Dodd-Frank and the so-called Basel rules and replacing them with a simple requirement for more bank capital—an equity-to-asset ratio of perhaps 15%.

This is much more important than any of the Wall Street Journal’s other recommendations in the article. I favor an equity requirement of 50%, implemented as a capital conservation buffer prohibiting firms with less equity and more leverage than from paying dividends, buying back stock or bailing out foreign subsidiaries under looser rules until the bank reachs that 50% equity to assets ratio. But a straight 15% would be a good start.

"The Geography of Financial Misconduct," by Christopher A. Parsons, Johan Sulaeman, Sheridan Titman →

The badness you do is not only bad in itself, it has offspring. This paper is interesting in providing some empirical evidence that being bad encourages others around you to be bad as well. Here is the abstract:

We find that a firm’s tendency to engage in financial misconduct increases with the misconduct rates of neighboring firms. This appears to be caused by peer effects, rather than exogenous shocks like regional variation in enforcement. Effects are stronger among firms of comparable size, and among CEOs of similar age. Moreover, local waves of financial misconduct correspond with local waves of non-financial corruption, such as political fraud.

Anat Admati Makes Time's 2014 List of 100 Most Influential People →

This is a link to Rana Foroohar’s piece about Anat Admati in Time.

Anat is one of my heroes for her dogged advocacy in favor of the high equity requirements that will give us a stable financial system.  

The J Curve

Reblogged from econlolcats:

Things are gonna get better.

I have a few thoughts about the J-curve in International Finance. The idea is that the medium-run supply and demand elasticities with respect to the exchange rate are higher than the short-run elasticities. So in an era of deprecations within a fixed-exchange-rate regime, that would mean that the quantities of exports and imports would at first respond less than the prices, but later on the quantities would move more, so the value of net exports would go down right after the depreciation, but later go up.  

Here is my question. Think of a flexible-exchange-rate regime in which capital flows are determined by what people want to do with their portfolios, as I describe in my post “International Finance.”  Then, if the domestic central bank cuts interest rates and people want to shift toward foreign assets, that intentional capital outflow plus any unintentional capital flow plus any other flows of funds across borders that are not associated with the purchase of goods and services internationally (such as remittances) has to equal net exports. There might be a short time when unintentional capital flows cancel out some of the intentional flows, but it seems to me that in a flexible-exchange-rate regime, pretty soon net exports have to match those intentional capital flows. So the prediction would be that the low short-run elasticities of imports and exports would show up in a bigger movement in the exchange rate in the short run than in the medium run. Of course there are some risky arbitrage possibilities with that kind of movement. But do we see such a quickly-reverting pattern for exchange rates anyway? It certainly seems like exchange rates move an awful lot in the short run.

An interesting case is when the short-run price elasticity of net exports is less than one. (Note how different that is from gross exports or gross imports having an price elasticity less than one.) If depreciation means less of the local currency gets spent on net exports, then net exports can’t equilibrate with a fixed level of capital outflow. What I think would have to happen in the short run is that the initial capital outflow causes a drastic enough decline in the value of the domestic currency that the financial market rethinks the initial intentional capital outflow. That is, someone needs to see the domestic currency as so cheap they want to move their portfolio into it. It may take a very large depreciation before that is the case. Does that story make sense?

Tomas Hirst on the Decline in the Medium-Run Natural Interest Rate →

In the Alphaville post linked above, Tomas Hirst gives a persuasive account of why the level of interest rates that will hold after economic recovery is likely to be lower than in the past. 

(For the difference between the medium-run natural interest rate and the short-run natural interest rate, see “The Medium-Run Natural Interest Rate and the Long-Run Natural Interest Rate.”)

Robert Shiller on Eugene Fama →

Robert Shiller says mismatch between Eugene Fama’s findings and theories must make him feel like a priest who has discovered God does not exist.

Jonathan Clements on Integrating Human Capital into Your Portfolio

Link to JonthanClements.com

Jonathan Clements’s June 14, 2014 Wall Street Journal article “How to Calculate Your Net Worth” is an excellent discussion of integrating human capital into your portfolio. Here are some of his main points. The bolded labels are mine, the rest is his:

1. Human Capital is a Big Part of Your Portfolio. If you’re under age 50 and gainfully employed, your most valuable asset is probably your human capital—your ability to pull in a paycheck. The Census Bureau estimates, based on a 2011 survey, that a college graduate who works full time for 40 years might have lifetime earnings of $2.4 million, while someone with a professional degree, such as a doctor or lawyer, might earn $4.2 million.

2. Insure Your Human Capital with Life Insurance. Your human capital should heavily influence how you handle your larger financial life. For instance, to protect your human capital, you likely need health, disability and life insurance. Suppose you go under the proverbial bus or, alternatively, go under the bus but survive. In either situation, the right insurance can help your family cope.

3. Borrowing Against Your Human Capital Can Make Sense. Early in your adult life, you might take on a heap of debt, including student loans, car loans and mortgages. Reckless? Arguably, it’s rational. By borrowing, you can purchase items you can’t currently afford, thus smoothing out your consumption over your lifetime. With any luck, you will have years of paychecks ahead of you, so you can service these debts and eventually retire debt-free.

4. For Some, Human Capital is a Relatively Safe Asset That Can Be Balanced Out With Aggressive Investment in Risky Assets. Your human capital is also the rationale behind investing heavily in stocks when you’re younger. Think of your regular paycheck as akin to receiving interest from a bond. To diversify your big human capital “bond,” you might devote your portfolio mostly to stocks. But as you approach retirement and your last paycheck, you should shift maybe half your portfolio into bonds, so you have investment income to replace the lost income from your human capital.

In the rest of the article, he talks about how (a) you might have some human capital even after you have “retired” if you don’t retire completely, (b) integrating social security wealth (the value of the future social security payments you will get) into your portfolio and © liabilities like everything you will need to spend on a kid.

Let me also flag Jason Zweig’s nice article the day before “Can You Handle the Market’s Stress Test?” about how to fight “loss aversion”–being very risk averse toward relatively small risks. Here is what I tweeted about it:

How to fight loss aversion: avoid nonfinancial stress and make sure to net out gains and losses against each other.

Japan's Move Toward a Sovereign Wealth Fund Policy

Image from Japan’s Government Pension Investment Fund’s “About GPIF” page

On January 3, 2013, I wrote in Quartz that the US should establish a sovereign wealth fund to aid in macroeconomic and financial stabilization. Since then, I have returned to this theme many times. Here is a list of my posts and columns that talk about using a sovereign wealth fund as an instrument of macroeconomic policy:

1. Why the US Needs Its Own Sovereign Wealth Fund

2. Miles’s First TV Interview: A US Sovereign Wealth Fund

3. Miles Kimball, David A. Levine, Robert Waldmann and Noah Smith on the Design of a US Sovereign Wealth Fund

4. Libertarianism, a US Sovereign Wealth Fund, and I

5. How a US Sovereign Wealth Fund Can Alleviate a Scarcity of Safe Assets

6. Contra John Taylor

7. Off the Rails: How to Get the Recovery Back on Track

8. How to Stabilize the Financial System and Make Money for US Taxpayers

9. Four More Years! The US Economy Needs a Third Term of Ben Bernanke

10. After Crunching Reinhart and Rogoff’s Data, We Found No Evidence High Debt Slows Growth

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

12. Meet the Fed’s New Intellectual Powerhouse

13. Answering Adam Ozimek’s Skepticism about a US Sovereign Wealth Fund

In addition, I have three storified Twitter discussions about sovereign wealth funds:

1. Miles Kimball, David A. Levine, Robert Waldmann and Noah Smith on the Design of a US Sovereign Wealth Fund

2. Twitter Round Table on Contrarian Sovereign Wealth Funds as a Way to Tame the Financial Cycle

3. Vaidas Urba Stress Tests Sovereign Wealth Funds,

some posts on closely related issues (two of which are guest posts):

• International Finance: A Primer

• Q&A on the Financial Cycle

• Zane Salem: How to Boost US Exports

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

and many posts (of which I will only list three right now) on a key scientific issue relevant for sovereign wealth funds–the level of efficacy of quantitative easing: 

• Balance Sheet Monetary Policy: A Primer

• Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy

• Wallace Neutrality Roundup: QE May Work in Practice, But Can It Work in Theory?

On Tuesday, June 10, 2014, Eleanor Warnock reported in the Wall Street Journal reported that Japan is making a substantial step toward my recommendation that rich countries should use sovereign wealth funds for macroeconomic stabilization, even if their governments are, overall, in debt. Here is the beginning of Eleanor’s article “Giant Japanese Fund Set to Invest More in Stocks, Foreign Bonds”: 

Japan’s $1.26 trillion public pension fund will likely announce a boost to stock and foreign-bond investments in early autumn, the head of its investment committee said Tuesday, potentially sending tens of billions of dollars into new markets.

“I personally think that we need to complete [the new portfolio] in September or October,” Yasuhiro Yonezawa, head of the Government Pension Investment Fund’s investment committee, said in an interview. “There’s no reason to be slow.”

Mr. Yonezawa outlined a tentative plan for a portfolio shift that would raise the allotments of the fund’s assets to go into domestic stocks, foreign bonds and foreign stocks by five percentage points in each category. The aim is twofold: to boost returns to ensure Japanese retirees get the payouts they expect, and to stimulate risk-taking at home by funneling money into growing Japanese businesses.

That is in tune with the prime minister’s pro-growth “Abenomics” policies.

I don’t mean to claim having had any influence, but I consider what Japan is doing in line with the kind of thing I am recommending, though of course they do not go all the way to the institutional structure that Roger Farmer and I are recommending in the post listed above with Roger’s name in the title.

Update: Roger Farmer now has a book advocating sovereign wealth funds: Prosperity for All: How to Prevent Financial Crises. Also, here is a useful post by Eric Lonergan on this topic: “Tristan Hanson and Eric Lonergan: What Would a UK Sovereign Wealth Fund Look Like?”