Monday, August 30, 2010

Don’t Pick- up that $100 bill. It isn’t really there. Defending Efficient Markets

A guy sees a $100 bill on the sidewalk and walks right by it. A Keynesian comes up to him and asks him why he didn’t pick it up. The guy answers that he believes in the Efficient Market Hypothesis (EMH) – and the bill must not be real or someone else would have already picked it up! This joke is a real knee-slapper for academics. It is meant to demean the EMH. This not only shows why academics are not allowed to mingle with normal people but it also irks me that my fellow academics have too much fun beating a straw horse.

Why defend the EMH?  One reason is because it is 95 degrees and Betty will have me doing tasks in the back yard if I don’t pretend to be doing something in my nice cool basement office/laundry room/ junk room.  The other reason is that it needs defending from people who would use this as part of their rejection of markets and capitalism. Some experts believe that our recent financial crisis proves the EMH is wrong.  Even worse, it gives them a high horse to preach for more stimulus and more regulation.  So I would like to give them a little piece of what is left of my mind.

Before getting into the particulars we should take a step back and think about the whole idea of learning and hypotheses. You don’t have to have a PhD  to see the importance of hypotheses. As a young parent you believe that you should keep a close eye on your two-year-old. You have a hypothesis that if you completely ignore your child, a problem could arise – perhaps even something terrible could happen. I remember when we once saw our neighbor’s child on the roof of their house. They blinked one minute and somehow he was on the roof. It scared the crap out of all of us. Hypotheses like this one lead to action items or policy prescriptions. If the hypothesis is true, then you need to have rules for vigilance. You need to be a very active parent. We usually frown on leashes for children but I know of some parents who have resorted to such things.

Financial economists have a hypothesis about the prices of assets like stocks and bonds – and houses. The hypothesis states that the price you observe in the market for GM stock or for the average of all stocks is the result of buyers and sellers searching for all the relevant information, analyzing it, and then using it in their sales and purchases. This is not very sophisticated stuff. It just says we are not a bunch of LAZY LOSERS. Most of us – before we buy a refrigerator or a car or a share of stock – try to figure out what it is worth or at least find some information that would support our buying the item at a particular place and time. Suppose you do a little research and you are ready to buy the latest I-Phone when your mother comes in and says she heard that I-Phones cause pimples. But the Droid does not cause pimples… So you look in the mirror and pop a few – and then make your decision based on all the information.

This is not a crazy hypothesis to say that people try to buy as well as they can! Would you rather assume that most people are really lazy and ignorant and dumb and they just buy stuff regardless of price or other relevant information? I hope not. My father would spin in his urn.
Okay – so people – both buyers and sellers – gather and utilize information when trading various assets. This implies that the current market price, which is determined by the interactions of buyers and sellers, REFLECTS THE STATE OF RELEVANT EXISTING INFORMATION. It makes no sense that people would totally ignore pertinent information that was out there.

Basically this is what the EMH says – that current prices embody current information. It also implies that it is difficult for someone to make gains in the market that are not available to everyone else. If prices register all the current information, then it is difficult for one person to profit from the information.  If the EMH is true, it stands to reason that it is hard to “beat the market”. EMH friends advise me that I should buy an index fund and just hold it. Trying to pick individual stocks and to time the market (buy low and sell high) is virtually impossible if information is abundant.

Another implication of the EMH is that government intervention into markets is unnecessary. If prices are being driven by information flows about fundamental factors, then prices are playing their appropriate roles in a market system. Consider the recent bubble in asset prices. At the time Alan Greenspan did not think the Fed could or should do anything about rapidly rising housing and stock prices. Presently the government doesn’t talk much about a bond price bubble. Why? Because Greenspan and Bernanke believe that asset prices are being determined by fundamental factors.  They may not like these fundamental factors but by their very nature they are not easy to change or remediate with policy.

But notice that if the EMH is wrong, then perhaps phantoms or something or someone terrible is behind price changes and something should be done about it.  This creates a stronger role for government intervention – if the EMH is false. So is it true or not?

One piece of information being used these days is to point to Hedge Funds and to acknowledge that some of them have made a ton of money choosing stocks and timing the market. If you have not already, you should read Sebastian Mallaby’s “More Money than God”.  But just because there are examples of Hedge Funds or other investors who made a lot of money, this does not necessarily disprove EMH. How many Hedge Funds lost money trying to pick stocks and time markets? How many funds made a lot of money trading only to eventually lose it using the very same models and approaches? All it takes is a few very successful and very lucky pickers to get the attention of the press. A few successes do not, however, make a rule. If 10,000 monkeys are given computers and 10 monkeys print out the line – Davidson should receive a Nobel Prize – then would you nominate me for the award next year?   Hopefully the outputs of the 9,990 monkeys would have some sway with you.

Furthermore, the EMH never said that it is impossible for some people to know more than others for a time and it never said it was impossible for unscrupulous people to contrive means to fool the public. The EMH only says that ability to corner the market on information should not go on forever and once information becomes public prices will reflect fundamental forces.  
Finally, there is the paradox that if EMH is true, how is it possible that asset price changes could look so much like bubbles? You have heard all the stories of rapid price appreciation – and people wondering just how long it would keep up. In the meantime, people were buying houses and stocks at prices that seemed drastically out of line with reality. How can a story about rationality and efficiency explain buying $100,000 condos for $300,000?

The answer lies in what you consider to be the appropriate price. Should the appropriate market price consider future expectations?  You are considering buying a nice condo. Last year similar condos were selling for $100,000. Today you learn that oil has been discovered on the property and all condo owners are expected to receive $500,000 in future royalties. What would you pay for that condo today? That lovely little property that was worth $100,000 yesterday is worth more like $600,000 today. Is that irrational? That’s a big change—but it can be explained by expectations about the future. What would the condo be worth if scientists found that the property was being built on top of a former electronic factory and that the land was giving off cancerous fumes?

I hope you are getting the point that the EMH is perfectly compatible with extreme changes in price. Now, let’s apply this to recent events. There were plenty of reasons to explain why housing and stock prices were rising before 2008. No one can know the future so there were many thoughtful discussions that led many people to conclude that the fast pace of house and stock prices made some sense. There were also many people warning that the prices could not sustain such a rapid pace. All opinions were out in the public and all we can say in retrospect is that people operated with an expectation that prices would continue to rise. That expectation made more people willing to buy and willing to buy at a higher price. The expectations were self-fulfilling. At least they were until the correction came. While this suggests that bubbles do pop or corrections do come – this does not in any way disparage the EMH. EMH simply says people use information in transactions. When expectations about the future are strongly and passionately held – this is part of the information. Those prices that today seem so out of pace with reality – were efficient guesses three years ago. They used all the information.

Today we have a different set of expectations and a different and depressed level of prices. These are efficient prices for today’s information. And this leads us to the final point – what can or what should be done. Let’s not throw away the EMH – rather let’s use it to decide what to do. It seems to me that what went wrong were two things. First, regulators didn’t do their jobs. The whole credit chain fell apart as EVERYONE justified their expectations by leveraging in dangerous and illegal ways.  And the regulators let them. Second, policymakers helped to sustain the fundamental factors that led to a desire for more leverage and for higher asset price inflation. Greenspan didn’t see how low policy-induced interest rates induced a desire to take more risk in markets.  The Fed stoked the fires.  And Fannie/Freddie fanned the flames.

Now the expectations are that prices will continue to fall. That means there is a good way and a bad way for policymakers to act now. The bad way is to try to grease the wheels of credit expansion. That just gets up back into the same garlic pickle.  The good way is to approach the fundamentals. People will believe that the worst is over when policymakers earnestly address what was wrong. To do this they need to do sensible things that reduce our need to leverage ourselves beyond our ability to pay.  Regulation and policy should be addressed to sensible use of borrowing by the government and the private sector. Until they do that it is hard to see an end to the current economic slowdown. Now where did that $100 bill go? 

Monday, August 23, 2010

Lilliputians at the helm -- Why we can’t escape this recession

I heard this joke a long time ago – A guy is driving his car in the mountains. As he heads into a sharp turn a person standing next to the road yells to him – “Pig”. The driver is incensed and yells back at him “Jerk”. Immediately after turning the corner he runs right into a pig in the road.

This joke reminds me of our political leadership. They seem to have no ability to communicate. It seems to me that the problem is worse now but maybe it has always been that way. I don’t know but it is making me more and more irritable!

Since my life has been spent thinking about macroeconomics, it amazes me how the current debates about economic stimulus get us nowhere.  Even the pace of the recovery has become politicized. Republicans seem to want the economy to double-dip so they can point their fingers at the Democrat’s whose stimulus policies did not work. Democrats want the recovery to look good but not good enough to stave off another round or two of stimulus.

While economists also join the usual partisan bickering we are inflicted by our inability to say anything that the politicians seem to understand.  Economists are a lot like meteorologists during hurricane season. We have a lot of theory and a lot of data but we still make a lot of errors! When we try to explain our reasoning, the average politician or TV viewer heads to the kitchen for another slice of black forest cherry cake with vanilla ice cream.  Don’t say all that jibberish! Just tell me if a hurricane is going to hit my house! And when!
The lucky thing for meteorologists is that politicians don’t usually act on hurricane predictions!  So we economists duke it out in the Wall Street Journal, the Financial Times, and Fox News.  I knew that would wake-up some of you! J    And yet, the politicians keep saying inane things and then VOTING on real policies that will affect most of us from now until Hell freezes over.

So I am going to give both sides a little advice. First, in all likelihood we are not headed for either a pure capitalist or socialist state in the near future. This is not about extreme states – it is about the best way to permanently exit a recession and a way to return the unemployment rate to something more normal. SO SHUT-UP YOUR SLOGANS AND QUIT CALLING EACH OTHER NAMES. 

Second, this recession IS different. It is not only deep and enduring but it is the result of a perfect storm of myriad forces that took some time to manifest and will take some time to heal – with or without brilliant policy. My neighbor had serious heart surgery recently. He is on the road to recovery but he knows that not every day will be a good one. There will be ups and downs. He must be patient. Healing will take a while. Why then do our politicians pounce on every bounce in the economy – ready to declare a horrible or beautiful new course of policy? Geez guys and gals – the recovery is not going to be smooth or linear. TAKE A BIG BREATHE.  You have an unprecedented amount of stimulus working in the system – don’t add more!

Third – talk to each other. You guys are like rival gangs at a biker bar. The second Big Moe’s elbow accidentally barely scrapes Hot Mary’s elegantly sculptured boob tattoo of a snake eating the head of a winged dinosaur, all hell breaks out.  As soon as Mary screams the Purple Devils and Mauling Marauders weapon-up and go to their respective corners to prepare for the battle. The Democrats are armed with silly slogans about multipliers and a heart full of compassion for the unemployed while the Republicans load up on Barro’s version of rational expectations and strongly expressed love for fiduciary responsibility. You don’t talk to the enemy during the war – you lob stupid bombs at each other until the other finally gives up – i.e. loses the election.

One must wonder if our politicians are not like proverbial warriors who live only for the fight. My guess is that given the special nature of this recession it is going to take some real compromises to get this thing fixed. Consider the compromise story.  Policy has already and will continue to address all of the following issues– stabilizing aggregate demand, financing the aging of the population, correcting imbalances in the distribution of income, regulating the financial sector, reforming healthcare, widening access to green energy, a war on terrorism, immigration policy, and more. It seems to me that a more overt recognition of the complexity of these issues warrants significant compromise on both sides. Yet instead of viewing the whole policy scene as an opportunity for both parties to improve the country, they take each issue piecemeal and try to win the hearts and minds of the voters bit by bit. Surely with all these opportunities for legislation, there is plenty of room for give and take. Both sides could declare victory. But so far, our warriors seem to relish in the fight and grapple for wins on virtually every point of contention. Meanwhile we languish in a seemingly never-ending economic limbo as our politicians play dueling banjos.

Why does common sense seem so out of line with what we observe from our politicians? I think it is because we have really big issues right now and we have really small politicians. While I like today’s movements towards more transparency, right now I long for the good old days when politicians went behind closed doors, drank brandy and smoked cigars, and made deals.  Imagine the scene -- Obama taps his ash, leans across the table and tells John Boehner – I’ll give you two corporate income tax reductions for one extension of job benefits. John smiles and rubs his knee against Nancy Pelosi’s throbbing thigh and says, Okay Nancy, throw in a reduction in capital gains tax and I’ll not only go with the unemployment extension but I’ll give you a new tax on imported oil. Nancy pours her Armenian cognac in John’s lap and says it all sounds good so long as we throw in a few more dollars for education.

Okay, so I drink while I write. But you get the point. We need a new crop of politicians – if you don’t like what you see, then why do you stick with the idea that these bozos in both parties are there to help us? These folks are not helping us and we need to show them the door. We need some political leaders who will stop being warriors and try becoming statesmen. This is a very challenging time. We need better.  

Monday, August 16, 2010

China is #2. China is #99. What should I think?

Today published a small article announcing – ta da – that China has overtaken Japan with the second largest GDP in the world, second only to the -  ta da – the USA. We’re number 1, we’re #1. Do the wave now.

Anyway, in the case of China, the numbers are very interesting. For example, the comparison reported today has both China and Japan at about $5 trillion in Gross Domestic Product.

Note that when you compare the GDP across countries, you have to put all country amounts into one currency. This currency is usually the dollar. So the $5 trillion is the result of taking the country’s GDP in its own currency (yen or yuan) and using current exchange rates to convert to dollars. That sounds straightforward enough were it not for the fact that today’s exchange rate might be a little weird. That is, today’s exchange rate might not truly represent the  fundamental market forces that “ought to move it in one direction or another.” Or one might say the exchange rate is out of long-term equilibrium. So being weird they don’t trust it and then put it in jail. Economist’s jail, that is.

With the current exchange rate in jail, experts create a substitute that better reflects fundamental market forces – or at least it better represents changes in relative country prices. If China has a cost advantage and that makes its traded goods prices more competitive than other countries, this leads to a Chinese trade surplus. 
Theory suggests that the value of the yuan should rise to clear that surplus. Thus, an economist would say that the equilibrium value of the yuan is really higher than today’s market value. They call this the PPP (purchasing power parity) exchange rate. I hate to say PPP because every time I type PPP I have to run upstairs to the bathroom. But that’s an old man thing so don’t get off track here.

When we use the PPP estimate of GDP to compare countries, China has been #2 for quite a while.  Go to Wikipedia to see that China’s GDP at PPP is double that of Japan’s.  So while PPP does not change the ranking for Japan and China – it does give a very different picture – in one case the GDPs are the same – in the other case China’s is double that of Japan.

Okay – so one more statistic. Wikipedia also has a table with GDP at PPP per capita. We know China has a lot more people than Japan – so let’s see what happens when we ask how well the average person is doing. In that table, the US comes in 6th, Japan is 23rd, and China is 99th. Yes, China was right behind economic super powers Guyana and Nimibia. Hmmm.
So what does all this mean? I don’t really know. Notice how I made this post really short. It would take a very long post to discuss all the economic, political, and astro-physical implications of all this. So I will leave it to my wacko friends to say more.

But I will say this. There are many dimensions to a country’s economic size or might. Naturally a country with the world’s largest population should have a large GDP. But how strong can a country be if its average citizen is extremely poor? And in the case of China, a lot of the goods produced and measured in GDP go elsewhere – so what the average citizen living in China gets is even lower than the reported GDP figures. Clearly it makes sense that the Chinese government would want to improve per capita GDP.  With so many people, this will only push China farther up the ranks in terms of its total GDP produced. To think that a country with roughly four times the population of the US would forever be behind in terms of GDP simply makes no sense. So you go girl!

Finally one more point – I know there are many, many errors in cross country measurement. You can’t really compare the price of oxen in China to those in the US. There are also many problems in determining the value of the PPP exchange rate. But don’t let those measurement problems deter you from my main message in this post. China is a large, poor country with designs to be richer. As they get richer per capita, they will gradually approach and then exceed the GDP of the US.  But they have an even longer way to go before the average person in China will enjoy the income, wealth, and economic freedoms that we have in the US. 

Friday, August 6, 2010

Fairy Tales Can Come True. It can happen to you….blah blah blah

I was going to take the day off but then I read some of the news and if there ever was a time to write a blog post – it has to be today.

One of the best parts of my life was reading bedtime stories to my kids. Now they read them to me. Ha ha. Just kidding. But I did love reading to them. So it occurred to me that some of the fairy tales I am reading now in the press will have a bigger effect on them than Dr. Seuss or the Man in the Yellow Hat.
Fairy tale #1. A matter-of-fact story came out today about Medicare and Social Security funding and how the latter was fine until 2037. The story didn’t use Al Gore’s memorable term, Lock Box, but it did re-conjure-up that illusion. You know what a lock box is, right? Basically it is a physical thing that keeps money in it so that when bills come due you can pay them. Or it can be a physical thing that you bury in your backyard and tell your kids to dig it up when you die. Your kids, not having had a very good education in our failing public schools, will believe that old Dad and Mom have placed some very valuable items in there. Once they dig up the box and clear away the dirt – they will be rich!

Anyway, that’s what most of us think is a lock box. Al Gore made the mistake of likening the balances in the Social Security Trust Funds to a lock box. And that is why Al Gore had to sit in the corner and eat cold porridge. Anyway, imagine that your son digs up your lock box – opens it up – and finds a piece of paper in it. The paper contains a note that says, “honey, we spent all the money on Cognac and we would recommend that you ask your sister for a loan. We do love you very much.”

You think I am kidding. I think not. This year. THIS YEAR the social security tax revenues are not large enough to pay the beneficiaries (old helpless creatures who need Cognac). But the Social Security Trust Fund (SSTF) will make up the difference. What is the SSTF? A large pile of ten dollar bills? Is it a bunch of gold? HA HA – I think not. It is a bunch of paper that means the Federal Government must pay back what it borrowed in the past from the SSTF. The Federal government puts money back into the SSTF – and then they pay it to the retirees. Where does the Federal Government get the money when it already has a very large deficit? It gets it from raising your taxes! There is nothing in the lock box except a note that says the government promises to makes you charge higher taxes! Even worse, the amount in the SSTF – the amount the government borrowed from it over many years – will run out in 2037. The lock box will not only not have money in it – it won’t even have any more I-owe-yous. This means that your taxes will go up more and more and more as we approach 2037. My son will be approximately my age in 2037.

Fairy Tale #2. It was announced that President Obama does not want to take his latest brainy remedy for unemployment through Congress. Instead he can make a Presidential mandate that allows the Fannie/Freddie twins to spit smoke and fire. Or at least Fannie/Freddie will be able to give more mortgages to people without having to deal with all that silly paperwork. What a burden for bankers to ask embarrassing questions like – “could you ever from now to eternity pay us back one red cent you are borrowing for this Italian villa that was recently transported and reconstructed brick by brick in Ellettsville IN?

Okay – we’d love to see people buying more houses. That would be good for the economy. Homes would be built, developers would be able to go on Rhine Cruises, and more workers would get jobs. But geez you guys, how much does the government need to do beyond the lowest mortgage interest rates since Hugh Hefner was a baby? And didn’t the current crisis result mostly from subprime housing loans? Why on this earth would our president want to go down that path again? Why? Because of Fairy Tale #2. He does not have to listen to congressmen wail about budget deficits and debt. Future Fannie and Freddie liabilities can be increased infinitely today without the numbers actually showing up in the official government budget figures. Of course we know that granting loans without scrutiny will lead to government funding of the bad loans – and that will eventually show up in the budget. But these numbers will not be recorded today nor will they show up before Halloween.

THE KING HAS NO CLOTHES, THEY SCREAMED! But it is just a fairy tale. There is a lock box and we shouldn’t worry about social security. We can fix the economy by giving people low-interest loans that do not have to be paid back by the borrowers. I can lose 100 pounds of unwanted fat by taking the latest pill.
Good night kids. Sleep tight and don’t let the bed bugs bite.

Tuesday, August 3, 2010

Quarter 2 Real GDP – Why does the press prefer to look through mud-colored glasses?

The second quarter Real GDP figure was announced last week and as usual it got a lot of attention. There were many stories written and the general tone of most of them was worrisome – the 2.4% annualized rate of growth in real GDP from the first quarter to the second quarter of 2010, was low for two reasons – it was lower than the 3.7% growth in the first quarter and it was lower than experts predicted.

Of course, that is NOT what many people wanted to hear. It reinforced the idea that we might be headed toward a double dip recession (why is a double dip good for ice cream but not for the economy?) or deflation. The Keynesians shouted – “I told you so” – and many articles were written to the effect that we need even more monetary and fiscal stimulus. All this was based pretty much on one number for one quarter! It’s a little like winning one hand at Black Jack and then emptying your checking account so that you can bet your whole fortune on your sure-to-come gambling earnings!

To be fair, there were a lot of articles written and not all of them read like a Keynesian recruitment poster. So let me try to bring in some other facts that put the 2.4% number in a broader and more positive context. If you go to the following link you can get enough GDP data to build an Egyptian pyramid.

First, the 2.4% was the fourth consecutive quarter of positive growth in real GDP. That means a full year of growth since Q3 2009.

Second, real GDP statistics are revised many times. So the 2.4% is not the last word on Q2 of 2010. To emphasize that this first look at the number is based on incomplete information, it is officially called the Advance Estimate. Q1 2010 real GDP got revised upward from 2.7% to 3.7%. Wowee. That’s a big revision. I hate to tell you this, but the last revision to Q2 2010 will come about five years from now. REALLY. I am not fooling. Before then, you will see at least three updates – in one quarter, two quarters, and in one year. So stay tuned to learn more about Q2 2010.So people were oooing and ahhhing and making policy suggestions based on a number that isn’t much better than a lottery ticket.

Third, you can see a lot of very specific data if you go to the above site and download data tables. For example, we are very concerned about personal consumption spending (PCE). You will see that PCE rose by 1.6% in Q2. That is exactly how much PCE rose – an average of 1.6% per year – during the previous three quarters. So with respect to PCE, it was growing at the same rate as it had been during the recovery. I know we want to it grow faster – but there was no slowdown evident in Q2 PCE.

Growth in consumer spending on services – the largest component of PCE – had it fastest growth in several years. Geez I guess they forgot to mention that in their ugly little story. PCE in real annual dollars was about $9.2 trillion in Q2 and PCE-Services spending was about $6.0 trillion. So PCE-Services is roughly two-thirds of all PCE. That makes it almost half of all of real GDP! Note that consumer spending on durable goods was only about $1.2 trillion in comparison. It is fine to worry about the automobile industry – but we should not let the rear view mirror get in the way of watching spending on consumer services.

What else? One major reason that real GDP slowed a bit in the fourth quarter has to do with how we account for imports. GDP is a measure of domestic production. Because imported goods are not produced in the US, they have to be netted out – subtracted from the GDP sales figures. Imports of goods rose by 35.4% on an annualized basis in Q2. So that explains a lot of why real GDP slowed. But note that while it subtracts from output – it does show a resumption of spending. It shows some optimism about future spending. Of course, if all we do is buy imports and do not increase our spending on domestically produced goods and services, this will not help to increase future real GDP.

Missing in some of these articles was an explanation of residential spending – which rose by 27.9% in Q2. Hmmm – and that was only the second quarter that such an increase occurred in several years. Spending on the production of new residences – spending on newly built houses, apartment buildings, condos, etc – fell by 12.3% in Q1 and by 0.8% in Q4 2009. Someone should have made a big noise about this!!!! But I guess it didn’t fit in with their stupid sky is falling story. Supporting a picture of rising construction spending is that Q2 was the first time that spending on business structures (plant, office buildings, etc) showed any growth in years. It grew by 5.2% in Q2.

Part of the good growth story was a 14.1% growth in exports of goods and a 21.9% growth in business spending on equipment and software.

Some of our economist friends and their buddies in the press saw a glass of bourbon sitting on the bar. They preferred to see it as half empty and unworthy of drinking. While this was no batch of Pappy Van Winkle, it was a glass of hooch worth drinking. It is a shame that even a routine data announcement has to be tainted by such incomplete and biased analysis.