the Economy: Home and the World

In The Second Machine Age, Erik Brynjolfsson and Andrew McAfee capture the GDP effect of some technological progress as the price of a good falling from infinity to zero. This might get the supply-side tension right, but there are a few other problems in measuring long-term changes in standard of living. This post is a question more than answer and one that touches on interesting aspects of the debate on unmeasured consumer surplus, magnitude of economic wellbeing, and secular stagnation.

As a baseline, consider the BLS method of hedonic adjustment. To account for changes in product quality, they generate a regression of log price on various attributes (for example pixelation and screen size for television). They then consider improvements in these factors over time to make sure estimated inflation doesn’t overstate the truth.

This gets the year-on-year figures right, but makes long-term adjustment really hard. Specifically, consider your Internet service that’s probably too expensive. Hedonic adjustments will adjust for increases in speed, at least at a first order. Now of course, the consumer Internet didn’t exist in 1980 and therefore it’s theoretical price was infinite.

But suppose you could move the Internet back to 1980. Everything. Routers, telecom wires, transpacific cables, etc. The market price of this service would be next to nothing, since no one has computing technology to browse the web, since no engineers exist to create worthwhile content, and since building the necessary infrastructure from the state of science at that point in time is extremely hard.

In that sense, the shadow market price of the Internet that doesn’t exist yet is 0. This isn’t true for all technology. Shoes today are way better than shoes in 1980, and even if the technology didn’t exist to create them as we do now, the market price would still be far greater than that for the 1980 equivalent.

This framework as easily suggests there was massive deflation in the price of shoes (which is true) and a massive inflation in the price of Internet (which is false).

Our examples don’t need to be so extreme. An iPhone would be considered vaguely useful as a portable camera, but without technology to listen to music it wouldn’t be nearly as popular as it is today. Still it’s an incredible product and well-above its time in technology and should command a premium (this is the entire argument of a hedonic adjustment). And this of course assumes a stability in tastes and preferences.

This is intimately connected to the question of consumer surplus. It’s frequently said that productivity improvements are underestimated given the “explosion” of consumer surplus from web services like Netflix, Google, and Facebook – “how much would you pay for Facebook”, the question goes. Still it’s unlikely that this surplus actually goes unmeasured. I almost certainly wouldn’t pay $100/mo for LTE data on my iPhone if I couldn’t access Facebook, Google, or iMessage. Without considering the cross elasticities between free products, and the new industries they tempt, it’s hard to argue that GDP is underestimated relative to the true economic benefit.

Consider clean air. One day China will have a technology that cleans its air despite extremely intense energy consumption, and it will be extremely cheap relative to the life and economic savings it generates. Its creator will be praised for creating all sorts of consumer surplus unmeasured in China’s GDP. Unmeasured except for the boom in foreign investment, outdoor playgrounds, and botanical gardens that is.

Arguing that we didn’t have Netflix or Google in 1980 isn’t enough. We pay for Comcast and Apple, which are both prominent in GDP numbers. Of course this doesn’t say much about the distribution of that surplus – it might be that this benefits certain percentiles more than others, but this isn’t an easy claim to make without reference to the relevant cross elasticities of demand.

Does this mean inflation isn’t transitive? How would we model that? An error term that grows unreasonably when considering changes over decades or more?

It might be that the right answer is extremely large standard errors in estimates of long-term inflation. As certain markets grow large at the expense of others – cars versus cabs, for example – the statistical basis for making hedonic adjustments against an increasingly non-representative base challenges statistical conviction.

This is relevant in finance as well. 30 year Treasuries price in some expected degree of inflation. But the annualized inflation rate is likely very different from the true inflation, even though it’s correct on a year-on-year basis. Moreover, to the extent inflation is low from hedonic adjustment, it is because of a dramatic increase in the real growth rate.

Is there another premium in long-term bonds? A term premium yes, but also a “hedonic error premium” – which would include the expected inflation as measured (i.e. the breakeven rate) along with the error term that is larger in 30 years than it is in 10 years?

We could have a market for how much better 2015 is than 2014. We don’t have a market for how much better 2015 is than 1800. A diligent team of investors could answer the question “how much would you have to pay me to use 2010 healthcare instead of 2015 healthcare”. It’s not clear the same team could answer the question “how much would you have to pay me to use 1980 healthcare instead of 2015 healthcare” (a question posed by Larry Summers to suggest there is unmeasured productivity improvement since 1980).

Or it could just be that the existence of old age dating apps and the Internet makes being 85 much more tolerant – and the consumer surplus of the needless to say cheap apps is masked in elderly healthcare costs.

Now this isn’t to say technological progress is underrated in its contribution to humanity. If anything we probably owe earnings growth in legacy industries to technological surplus.


Most people agree GDP is probably a flawed tool. Results from a few papers I’ve recently read – which I’ll get to shortly – increase my curiosity. Ignoring its many other shortcomings, I want to focus on the difficulty of measuring realized GDP. My entire premise might be flawed, and definitely contact me if you can explain why. I might be very confused about the whole thing.

Consider an economy with households, firms, entrepreneurs, and banks. Households keep all their income as deposits in a bank, which invests in firms in the form of long-term debt, with residual business income accruing to entrepreneurs who hold equity.

Suppose tastes and preferences change and households no longer purchase widgets. Unfortunately at the beginning of this year firms had invested in large factories to scale their widget factory, financed largely by debt. Widget factories, having lots of unsecured debt, decide to default on the principal. Continuing operations is profitable for another year or two, however, and therefore they remain current on interest payments for another 2 years.

If widget factories decided to go bankrupt today, banks would have to writedown all their debt – taking a huge expense – and resulting in a sharp fall in production. Instead, widget factories will slowly default over the next decade, overstating ex ante GDP.

Now this effect might be moderated with a sensible requirement that banks immediately expense income for a loss reserve as they lend – with symmetric errors between reported and true earnings as borrowers default and recover. However my understanding is that the BEA uses current earnings excluding such accounting practices; and even if such were included the effect still remains large, especially when historical delinquency rates fail to capture the prevailing economic environment.

A working paper from Amir Sufi and Atif Mian prompted this question. In particular, they find that a one standard deviation increase in the household debt to GDP ratio over the last 3 years (6.2 percentage points) is associated with a 2.1 percentage point decline in GDP over the next three years, and outcome that seemed extremely large to me, especially given the econometric robustness they detailed.

Could it be that periods of substantive increase in household debt, and the rising delinquency rate that comes with it, make it harder to match economic revenues with economic expenses – perverting growth estimates? Even if the effect on GDP itself is small – which, if true, it cannot be given the meaningful role banks play in advanced economies – the effect on growth is meaningful. Consider valuation adjustments in financial inventories:

Screenshot 2016-02-02 00.48.50.png

Economic losses are unlikely to have been so concentrated. Non-recourse borrowers were economically delevered as soon as housing prices started to fall; and the ex post GDP in these years was much lower than that reported ex ante (not to be confused with revisions).

In this particular case, it is also likely the regression coefficient on HHD is also overstated. The increase in (Reported HHD / Reported GDP) is about 6% lower than that in (Economic HHD / Economic GDP) under standard calculations – where banks reserve losses at historical rates, growth is about 3% in the period of increasing debt, and the debt cycle gathered momentum over 10 years. In practice the effect is likely a little sharper as GAAP loss reserves are not included in the BEA estimate. In other words, the increase in the HHD/GDP ratio needed to achieve the same decrease in GDP is actually larger than estimated.

The particular problem I think this poses for economic analysis in general is from measurement error. Even if revised reported GDP is negligibly erroneous against perfectly reported GDP, both are meaningfully erroneous against perfectly reported economic GDP. There’s no good fix to this problem – it’s really hard to find out who has economically defaulted and who hasn’t. Doing a better job adjusting for loan reserves might help, but also open a host of other problems regarding standardized measures.

Of course the reported GDP eventually converges to the economic GDP, as losses must eventually be recognized. However, this process is subject both to institutional flaws, such as slow bankruptcy proceedings, as well as macroeconomic trends, such as low interest rates that allow borrowers to remain current on bad principal for a longer period of time.

Maybe more importantly, the measurement error attenuates regression coefficients and economic GDP turns out to be a lot more important than we gave it credit for.

I’ve worked out a back-of-the-envelope model to see the discrepancy that I’ll write about soon. In any case it generates an annualized 0.3% to 0.75% error in annualized growth rates under reasonable economic environments.

Some remedies might include a push towards using market, rather than face, value of debt. For example, sometime in 2007 the market value of subprime started collapsing even as no writedowns were realized – because investors realized the owners of these houses either had, or were going to, default and hence effectively unlevered.


The harder question is estimating the current, capitalized value of GDP. If there is any interesting writing on this topic, I’m interested.

By now you’ve heard that YC wants to learn all about it. I’m completely unqualified as an economic experimenter, but I have a few thoughts about the curious premise.

Very obviously any affordable study can only observe the individual rather than structural benefits of a basic income. There are genuine nonlinearities in the progression towards a world where (1) everyone has meaningful purchasing power, (2) where inefficiently-administered government welfare systems don’t create needless problems, and (3) where (1) and (2) are taken for granted.

But it’s also very likely that the move towards basic income will probably start with annual awards on the order of $1,000 to $5,000 in concert with a host of other legacy welfare technology rather than a complete revolution. Especially in the United States.

Therefore the reach of Sam’s fundamental question – “do people, without the fear of not being able to eat, accomplish far more and benefit society far more” – probably exceeds its grasp. But we can study the latter, something I’ll get to soon.

It’s also worthwhile being mindful of creating an observer effect. It certainly seems like a bad idea telling a young family with a newborn that it has a good fortune of a basic income, and don’t worry economists and sociologists will only study its developments every month. This effect would be particularly acute if the basic income is anything meaningful. Call this the “be careful not to create a lottery” bias.

If compelled I’d propose the following.

  1. Scrap the 5 year limit. It dramatically constrains the economic scope of a basic income and is unlikely to yield an interesting result. Individuals smooth income over a large period of time, and this is likely to suffer from a “lottery bias” as a result.
  2. Opportunity is one of the most important themes in American socioeconomic discourse, and opportunity is most elastic during childhood. Find a way to have a substantive answer to the question “how does basic income level the playing field for poor children”.
  3. Avoid the observer effect by finding ways to give people a basic income without their knowledge: though this is tricky for reasons I’ll outline below.
  4. Attempt to maintain general best practices for experiments (randomization, large sample for high statistical power, etc.)

The best way to satisfy (1), (2), and (4) might be something like an annual award on the order of $3,000 to $10,000 for couples that have just had a child for randomly selected people in randomly selected cities (ensuring some diversity in both type of people and type of city) for 20 years.

500 families in 10 cities at $5,000 would cost $25 million a year. That sounds doable for the Silicon Valley elite. Though there are plenty of ways to reduce this and still learn a lot. We can start with a single city. We can cut the study period to 10 years (and divide the group into early and late childhood – to see where the effect is strongly felt). I imagine the project should start in a single city – the administrative cost of studying 10 over 20 years isn’t negligible.

Though $5,000 isn’t a basic income, it is a little under what the average family spends on food. $10,000 to $15,000 is affordable, especially if we have only a single city. But at this order we sacrifice statistical power and also tempt strong observer effects.

For one, $10,000 to $15,000 awards will create envy. In neighborhoods where this program is most useful, this figure eclipses 100% of disposable income. The point of a basic income isn’t to create a table of special kids eating avocados amidst an inner city cafeteria serving mass frozen pizza. It would also be impossible to provide such awards without alerting the recipients.

Indeed doing so in general is hard. Working with employers is one option, though as economists know telling an employer you’re giving employee X an extra $5,000 means it can spend less to keep that employee than it would have to otherwise.

  1. It would be good to work with corporate echelons of a distributed employer that would randomly increase the salary without the knowledge of more immediately located hiring managers.
  2. Working with the IRS to randomly increase tax refunds to selected families could also work though this would need someone willing to work with the IRS.

The ability to precisely study beneficiaries is diminished if one is vigilant about a non-observable experiment. That’s a tradeoff YC will have to make. But the guilt, envy, awe, shock, and puzzle of receiving a lot of money will have large effects.

As a guiding principle, it may be cheapest to start an experiment that researchers can most quickly learn from and modify as needed (sequential hypothesis testing is valuable here). Building an apparatus where making modifications and adjusting the experiment doesn’t void the statistical validity of results already obtained is valuable.

Maybe the simplest advice is spend a lot of money by giving reasonable chunks of cash to a lot of people over a long period of time. Once collected data is made public the academic value of this data will be unbeatable. This is a landmark study if done correctly. It would directly challenge the government as both a provider of welfare, but philosophically demonstrate the capacity of Valley billionaires to produce meaningful research answering the hardest questions in social science.

I don’t know. Alex Tabarrok has an answer, though I’m not sure its sufficiently skeptical.

Of course, housing is overrated as a financial investment, largely because for most people it isn’t a financial investment, as much as a hedge against an increase in price of rent. You don’t get “a great investment and a place to live” primarily because you only get a place to live and very little investment. When the S&P500 shoots up, most of us can sell and live richer lives. When the housing market goes up most of us can sell… and buy another house a market that has already realized appreciation.

There are instances in which you might notice a genuine increase in wealth associated with a tighter housing market. If the price of large homes outpaces that of small homes, and you’re about to retire at that moment, you might be in luck. If a new job takes you away from San Francisco where prices have skyrocketed, you might be in luck.

But in general it’s not exactly easy to predict these trends – and it certainly shouldn’t be the province of homebuyers and the real estate agents that inform them. That doesn’t mean home ownership is a bad idea. In general, we don’t like cash flow volatility. A young couple working at Facebook, with enough cash for a downpayment and enough earning power for a good mortgage, might prefer to avoid the ups and downs of a tumultuous Bay Area rental market by purchasing a house. We’re all short the market to some extent.

In parts of the country without stratospheric home prices, a rental market is pretty nonexistent for affluent buyers. To the extent you want a nice family home with a pool in a safe, Iowa suburb, you may not have the option to rent. Indeed, “should you buy or rent a house” is question relevant only for affluent urbanites who have both the option to rent a decent place and credibility to borrow on good terms. The best argument to buy is that you probably live in a city where only kids at the local college rent.

The tax benefits of ownership are also questionable. While a mortgage interest deduction certainly exists, this is passed through to renters. In general it subsidizes building property since land is inelastic, and therefore is likely most beneficial for affluent midwesterners who like a lot of property on worthless land. This is not to say ignore the benefit in your calculus, as much as not to tell yourself that this benefit militates in your favor without actually looking at the numbers – more precisely, learning that there is such a deduction without any further information shouldn’t change your decision.

A thought experiment is useful. Imagine a town with some borrowers, owners, and a few landlords. If the government subsidizes interest on houses, market competition only increases the value of land relative to everything else but doesn’t change the relative price. Marginal investment is poured into building more property on top of that land. The supply of property-intense housing increases, and the price falls. Renters and owners both benefit equally, and because of competition not at all. The only obvious winners are landlords. The mortgage deduction doesn’t benefit the affluent, it benefits large landholders and their investors. Yet another tax debacle that benefits the superrich.

The pass through effect is muted somewhat by the asymmetry of potential buyers and renters in that some individuals might be “captive renters” as they can’t access affordable, long-duration credit on the principal at hand. Though this is almost tautologically irrelevant for markets where the question “should I buy or rent” persists; for any given house the individual who can pay the most, either capitalized or amortized, can afford to borrow.

Of course, accepting that housing is rarely an investment also challenges the associated wealth effects, either positive or negative, that many economists have observed. To focus the skepticism a particular theory, the Sufi-Mian leveraged loss multiplier, consider liquidity instead of solvency. The prevalence of non-recourse borrowing in the United States meant borrowers could pull residual equity into cash and leave if that value was above the collateral value.

Between 2003 and 2007 we had a bunch of people with high propensities to spend with access to non-recourse financing collateralized on a volatile asset. This was money that would be paid back only if prices kept rising. They weren’t leveraged precisely in the state of the world where that leverage would have been binding. It turns out that this was the state of the world that came to be, but the decline in spending wasn’t a question of solvency but loosing access to extremely cheap liquidity. Of course consumption and residential investment fell most in the leveraged areas where it increased most because that’s where closing the tap of free cash most dramatically affected ability to spend.

The best reason to rent might be that many educated people think housing is a good investment increasing the price of housing credit beyond what is justified – and an unlimited supply of conforming loans doesn’t really matter in this case since the people for whom this question is relevant are almost certainly buying a house above the conforming limit. People may also tell themselves that they get a tax credit one way and not the other (even though this is priced in both ways to begin with) which would further distort the market in favor of renters.

And even if housing was an investment, buying a house would infrequently be the best way to get there. The home you own faces plenty of idiosyncratic risk against the market as a whole – by region, by local policy, by construction style, etc. It would be foolish to expose yourself to this risk without relevant expertise – something both homebuyers and their real estate agents certainly lack.

There are other ways to express your beliefs about the housing market. If you already own a home, get a second mortgage against it and use that to buy an ICF index, your financial position might be closer to what many financial writers ascribed to middle-class Americans in 2005. Though, as you can see, that is probably far from where you actually were at the time.


I’m not saying this is a good thing or that it is necessarily true, but it appears some people are confusing “this sucks for poor people” (which it does) with “this increases income inequality” (which it may not).

It’s important to distinguish gentrification from zoning inequality in this context. While the price rises with gentrification so does quality – and while that may not be at parity with the dollar for poorer people it is still important. Let’s stipulate that ridiculous rents in San Francisco are primarily a result of extreme zoning laws and red tape.Then there are two cases we must consider, of inequality in and around SF and inequality nationwide. Dexterous definition becomes important.

On the one hand, by raw income, inequality almost certainly decreases as people are priced out of the bottom but not the top. The second-order effects of gentrification might modify this somewhat but in any case would be a redistribution within the upper middle class. And whatever metric you use – top n%/bottom n%, gini, mean/median, etc. – removing the bottom 10% will reduce the inequality except perhaps in pathological cases.

And yet it is the case that most residents get some sort of consumer surplus from living in SF and adjust by paying higher rents, diminishing consumption of other items. There are also many moving parts here. Of first-order importance is the relative adjustment of the rich vs. poor. But there is also the question of which goods and services realize lower demand, and who that affects from both a demand and supply side.

There is the undeniable cost of dislocation but so long as housing regulations don’t become progressively harsher this is one-off and regardless not something economists should be concerned about. If having artists is important, the city can easily include an artist tax credit in its next budget. One would need to do a lot more work than simply acknowledge extreme rents to conclude that rents increase inequality within San Francisco.

That leaves the question of nationwide inequality. Surely the absence of affordable housing should increase inequality versus the counterfactual, right? Maybe. In effect pretty much everyone, including the rich tech family that’s paying $10,000 for a 2 b/r, suffers from high prices.

The only beneficiaries are those who have a net long position in property. The simplest way to explain this would be that if I am contractually sworn to be a taxi driver, I observe no increase in wealth if the price of my medallion increases since I am always net short – but I would if I lent an extra medallion to a friend.

It’s clear that poor people are definitely short, middle class people maybe flat, and a sliver of rich people long the housing market. Home ownership rate in SF is around 35%. That means about 65% of people are somewhere short, and of the 35% a whopping majority will be flat.

There is also the point that the “original short” of a tech employee is much higher than a hair stylist. To work at Facebook you need to live around the extremely expensive region. To work as a stylist you can work anywhere. A stylist obviously prefers not to move, but can do so with less penalty to earnings than a top software engineer.

There are other effects too. San Francisco is obviously a high-paying region for relatively unskilled, service jobs. More affordable housing would let more people indulge in this market. But it’s not clear which way the net effect runs, in particular home prices which command over 50% of the income of such individuals has a strong pass through into wage rate demanded.

Important considerations motivated by research Raj Chetty etc. are access to public transportation and commutability of a city. That is within-city inequality might be preferred to across-city inequality, and ceteris paribus more zoning laws encourage the latter.

It might well be the case that income inequality is increased by zoning regulations but the argument needs more evidence than dislocation and expensive rents. However without a doubt this sucks for poor people and zoning regulations should be abolished immediately on simply that account.



Several years ago political activist Ron Unz wrote a lengthy essay suggesting that elite universities have held Asian applicants to much higher academic standards than other groups, particularly Jews. He cites the disproportionately Jewish composition of top universities, and uses a questionable analysis of PSAT records to conclude that elite universities are part of a vast Jewish conspiracy (not that you’ve ever heard this story before…):

Taken in combination, these trends all provide powerful evidence that over the last decade or more there has been a dramatic collapse in Jewish academic achievement, at least at the high end.

Unz reaches this conclusion by analyzing lists of high performers that appear to be overly Asian, at least by last name. This isn’t necessarily false – though there is significant bias given that one can with near certainty identify a name as Asian, but would have a relatively harder time achieving such power with Jewish names – but it certainly isn’t a good way to measure bias.

Despite widespread criticism, this article is favorably featured in a number of top blogs and publications, including the New York Times. The point of this post is to conclusively add to the already-large repository of evidence that Ron Unz is a liar.

If the claim is that an admissions committee is biased towards Jews and therefore holds Asians to a relatively higher standard, it necessarily follows that admitted Jews underperform the general university population. The honest way to test this hypothesis would be to check the extent to which ethnicity is associated with academic performance.

Maybe Unz and others were too lazy to compile the necessary data but, given what it reveals, it is likelier that they wanted to hide it. While universities don’t explicitly make available academic performance of accepted students by race, let alone ethnicity, this information can be inferred from public data – a number of universities publish a PDF of commencement programs, which usually contain the names of all graduating seniors, their department of study, and important academic honors they’ve received (Latin honors and prestigious fellowships among others).

The somewhat similar structure of these documents (for example, see the University of Pennsylvania or Princeton) makes it possible to parse the PDF files for the underlying information (it’s a somewhat messy task – send me an email if you want the code). Since these files are available from 2007 or so, with various omitted years for various universities, it is possible to generate matched data of name, graduation year, major, school, and any academic awards received.

It’s neither difficult to infer gender from the first name nor catastrophically harder to infer ethnicity from the last. It is easy to stratify Asian ethnicity by referencing a sufficiently large list of common last names (from the Census and other sources). The false positive rate here is extremely low (that is Varun Agarwal is extremely unlikely not to be Indian).

Identifying Ashkenazic names is harder, as there is commonality with European, especially German, surnames. Additionally, Jewish-Americans may have adopted more generic names that makes powerful identification challenging. However, for any given name, using an extremely large list of common Ashkenazic last names, and adding the score of the top 3 matches based on a Levenshtein distance fuzzy matching algorithm, it is possible to get some sense of probability that a name is Ashkenazic.

Since I don’t have verified data on the ethnicity of graduates by name, it’s difficult to test or train this strategy. That said this doesn’t really disturb the results. For one, this error is probably random – i.e. associations between ethnicity and achievement, if any, are unlikely to depend on the conviction with which an algorithm can determine ethnicity. Moreover, to the extent there are attenuated coefficients, the bias will only be in favor of Unz’s claim – i.e. odds appear to be lower than expected by a factor proportional to the ratio between classification error and total error. Furthermore, even if there is a strong association one way or the other simply between Jewish sounding names and odds of success, that remains an interesting finding in and of itself.

For a flavor of the classification strategy, the table below charts 10 randomly sampled names at various thresholds of an “Ashkenazi score”. Clearly there is a link between strictness of threshold and what one might consider to be typical Jewish-American last names.

Screenshot 2015-12-18 19.26.10Next, to estimate the order of attenuation bias, one can compare the estimated coefficient on Jewish odds by for each threshold:

Screenshot 2015-12-18 19.24.48

When including scores above 100 (which includes pretty much every non-Asian name, and some Asian names as well) the variable has little explanatory power if any – the measurement error dwarfs the residual error because this factor is true for pretty much every name. Clearly as we increase the threshold above which we admit a name as Jewish, the coefficient increases. This doesn’t imply anything about those who have more obviously Jewish surnames as much as give an order of magnitude estimate of attenuated coefficient bias, which is obviously significant. Of course if it is true that Jewish students have higher academic performance, part of the increase also emerges from the increasing proportion of the included group that is actually Jewish.

To maintain comparability over time by school, Phi Beta Kappa and equivalent honor societies are used as proxies for underlying academic achievement, exactly the dimension along which Ron Unz argues that Jews underperform. Phi Beta Kappa (and equivalents for engineering and business majors) is composed of students roughly in the top 10% of their graduating classes by GPA, with additional input from faculty recommendations.

It is not inconceivable that there is bias ingrained in the election process. That said, it is unlikely that this bias is somehow systematically focused against Asians in favor of Jews further moderated by the fact that GPA is still the predominant requirement. Here are the results based on regression on almost every Penn graduate over the past decade:

Screenshot 2015-12-17 23.28.20

The important point is that, controlling for graduation year, gender, school, and dual-degree status, the odds of being in an academic honor society increases by about 1.5x for those very likely to have Jewish last names. Achievement by major offers a simple reality check – it is relatively harder to maintain a high GPA in a Wharton + engineering dual degree program. I have been able to compile similar data for Brown and Princeton, where I notice similar trends.

The point of this data – to be clear – is not to make a judgement on the academic achievement of various ethnic groups and therefore a claim on how admissions offices should operate. Other factors are may be much more important – however this data is a useful antidote to anti-scientific crusaders maligning large groups of people, without realizing that the underlying statistics on these questions are inherently complicated and do not yield easy interpretation.

One can say with little qualification that the set of vapid claims Ron Unz makes, which the New York Times editorial page approvingly cites, is predicated on bogus data. Not only does it fail to make any effort to identify Jewishness beyond non-fuzzy matching with top 100 lists, but it also fails to use data on actual achievement at school in favor of questionable data from PSAT scores. The above analysis is much more conceptually sound given the more careful identification of ethnicity, and the superior measure of achievement which requires no assumption about the admission officer preference function.

Unz and his co-conspirators have not only promoted sloppy data and a sloppy analysis, but have also completely disregarded any scholastic standards whatsoever before committing to a negative story about an entire category of students, which would be a cautionary tale if it was not so laughable in face of actual results.

Be careful when citing this post. You might notice that while Jews perform extremely well relative to baseline in every school where there is a significant variable at all, the coefficient for engineers is low (even though math and physics would be included in the first category where performance is fine). Ron Unz has an explanation for that:

We should also remember that Jewish intellectual performance tends to be quite skewed, being exceptionally strong in the verbal subcomponent, much lower in math, and completely mediocre in visuospatial ability; thus, a completely verbal-oriented test such as Wordsum would actually tend to exaggerate Jewish IQ.

Albert Einstein and Richard Feynman; those literary geniuses. He reaches this conclusion, of course, based on some colorless tale of orthodox Jewish reproduction patterns in urbanized environments (or something like that I didn’t actually bother to figure out what he meant). Of course, Unz is probably banking on the hope that Jews are too mathematically illiterate to see through his lies.






Kevin Warsh recently coauthored a piece in the WSJ suggesting that lower interest rates actually penalize business investment, contrary to common knowledge and mainstream theory. The specific argument itself is wrong, at least by itself. Even if lower interest rates did somehow encourage buybacks, that’s cash ultimately returned and theoretically invested where it’s most needed. Now this might not increase business investment, but that’s another argument entirely. Brad DeLong isn’t happy and Larry Summers agrees, though is open to any logic about why this might be the case. 

I’ve vaguely thought about this before, and think it’s worthwhile to think about the assumptions under which lower short term rates might reduce current investment. Even accepting this is most likely not the case, the process of figuring out how something might happen at least provides a set of empirical projects researchers might pursue in determining this question. To the extent these arguments are reasonable they also provide a useful counterpoint to conventional wisdom.

Note the point here isn’t to argue in favor of lower or higher rates – indeed answering this question has little bearing on that topic, without further assumption about the quality of the business investment itself. We’re also not trying to tell ad hoc stories – for example how, perhaps, low interest rates might signal uncertainty about the economy, reducing investment. Rather, the interesting if impertinent question is the existence of any obvious theme or set of incentives that create a world where interest rates are positively correlated with investment.

I have four suggestions.

True versus observed investment

The first point I would make is regardless of true investment, lower interest rates probably tend to positively bias the observed investment. This doesn’t move the ultimate question in one direction or the other, but raises questions about any data used to justify a particular position. My intuition behind this is simple – though possibly incorrect. Consider a firm that borrows from a bank to invest in what turns out to be a bad project. In theory managers learn about a loss and recognize it immediately. But in practice it’s hard to know when the economic fundamentals of an investment fail to match their invested value – that is fail to generate a positive return net of a capital charge (in this case the interest rate).

An obvious example to this effect might be Japanese banks that can delay recognition of economic loss simply because they can return the cost of capital to investors – who expected the project to work out – by rolling over inexpensive debt. Eventually, of course, all accounts must be settled and someone won’t be happy. You might think of this as an illusory double-counting mechanism that is particularly prevalent when the cost of doing nothing is low.

This requires nuance about the constitution of ‘business investment’. We must in some sense think about the true ex post value of the investment – otherwise it wouldn’t matter whether business investment meant cash spent on a cup of coffee or building a new tower. Of course this isn’t something we can know for sure in real time, but a simple effect of investment cycles that we should note when thinking about interest rates. The important point here is this won’t get out of hand in a world with high interest rates.

Agency dilemmas and a growing gap between volatility to manager and volatility to investor

Another story might involve agency problems between owners and managers. Investments are made in expected value – with some compensation for risk. Investors can diversify firm or project risk, whereas managers cannot. There is an enormous literature discussing and debating manager risk-aversion and its effect on investment though there is an important wedge when individual firms can commit to a limited number of projects, unable to diversify risk and thereby failing to invest in positive expected value projects that investors like.

Low interest rates affect this wedge. If the marginal project that becomes profitable at a slightly lower rate is one with high variance, individual firms may not be compelled to invest – despite every economic argument that the opportunity cost of holding money is now higher. This is particularly true when projects are not traded and limited to a small number of firms. (Do you know about various potential investments a Wisconsin waste management company might make to decrease the number of routes it has to make every morning and, if you did, would you have the capacity to purchase this investment and use it to the same effect?)

It might be – and I’m only theorizing potential assumptions, not claiming any to be practically true – that marginally profitable projects are increasingly risky for the individual firms that compete. But this wouldn’t be an outlandish claim, either. The discounted value of a project grows dramatically faster as interest rates fall. Small errors in judgement have larger feedback into economic calculations, amplifying the gap between investments that are made and should be made. There’s evidence to back this story. Where interest rate have fallen to zero, corporate executives still demand a 10% hurdle rate. Indeed lower interest rates change the opportunity cost for investors, not managers. This shouldn’t matter, but maybe agency dilemmas are significant.

This matters only because price changes manifest in both an income and substitution effect. If the income effect of lower interest rates, a smaller supply of investable capital, works as predicted at low interest rates, but the substitution effect is increasingly challenged by other factors, this change might reduce business investment.

Attenuation of relative debt preference

Also note the general agreement that the tax code privileges debt. There’s the explicit tax shield, along with various other interest deductions that bias towards lending more and borrowing more (with an indeterminate effect on price). Some of these are restricted to interest payments, excluding settling the principal. Lower interest rates would tend to reduce the debt bias. That is they might increase overall debt, but reduce the divergence vis-a-vis equity in a world where both are treated equally.

High leverage industries tend to be more capital-intensive, with large outlays for business investment. Airlines are a good example. If the relative bias changes with interest rates, and investors privilege industries that are typically equity-financed – again, keep in mind the distinction between change in bias and change in actual quantities – business investment might decrease.

Note this doesn’t reduce ex post returns – for example software firms have been able to produce remarkable returns without much invested capital. Indeed investing much in an industry that returns little isn’t always better than investing less in an industry with outstanding potential. This is a point of stipulation in the secular stagnation argument, and is potentially very true.

Permanent patience

Finally, I think we should distinguish between a dramatic fall in short-term rates to encourage investment in a recession to prolonged low rates because of a lower bound. Low rates now, and commitments to lower rates in the future where there isn’t an obvious ‘return to normal’, substantially decrease the urgency of any capital decision on the technical principle of ‘well, what else are you gonna do with your money’. This sort of flies in the face of what a discount rate even means, but your life period loss function for delayed investment will certainly be greater when the penalty from impatient investors is higher. Furthermore, if low interest rates are associated with comfortable liquidity conditions the cost of waiting may not be high.

Distinguish between the average investment (which may be amazing, and does not matter) and the marginal investment (which may be mediocre, and definitely matters). This patience and a slight risk aversion can’t be explained away by simply noting ex post fantastic investments that were risky and did turn out well, as much as noting that the incentive to make the many marginally profitable investments might be lower today for reasons outlined above.

None of this is to say that lower interest rates reduce investment, as much as to propose a pathway through which that argument might be made.

Some people argue that inflation causes high tax rates. In the obvious – and obviously correct – sense that taxes are progressive, resulting in bracket creep. But also in the more insidious sense that asset appreciation through inflation creates a nominal tax burden that must be paid out of a base of no real income. This is a point forwarded by the Tax Foundation, prominent economists, and just about every entry on the search entry “capital gains tax inflation”. These arguments all describe how inflation substantially increased the real tax burden between 1955 and 1990. Unfortunately, none of it is as straightforward as the writers make it out to be.

Let’s make a few assumptions. At the margin all taxes are proportional to value, that is no lump-sum levies. Assume there is no bracket creep, and that marginal government spending is restricted to transfer payments. The role of taxes in this world is, then, limited to assigning the distribution of income among various groups. The argument, then, is tantamount to claiming that the “inflation tax” perverts the tax system to skew post-tax income away from capitalists towards everyone else.

When you think of it this way, inflation doesn’t matter. If I own a security that appreciates $10 through inflation, generating a tax burden of $2 the natural reaction might be that the government is creating a real tax burden out of no nominal income. An “infinite” tax rate. Except inflation affects all future cash flows, including income from labor, which also increases in the state with inflation. If inflation affects most assets evenly over the long-run, not charging a tax on nominal gains would increase the relative distribution of income accruing to capital owners, necessarily at the expense of everyone else.

Another way to think of it is that the government has real liabilities – workers, indexed transfer payments, and material costs will all eventually rise with inflation – and to finance the larger nominal outlay it must also receive a larger nominal income from each group. To the extent taxes are levied as a percent of income this does not change the final distribution between capitalist and worker.

The truth of this simple claim can be noticed by taking the infinite tax argument to its logical conclusion. Suppose we have really high inflation for a while and taxed only real gains – out of concern for the Tax Foundation. If the stock of capital increased from $1 to $10, without any real gains, the capitalist faces no tax burden. Except everyone else – rentiers, workers, lenders – does face the nominal burden, and pay more in taxes. This naturally results in a capital subsidy.

One might argue that really we should tax only real gains on both capital and labor. This, of course, isn’t the argument that everyone cited above is making as they restrict the argument to an “infinite tax on capital” and believe there is something special about the nominal appreciation that makes capital different. Also note this would mean there was an “infinite tax” on labor, making the claim that there is some net inflation tax (i.e. change in distribution due to inflation) very likely false. More importantly – supposing the relative distance of various brackets were indexed – indexing real income on capital and labor is a really challenging strategy.

For one there’s a lot of error in these measurements, creating a political bias to understate inflation figures to juice tax revenue. It also assumes there is some measurable, true inflation ignoring the complex heterogeneity of various liability structures. Of course, ultimately, if we did figure out how to get around these problems and taxed everyone on t – 10 dollar values, the net distribution would change none at all since all income would be modulated by the same factor.

In reality, of course, some of the assumptions that led to this conclusion aren’t true. Inflation doesn’t affect everyone uniformly – at least not over any fixed period of time – and each individual has different preference for changing prices since the goods market may react more sensitively in one industry than the other, hurting some people more.

It might be worthwhile to study these assumptions, and figure out cases where higher inflation changes the distribution away from capitalists purely through the nominal tax rate. But the sort of work you saw from the Tax Foundation, apparently detailed, wonky, and evidence-oriented is misleading. It is either tautologically true saying absolutely nothing (inflation means bigger numbers) to certainly false (that inflation changes the net distribution without further assumption).

This isn’t particularly tricky to see, and is simply a consequence of efficient markets. If present value is the weighted sum of future cash flows, it makes no sense to argue that inflation affects the two sides of the equality any differently.

A lot of smart people got upset that John Paulson, the guy who made a fortune betting against subprime mortgages and probably lost it all on gold, gave $400 million for Harvard to start an engineering school. The arguments were standard – Harvard is an obscenely wealthy school that by and large caters to kids from obscenely privileged backgrounds. Surely the marginal value of $400 million dollars – indeed, $400 million dollars that’s not evening being spent – would be much higher in the hands of African children.

Except that’s exactly why it’s one of the best gifts to society. The many defenses (and there were many) that focused on research and technology investment miss the point. They’re correct, but that’s not where the money is (so to speak). Let’s talk about why we respect investors like Warren Buffet. Buffet puts in a lot of capital to identify companies that are undervalued and need money, provides operational support to bring them to their potential, and makes a profit. In the process, of course, society as a whole is ever so slightly better off, with that capital producing superior societal returns than the next best opportunity (the opportunity cost, or discount rate).

This doesn’t always happen. Investors are wrong. But for the good ones this is how it basically works. But imagine if Buffet reinvested the returns, and promised to keep reinvesting them forever.

That’s basically what the Harvard Company is. Sure there’s a payout, on the order of 5%, to bankroll the universities operations, but it’s principal (and returns beyond the necessary payout) are permanent.

Go back to what investment is. Before money. When A does work for B, in return he gets some claim on B’s future work. Now since C owes B some work, B asks C to settle his debt with A who, instead, redirects C to D since D needs help building something better. Now A isn’t altruistic. Eventually he’ll reap the rewards of his patience. But imagine he never did that.

Of course, this line of reasoning isn’t anything new for economists. It’s why they advocate (at times with dubious reasoning) preferential taxation on capital gains.

But the argument here is so much more compelling. Ultimately, I’m going to spend my capital gains (economists just want to reward me for being patient). Even if I redeem it in 10,000 years, it doesn’t change the calculus (I’d just redeem a lot of capital). But on an infinite timeline – which is what Harvard’s endowment is – not only is Paulson’s gift financing Harvard’s operations (which do include research), he’s permanently financing millions of business activities around the country which have all been better than the alternative – the endowment beats the S&P500 on an annualized basis by about 3%.

None of this is to say giving to Harvard is superior philanthropy than buying bed nets for African children. But for one, it actually scales (an organization with an operating budget of $3 million isn’t exactly going to be able to absorb a $400 million gift). It doesn’t really meet the “most need” criteria, but the broad social good brought by financing superior businesses and ideas is intangibly valuable as well.

There are a lot of problems with the way university finances work. For one, the land they’re sitting on and the payout from the endowment they consume shouldn’t be tax free, for the reasons many critics cite. Education is a social good, but (for understandable reasons) Harvard’s enrollment is far outweighed by the capacity of Harvard’s enrollment (which the the value of the institution and hence its tax shield). Instead, Harvard should be required to pay taxes on the land it sits on, as well as the portion of the endowment it commits to its operating budget, with a deduction for every student it enrolls.

This isn’t ending the debate. But if we want to engage in the conversation of telling other people what to do with their money (and hey, it’s fun) let’s at least do it intelligently. I’d love to see the pros and cons of the value added to society from a permanent investment in its potential ideas compared to, say, furnishing Givewell ideas (taking into account scale, liquidity, general welfare, and distributive welfare). Let’s not make it about privileged Harvard kids and poor African babies.

It’s a common proposition that prevailing market valuations are unreflective of underlying fundamentals. Some say that we’re living through an outright bubble and are in for a correction, and others that markets will be lethargic and stagnant over the next few months, without much room to grow at historical rates.

On the other hand, extremely low interest rates – not just in Treasuries, but safe(r) assets in general – suggest anxiety about future growth. If growth potential really is so fantastic, it doesn’t make sense to crowd into risk-free assets that have almost no claim on that growth. One explanation could be a decline in the risk premium, which militates in favor of the “lethargic and stagnant” view – that we’ve rerated valuations with a lower discount rate, but shouldn’t expect exceptional growth.

A decline in the risk premium would suggest a host of projects that were otherwise unprofitable become feasible, resulting in increased business investment across the board. This may be the case (and we can’t examine the counterfactual) but, somehow, this doesn’t sit well with the prevalence of cash and highly liquid assets piling up on corporate balance sheets.

One simple (if unsatisfying) explanation might be that markets aren’t efficient. There are two types of inefficient. The sort that persists temporarily, and that is bidded away as investors and arbitrageurs profit on the discrepancy, and the sort for which there isn’t an obvious correcting mechanism. The latter, I would argue, is rarer but one can definitely contrive explanations that make sense of the situation.

A possibility that I find appealing stems from a simple principal-agent dilemma. The risk profile for high-level managers (who are – as a baseline – compensated extremely well) aggressively pursuing projects that become viable on the margin is asymmetric. If lots of cash is lost, the manager risks his job. If it succeeds, given that it is a marginal investment, the effect on his bonus would be minimal. The literature on CEO salaries outlines incredible bonuses as an incentive to take big risks – but big risks with big payoffs (and big losses), not necessarily those that are merely better than nothing.

There is some real evidence that this sort of managerial kerfuffle is real:

Importantly, the hurdle rates are often left unchanged for years, even when interest rates drop. A paper included in the latest Reserve Bank Bulletin reports that some hurdle rates have not changed in years.

They were set when interest rates were “far higher than they are today”.

The bank’s findings match those of a survey by Deloitte that found that two-thirds of corporations recalculate their hurdle rate less frequently than they recalculate their cost of capital. Nearly half change their hurdle rate “very rarely”.

Among the reasons businesses give are that changes to the rate might “send the wrong message to staff proposing projects”. Another reason is that changes in the hurdle rate “require board approval”.  Or that keeping the rate high protects against the type of economic uncertainty likely to be present when interest rates are low.

One could argue that this risk aversion should befall investors and managers. Unfortunately, high-level managers have a much less diversified implicit portfolio (including the returns from their labor) than investors, and cannot diversify the idiosyncratic risk that emerges from projects that are profitable on the margin (wherever EV is all the investor would care about).

This outlines at least one possible case of “persistent inefficiency”. You might even argue that inefficiency is cyclical – spare me a few moments of speculative rambling before we get to real data. In a sense the “market” is like a public good. We put into it by performing due diligence on stocks, commodities, and countries to arbitrage any mispricing and more efficiently allocate capital. We take from it by holding its value as a given and using models to infer useful information. Implicit volatility. Inflation expectations. Future price probability distributions.

There’s a tension between the two that becomes especially pronounced when one takes from one pond and puts it into another pond. If you’re a fundamental investor discounting future cash flows, you might take the forward Treasury curve as a starting point to measuring the WACC. (In fact, unless Janet Yellen tells you what she’s up to, you don’t have much of a choice but to take the forward yield curve as a given).

There is some “fundamental” work that goes into generating the forward curve which currently underprices the Fed’s dot plot. The market is telling you that certain economic and geopolitical gravities are conspiring against the Fed’s chosen choice of action – to increase interest rates. It’s come to this conclusion under the guidance of thousands of macro investors who have studied these forces to the extent they can.

Then your value investors are taking this work and applying it to their valuations of individual companies. If the market is wrong, and the Fed is right, the discounted value of S&P cash flows would be lower than valuations imply. But David Einhorn and George Soros do very different things and, in a vague sense, rely on each other for their fundamental work.

This doesn’t really solve our problem. If markets are underpricing the Fed because they think its optimistic about wage growth and international stability, this would be reflected in lower earnings for American companies and be a “short equities, long bonds” moment.

But maybe there isn’t a paradox. And maybe markets aren’t really overpricing anything. That, at least, is the theory I’d like to forward.

If, at a first pass, Price = Earnings/(Risk-free Rate + Risk Premium – Growth), then G_implied = D + RP – (E/P). To my surprise, the picture you get really isn’t that crazy.


The blue line is market implied earnings growth, and the red line is smoothed (realized) NGDP growth. I took a market risk premium of 4.5%. The two aren’t perfectly aligned for three key reasons:

  1. Primarily, the rough estimation I used is incorrect. We should discount by the forward curve instead of the spot rate. Today this would increase the implied growth rate but not meaningfully.
  2. Implied earnings growth is ex ante whereas NGDP growth is ex post. Markets aren’t always correct, there are always random, exogenous, and significant events (wars, draughts, etc.) that couldn’t be predicted before, after which the market corrects. This explains why the two series aren’t perfectly equal, but more in generally the same direction (after the information is released, the market revalues as necessary, changing the implied earnings growth).
  3. And implied earnings are a level above growth (of which profit is a component) because capital’s share of GDP is increasing (and profits, hence, grow faster than the economy itself).

Otherwise, as expected the two series track each other pretty well.

In the long-term, nominal earnings growth in the 4-5% range, or real growth in the 2-3% range does not seem absurd – especially if you believe an increasing share of the economy will accrue to capital owners. Those who argue that the Fed is keeping the market artificially inflated may want to look at how the curve shifts if the forward curve steepens a bit. We will likely be well into 2017 by the time interest rates are even 1%, and even a 1% increase in G_implied may not necessarily be absurd.

And that’s assuming the Fed’s decision isn’t endogenous to economic factors that influence earnings. Very likely, if the forward curve steepens, it is a result not of a negative supply shock (runaway inflation requiring an increase in interest rates, for example) as much as a positive demand shock, where better-than-expected global trade and growth result in an increase in earnings to maintain valuations at a higher interest rate.

This post was meant as a composite of a number of thoughts that I’ve been playing with recently, many of which deserve their own blog post. A particularly interesting tangent would consider the effect delayed IPOs and exclusion of public investors from lucrative returns has on this analysis. My initial guess is “not much”. While it is a deeply interesting, and important, trend, it doesn’t effect public valuations much. Most of Facebook and Uber’s returns might have been captured in the private market but the valuation is slash will be reflected in the public market. And that’s what we’re concerned about here, not returns specifically.