Archive

Tag Archives: finance

Paul Krugman jots some very interesting thoughts about rents in the now-future economy. Brad DeLong notes that investment seems healthier than Krugman implies. But there’s more to the story.

Here are two stylized facts about the American economy:

  • Over the past 30 years the share of incomes captured by the top 1% has soared.
  • Wage’s share of income has fallen with preponderance of capital.

You would gather from this that ownership of capital is highly concentrated in said top 1%. You would be right. Under capital-biased technological change you would further gather from this that a random dollar earned in the top 1% is increasingly likely to derive from capital. You would be very wrong:

Image

Since the onset of labor’s decline in the ’70s, wage share of the top 5% has gone up by as much as it has fallen for the country as a whole. There’s been some volatility in the last 20 years, though. On the other hand, in 1960 the top .01% earned almost 20% of their income on dividends. That figure stands at 7% today:

Image

These data are from the highly useful “World Top Incomes Database”. By the way, it’s worth noting that the dynamics among the top 5% are driven by the 1%, and really the top .05% who control an inordinate amount of that income. Looking at the contrast between the national and top economies, we can deduce that either principal-agency dilemmas have become far more pervasive over time or there’s a lot more to the story than Krugman’s model.

Look, I’m actually pretty favorable to the former explanation. Because the top 5% is driven by the top .05%, which disproportionately consists of CEOs who just happen to be their own chairman, salary accruals have skyrocketed. But a lot of it has to do with two M’s and a J: MBA, MD, and JD. The majority of America’s rich aren’t actually entrepreneurs saving the world in Silicon Valley, as the Republican party may have you believe. Instead, they are largely, boring, rentier doctors, lawyers, and management earning huge excesses either because of government subsidy (doctors and lawyers) or network effects (businessmen). – Note I think lawyers play a crucial role for American society, but do believe a certain subset has benefitted enormously from government action.

Before I go on, I want to clarify my qualms with Krugman’s sketch. As the economy monopolizes, income is diverted from labor into what Krugman argues are rents. But his consideration is limited to where the income goes, not from where it comes. Even within a labor-intense class, as America’s rich surprisingly are, much of the wages can be unproductive rent. Using a Stiglitz-Dixit framework leaves the reader with the implicit assumption that labor income is somehow more productive than anything else. In fact the whole “labor share is falling” meme across the liberal blogosphere does this.

In better days – where the top 5% did not control so much of national product – this might be true. But today, it is not. The cartelization of America’s professionals through elite networking organizations (known to some as the “Ivy League” and others as the “AMA”) have sent consulting and medical wages well above their natural level.

And the subsidy to lawyers is even more infuriating. Indeed, every time the government passes a law, it ipso facto subsidizes legal practices across the country. Not the honest public defender in Omaha, mind you, but the corporate litigator in Manhattan. This is not a question of regulation, but the type thereof. Deregulation is never instituted in sweeping form so as to actually reduce market power of lawyers. Rather, the axis of evil between firm-LLP-lobbiest-legislature ensures maimed regulation in the form of loopholes only ultra-rich firms can realize.

Unionization – of doctors, lawyers, and corporate America – is on the rise. Not surprisingly, the labor share thereof is as well. Therefore I don’t like to think that income is being diverted from labor (and capital) into monopolistic rents. They’re not making it into corporate profits in the first place, but accruing in the form of “wages” which are really just rents. But why are profits going up then? I think Paul Krugman gets the symptoms right. Capital biased technical change doesn’t explain everything. Instead, because capital rents are falling, the owners thereof (top 5%) are leasing it out at an increasingly low rate, allowing profit to accumulate.

At the end of the day, we’re both describing the same situation with a different transmission mechanism. But this difference isn’t superficial. Paul Krugman says Apple’s earning rents because, it’s… well… Apple! What can the government do about that? Not very much. On the other hand, if you see the rising rents accruing in upper income wages as not the symptom, but the cause, you can identify the disease and implement a swift cure:

  • Mandate better best practices (CEO cannot be chairman).
  • Get rid of the AMA and implement a single-payer system. Or institute wage controls.
  • Write simpler (not weaker) regulatory law or, if this is impossible because of private interests, countersubsidize the market with a flood of corporate lawyers.
  • Focus on earned income, and not capital gains, taxes. Yes, most capital gains goes to the top 1% but all income earned over $400,000 goes to the top 1%.

I’ve also argued (and here) that contestable markets are better framework for the tomorrow-economy. I’ll leave more detailed deliberations, other than the linked, for later, but suffice to say that seeming giants like Google Reader have proved to be operating under nothing less than the threat of fierce competition, preventing the assumption of monopolistic rents.

Is ownership of intellectual property important? Yeah. But it is a longshot to assume that patents are wholly wasteful. They are definitely a strong incentive to create and invest. And rents earned thereof aren’t permanent – indeed Moore’s law compels rapid intellectual capital consumption, if you will. Usually when I hear people complain about patents, I sense the underlying argument is redistribution of brand. Could we let another company copy Coke’s logo or Nike’s slogan?

I can’t come to any grand conclusion, here. But we are having the wrong conversation if we’re talking about all time low wage share of the top 100% without talking about the all time high wage share of the top 1%. And if I am onto something, the problem is a lot easier fixed than either DeLong or Krugman suggest. On this note, something that we should correct:

Image

The above graph depicts the chance a randomly selected wage earning goes to the top 1%. It’s a simple calculation. We know that:

p(1% | wage) = p(1%)*p(wage | 1%)/p(wage),

p(1%) is the share of all income collected by the top 1%, p(wage | 1%) is the wage share of said income, and p(wage) is the wage share of all income. This is very interesting in how it compares to dynamics overall:

Image

A given dollar earned in wages (as opposed to land rents, interests, or dividends) is more likely to fall towards the rich than dollars earned overall. I’m not sure about everyone else, but this surprises me. We need to stop talking about capital. A lot of inequality looks like it can be solved by fixing the principal-agent problem, and breaking America’s ridiculous unions. Not of autoworkers or teachers. But of doctors, lawyers, and MBAs. Indeed, the rents earned by these three professions can be considered as a risk-free return (guess what the risk of an MBA from HBS is!) To the extent that the IQ of such falls broadly in the same range as potential entrepreneurs (who may not even know their latent skill), rents earned in these industry not only increase inequality, but asphyxiate entrepreneurial spirit by allowing an easy way out.

Ben Bernanke said recently:

The only way for even a putative meritocracy to hope to pass ethical muster, to be considered fair, is if those who are the luckiest in all of those respects also have the greatest responsibility to work hard, to contribute to the betterment of the world, and to share their luck with others. As the Gospel of Luke says (and I am sure my rabbi will forgive me for quoting the New Testament in a good cause): “From everyone to whom much has been given, much will be required; and from the one to whom much has been entrusted, even more will be demanded” (Luke 12:48, New Revised Standard Version Bible). Kind of grading on the curve, you might say.

I do not want to live in a society where Yale Law and then Wall Street is that which we demand of our best and brightest.

(I do understand there are some mind blowingly excellent MBAs, MDs, and JDs out there. I also think, on average, the profession earns more than it should via government protection).

Have you been advocating that fiscal stimulus is unnecessary for the past four years? Do you want help in defending your position? Are you a die-hard monetarist? Are you annoyed at how right Paul Krugman has been? What follows is your best shot at disproving him. Tread with trepidation.

If there’s one rational expectation in economics, it’s that Paul Krugman is an inflationarydollar-debasingausterity-thumpingirresponsiblefiscalist imp that needs to be controlled. And over a decade ago in 1998, the good doctor wrote:

The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

Back then, he had to end that phrase noting that “this sounds funny as well as perverse”. That’s a sea change from today, where this is taken as a foregone conclusion in wonkonomics. I see petitions for Larry Summers, Janet Yellen, and Christina Romer as great Fed chairs. That’s wonderful, and I’d be happy with any one of them (particularly Romer). But someone has to give me a detailed explanation why there isn’t a roaring movement – from Scott Sumner to Brad DeLong – calling on Barack Obama to nominate Paul Krugman for the most prestigious job in the country.

In January, Krugman politely declined a loud calling for his nomination as Treasury Secretary, preferring to remain an outside man. A latter-day Socratic gadfly, if you will. I agree, Paul Krugman in high political government would be a very bad thing. As I see it, such a position is best filled by a technocrat who can organize a willing coalition to frame the President’s economic policy into law. Paul Krugman is not that man.

Jack Lew is not involved with markets on an daily basis. We don’t much care how thick his briefcase might be. On the other hand, the Fed chair has the incredible burden of forming the most important expectations across international finance. We’ve all written many articles about how better monetary policy would slash deflationary expectations. We’ve talked about helicopter drops and QE infinity. We’ve talked about 4% inflation, and nominal targets.

Krugman is the intellectual father of irresponsibility, quite literally. If there is one man in this world who can convince markets that America will tolerate above-trend inflation, it is Paul Krugman. If there is one man in this world who can falsify Krugman’s own theory that we need more fiscal stimulus, it is Paul Krugman. Indeed, if Paul Krugman cannot credibly commit to be irresponsible, no one can.

Markets will smoke if he is shortlisted. If he is nominated, they will all but go on fire. So if you are interested in disproving Paul Krugman’s many calls for fiscal policy in a liquidity trap, you best champion for his nomination as Fed Chair.

(P.S. I did promise you “notes” plural. Your next best shot is to abdicate the scientific method, and choose to believe in hyperinflation, hard money, and short run superneutrality. This has been the option of choice for most.)

P.P.S Comon, is there a better “expectations channel” than krugman.blogs.nytimes.com?

Helicopter money has received a lot of praise, from left and right, as sound monetary policy. Some have gone as far as to say a universal basic income, or broad tax cuts, should be financed by printing money. I don’t like this as an argument for monetary policy for several reasons:

  • Financing tax cuts or a basic income is decidedly political, and blurs central bank independence.
  • It’s very difficult to granularly tune any such “drop”, or broader financing plan. They must either be discrete choices – a onetime expansion of the monetary base by emailing $1000 to each household (stimulus), or a coordinated policy decision.
  • Cash handouts that are big enough can have perverse consequences.

But there’s something much better device that can be finely tuned: the credit card. James Tobin remarked that the “the linking of deposit money and commercial banking is an accident of history”. It is this “accident”, to say the least, that compelled the United States to waste billions feeding AIG bonuses. Banks would not be “systematically important” if their collapse did not cause deep ruin.

Just like the Bank of America and Citigroup, I propose that the Federal Reserve issue each citizen of majority a lifetime credit card. During boom times, the daily interest rate on credit will be pegged to the inflation rate with default risk premium – users will prefer their normal card that offers a 30-day paying block.

However, if nominal GDP ever falls off path, the Fed directly lowers the rate until the FOMC’s forecast hits the target (also, board salaries are docked by the extent to which their forecast misses the target and the actual result misses the forecast). In the counterfactual, after Wall Street imploded, TARP would be completely unnecessary because the Fed would be providing incredibly cheap credit directly to consumers to reflate the economy (otherwise they get no salary!)

This policy isn’t plagued by a “zero lower bound”, either. Instead of highly questionable quantitative easing, the Fed can choose to inflate its balance sheet by bringing direct credit rates below zero, to increase consumer spending. This has the following benefits:

  • QE works through “hot potato” and “wealth” effects, and the extent of monetary base expansion completely contradicts inflation and job growth figures. Mostly because a lot of QE ends up in interest paying reserves, or the Fed mangled expectations. Likely both.
  • Any and all expansions of the monetary base are directly increasing consumption or investment. There is ZERO debate among economists whether this increases nominal GDP.
  • The card will simply be banned from repaying other debts (this will encourage private creditors to artificially increase rates on expectation of a Fed decrease, and hence will be an indirect QE: that is more profit for banks).
  • It also can’t be used on the stock market, we don’t want average Joe to conduct a leveraged buyout with his card. It is a physical card, and has the same limitations. Can’t do any fancy finance stuff with it.

Ben Bernanke would have seen this year’s job reports, thought to himself “wow, this is shit”, and decreased the interest rate on direct credit. He would also have the New York TimesWall Street Journal, and ZeroHedge advertise this rate cut everywhere (because he can), and this would get consumers to go buy more stuff. If rates were -10% (and that’s consistent, for a period of time, with the kind of QE we have) who wouldn’t buy that new Mac Pro?

Note that, if I buy something nice I can’t just wait for the negative rates to cut my burden to zero. As the economy picks up – and it will much more rapidly with this policy – rates again hit market levels. This will allow the Fed to more naturally (than QE) wind-down its balance sheet. Here’s why I’m confident this has to bring NGDP, inflation, and hence unemployment back on track. If it does not, we’ve basically found a forever free lunch. Because this cannot happen, there will be a time when credit rates rise, and that’s good.

That’s prong uno. As we’ve noticed, credit crunches after financial crises leave small businesses without access to corporate bond markets asphyxiated. The Federal Reserve will offer special corporate cards to such entities earning less than whatever the tax code defines as “small business”. (I’ll pass on actually reading it). This will offer ultra low-rate (0% or maybe less) long-run credit for expansionary investment. Cities and states will be given special rates to finance infrastructure or education (the mayor and governor will get diamond-studded platinum cards with free Air America miles).

Feedback loops will reflate the economy. Not only does direct credit access now evade the rotten financial system altogether, but businesses will expect increased demand (because of consumer spending) that will decrease their fear of low profits, and hence convince them that expansion is necessary. Further, more people will be encouraged to open new businesses, and this will keep markets competitive in a recession.

(Okay, there’s a big problem I’m not talking about, which is default. I used to be against this stuff, but since this is the opposite of predatory lending, I’d say the government has your social security number and way more information than normal companies, and can withhold tax returns or income (and even threaten penalties) for default. A little is okay and good.)

Finally, this plan can be augmented with its own Evans Rule (call it the Rao’s Rule?): “So long as unemployment remains above 5% or inflation under 3%, the Federal Reserve will decrease direct financing rates by k*(u-5)% a month” where k is some multiplier, and u is the unemployment rate.

This does a few things the Evans rule does not. First it provides a condition for easing not tightening, which is what we need in a recession. It also achieves what I call “informational neutrality” good news on the job market won’t scare investors into “TAPER TAPER!!!”, because any and all tightening of policy will be linked with proportional decrease in unemployment, and hence increase in aggregate demand. Also, this is not linked to the stock market in the way QE is. That’s a good thing, in case you were wondering.

Under this, the Fed can much more easily commit to be irresponsible (that is, tolerate above-trend inflation in the future), which is the only thing that can gain traction in a liquidity trap, as Paul Krugman famously puts it. All Bernanke needs to do is promise to keep credit card rates negative, or very low, until NGDP is on level (not growth). He needs to bully the FOMC into saying the same thing (and gag Richard Fisher) and there is no way markets won’t believe it.

Problem solved. Oh and the best thing? We could have let the damn banks fail in 2007. Competitive finance, here we come! We even managed to slip in a bit of sneaky fiscal policy with credit financed bridges and education. Might I even say this would end the phrase “zero lower bound”. (The economy’s not picking up? Well lower the rate to -500%, for god’s sake!) Or, if you want to be safe, just stick with Rao’s rule.

P.S. A rather obvious omission is, of course, a credit limit. This would likely be determined by income. The standard refrain might be queasiness at the idea that rich people get access to more cheap (negative) credit, but just consider this compared with the dynamics of QE. Further, most of the rebalancing of the Fed’s balance sheet during the recovery and boom will come from the “rich”.

In a 1963 paper Robert Mundell first argued that higher inflation had real effects. He challenged the classical dichotomy by suggesting that nominal interest rates would rise less than proportionally with inflation, because higher price levels would induce a fall in money demand, thereby increasing velocity and capital formation which, in turn, would bring real rates down. The most interesting part of my argument comes from a model designed by Eric Kam in 2000, which I’ll get to.

And as Japan emerges from a liquidity trap, the Mundell-Tobin effect (named, too, for James Tobin submitting a similar mechanism) should anchor our intellectual framework. I don’t see any of the best bloggers (I may be wrong but see the self-deprecation there via Google) arguing along these lines, though Krugman offers a more sophisticated explanation of the same thing through his 1998 model, this can only strengthen our priors.

Paul Krugman, Noah Smith, Brad DeLong, and Nick Rowe have each replied to a confused suggestion from Richard Koo about monetary stimulus. Smith, as Krugman points out, was restricting his analysis on purely nominal scope and notes that DeLong captures the risk better, so here’s DeLong:

But if Abenonomics turns that medium-run from a Keynesian unemployment régime in which r &ltl g to a classical full-employment régime in which r > g, Japan might suddenly switch to a fiscal-dominance high-inflation régime in which today’s real value of JGB is an unsustainable burden..

Moreover, to the extent Abenomics succeeds in boosting the economy’s risk tolerance, the wedge between the private and public real interest rates will fall. Thus Paul might be completely correct in his belief that Abenomics will lower the real interest rate–but which real interest rate? The real interest rate it lowers might be the private rate, and that could be accompanied by a collapse in spreads that would raise the JGB interest rate and make the debt unsustainable.

I’ll address the latter concern first. Let’s consider the premise “to the extent Abenomics succeeds in boosting the economy’s risk tolerance”. If the whole scare is about Japan’s ridiculously-high debt burden, and we’re talking about the cost of servicing that debt, as far as investors are concerned isn’t Japan’s solvency a “risk”. I don’t think it is, I certainly don’t see a sovereign default from Japan, but that’s the presumed premise DeLong sets out to answer. So with that clause, the question becomes self-defeating, as increased risk tolerance would convince investors to lend Japan more money. Note the implicit assumption I’m making here is that it’s possible for a sovereign currency to default. I make this because there are many cases where restructuring (“default”) would be preferable to hyperinflation.

Even ignoring the above caveat, the fall in interest rate spreads can come from both private and public yields falling, with the former falling more rapidly. A lot of things “might be”, and do we have any reason to believe it “might be” that inflation does nothing to real public yields?

Well, as it turns out, we have good reason beyond Krugman’s model suggesting that inflation increases only nominal yields:

  • Mundell-Tobin argue that the opportunity cost of holding money increases with inflation, resulting in capital creation and decreased real rates. This is a simple explanation as any, but would be rejected as its a “descriptive” (read: non-DSGE) model.
  • So comes along Eric Kam arguing that: The Mundell-Tobin effect, which describes the causality underlying monetary non-superneutrality, has previously been demonstrated only in descriptive, non-optimizing models (Begg 1980) or representative agent models based on unpalatable assumptions (Uzawa 1968). This paper provides a restatement of the Mundell-Tobin effect in an optimizing model where the rate of time preference is an increasing function of real financial assets. The critical outcome is that monetary superneutrality is not the inevitable result of optimizing agent models. Rather, it results from the assumption of exogenous time preference. Endogenous time preference generates monetary non-superneutrality, where the real interest rate is a decreasing function of monetary growth and can be targeted as a policy tool by the central monetary authority.

[Caution, be-warned that we can probably create a DSGE for anything under the sun, but I will go through the caveats here as well] Note that he’s not making any (further) remarkable constraints to prove his point, just relaxing a previous assumption that time preference is exogenous. A previous paper (Uzawa, 1968) followed a similar procedure, but made the strong, questionable, and unintuitive assumption that the “rate of time preference is an increasing function of instantaneous utility and consumption” which implies that savings are a positive function on wealth, which contradicts the Mundell-Tobin logic.

Kam, rather, endogenizes time preference as a positive function on real financial balances (capital + real balances). He shows non-neutrality with the more intuitive idea that savings are a negative function on wealth. (So unanticipated inflation would result in higher steady-state levels of capital).

Look, in the long-run even Keynesians like Krugman believe in money neutrality. By then, however, inflation should have sufficiently eroded Japan’s debt burden. DeLong’s worry about superneutrality in the medium-term, where debt levels are still elevated, seems unlikely even without purely Keynesian conditions. That is, no further assumptions other than an endogenous time preference are required to move from neutrality to non-neutrality. DSGEs are fishy creatures, but here’s why this confirms my prior vis-a-vis Abenomics:

  1. Lets say superneutrality is certain under exogenous time preference (like Samuelson’s discounted utility).
  2. Non-superneutrality is possible under endogenous time preference. Personally, I find a god-set discount rate/time preference rather crazy. You can assign a Bayesian prior to both possibilities in this scenario. But note, the models which support neutrality make many more assumptions.

Now we need a Bayesian prior for (1) vs. (2). My p for (1) is low for the following reasons:

  • It just seems darned crazy.
  • Gary Becker and Casey Mulligan (1997) – ungated here – quite convincingly discuss how “wealth, mortality, addictions, uncertainty, and other variables affect the degree of time preference”.

I’d add a few other points to DeLong’s comment – “the real interest rate it lowers might be the private rate, and that could be accompanied by a collapse in spreads that would raise the JGB interest rate and make the debt unsustainable” – if the idea of falling real yields is not plausible. A fall in private cost of capital should be associated with a significant increase in wages, capital incomes, and at least profits. This by itself increases more revenue, but likely a greater portion of the earned income will fall in the higher tax brackets, suggesting a more sustainable debt. Of course my belief is that both private and public debt will be eroded quicker, but even if that’s too strong an assumption, there’s no reason to believe that falling spreads per se are a bad thing for government debt so long as it maintains tax authority.

However, the Mundell-Tobin and similar effects derive from a one-time increase in anticipated inflation. It’s not even to be seen that Japan will achieve 2%, and that’s a problem of “too little” Abenomics. On the other hand, if Japan achieves 2%, and tries to erode even more debt by moving to 4% it will loose credibility. Therefore, Japan should – as soon as possible – commit to either a 6% nominal growth target or 4% inflation target.

This is preferable because it increases the oomph of the initial boost, but primarily it extends the duration of the short run where monetary base is expanding and inflation expectations are rising. A longer short-run, we minimizes DeLong’s tail risks of a debt-saddled long-run, even if you reject all the above logic to the contrary.

DeLong concludes:

Do I think that these are worries that should keep Japan from undertaking Abenomics? I say: Clearly and definitely not. Do I think that these are things that we should worry about and keep a weather eye out as we watch for them? I say: Clearly and definitely yes. Do I think these are things that might actually happen? I say: maybe.

 I agree with all of it except the last word. I’d say, “doubtful”.

Note: I’m trying to tentatively oodle and sketch my thoughts here. Forgive idiocy. 

There’s no doubt that tight money in Europe is crippling its economy. But today’s job report should make you think twice about QE, at least under the Evans Rule. Soon after we saw the numbers, DJIA soared by over 165 points in just a few hours. Here’s the problem, markets are responding to a bad, not good, report.

When the Evans rule is contingent on unemployment rate, rather than job creation, the flatline since May has eased investor worries about any “tapering” of bond purchases. We should see Treasury yields fall within the next few days. This is counterintuitive, if the Evans rule worked correctly: meek aggregate demand should chill the markets (or at least not cause them to jump in joy).

One interpretation of these results is the so-called “wealth effect” of quantitative easing, where consumers and investors suddenly start spending more because they feel richer, is a lot weaker than previously believed. If the wealth effect were strong low wage growth  would worry investors about weak demand. (And Scott Sumner correctly argues that the small increases are a supply side phenomenon).

And in a normal market, that’s exactly what would have happened. However, the Evans rule is framed so oddly that stock markets can, for a very long time, benefit directly from a stagnating economy. Investors are now reassured that QE will continue. They are dreading a real recovery. Even if policy was contingent on monthly job creation, today’s report would have assured investors, but at least that response would be measured by the economy itself, than an artificial statistic.

Even then, the perversity of QE is clear. Obviously, considering QE’s transmission mechanism, asset prices have to increase. However, we should at least believe that a lot more of the stock market boom in the past few months is QE and AS rather than improvements in demand. Otherwise, today’s jobs report should have been met with a “meh” response from the Dow.

The thought experiment is this. Let’s say May was a fantastic month, and the BLS prints a fabulous report. Would the stock market go up? To the extent it falls, or doesn’t rise as we would hope to aggregate expected growth (which is high, because the market knows the economy has done well) – QE is a distortionary force. It’s not a bubble, but it clearly confuses markets.

A well-designed QE policy would offset the market effect of information from the jobs report vis-a-vis its “natural” trend. What does this mean? If the job market was booming investors would face two countervailing forces 1) an expected tapering of QE and 2) increasing consumer confidence and demand (which moves in line with the market). If the jobs report sucked, investors would be confident in continued QE, but worry about falling demand.

This is a sterile design that doesn’t approximate the real world, but can inform what a correct QE policy would look like. For one, the value of asset purchases would be proportional to (or correlated with) job creation.

I suspect this is a rather confused post, but I’m trying to collect my thoughts. Hopefully I can produce a more detailed and cogent post later.

Indian newspapers are pretty gloomy right now – inflation, laggard growth, and a falling Rupee don’t make for a great  diet. Before I tell you why to be optimistic, I should define my terms. Optimism could be a resurgence to double-digit growth rates. That seems unlikely without a robust recovery in China, America, and Japan. Optimism could be a rapidly falling poverty rate. But that’s a really low bar for poor countries in India’s convergence club. To many here, it could be about India’s relative position to China. But that’s boring. I’ll loosely define optimism as the confidence that a good number of pundits short on India today will be be seen as myopic in five years.

Many standard economic indicators – government surplus, growth, and balance of payment – flatlined or dropped during the crisis and its aftermath. However, these are cyclical trends that have little bearing on future growth. In contrast, China has done exceedingly well in all of the above. But India has, to use a technical term, kicked ass in one indicator: real credit depth.

According to the World Bank, domestic credit provided by the banking system has grown from just over 60% of GDP in 2007 to almost 75% today. For reference, Brazil has flatlined around 95% and China at 140%. India has a long way to go, but the domestic banking system’s resilience to financial crisis and inflation makes a strong case for its structural health. 

India’s relatively shallow credit markets means we have a long way to go, and that’s cause for celebration. Further, India’s credit position relative to Brazil is more a reflection of a gradual, rather than immediate, liberalization of the capital account. Deep and liquid credit markets dampen entrepreneurial barriers to entry and hence encourage competition and innovation. That India’s savings rate has remained steadily high throughout an increase in credit suggests a more efficient allocation thereof. This, a secular trend, is rather more important than a volatile growth rate.

The government has further demonstrated a commitment to price stability, contrary to popular belief. The reason is subtle – the time at which India started offering inflation-indexed bonds (IIBs). There are three main “clubs” of countries that issue such bonds. First, Latin American countries with runaway inflation found IIBs the only entry into long-run capital markets. Second, countries like Britain and Australia which issued IIBs in the 80s and 90s as deliberative action to signal creditworthiness. Finally, America, issued the TIPS only as recently as 1997 as a means to long-run investor welfare. 

People are quick to place India in the first category but, as late as April, the wholesale price index (WPI) had fallen below 5%, less than half its double-digit peak. It’s curious, then, if the government were concerned about the inflation risk premium, why it didn’t issue IIBs in the heyday of price instability. By anchoring expectations before the first auction, India is best approximated by the second group, signaling a willingness to control prices in the long-run.

Relative to other developing countries, India’s vibrant democracy will reinforce bond market confidence as a welfare state emerges. The biggest guarantee American bondholders have against default are its pensioners, and the electoral bloodbath that would result. Therefore, there’s both an economic and political incentive not to default. Most Indians don’t own much wealth, at least not linked to its bonds. However, once a formal savings-based welfare state emerges, India is in a far stronger position than countries like China, which have only an economic incentive to avoid default.

Obstacles to this in the near-term include a deeply underbanked country, but that serves as reason for confidence not pessimism. With emerging electronic money transfer technologies, the financially-excluded are becoming more a low-hanging fruit than a pariah of the country. (This is a big bet, but in the long-run its one I’m more than willing to make. If a majority of the country remains excluded by 2020, call me out). 

Despite political instability in this government, it is likely that in the medium-run India will liberalize retail and finance to a much greater extent. The benefits of retail freedom are immense, as we know from Japan, mostly via indirect “knockback” effects. Larger and scaled firms like Walmart will invest in a deeper supply-chain providing India the cold-chain system which it desperately needs. Furthermore, competitive retail markets demand efficient input markets, thereby “percolating” efficiency through the system. 

Financial liberalization is trickier – even ardent free market economists like Jagdish Bhagwati note that capital accounts are precarious (they learn from 1997, and Indian resilience therein). Most importantly, a clearer statutory central bank independence is necessary. By many stalwarts (including India’s chief economic adviser, Raghuram Rajan), the Reserve Bank of India (RBI) is seen complicit in runaway deficits, by keeping capital reserve requirements high and thereby creating a captive demand for debt.

Recent success in taming inflation convinces me that smarter independence is on the horizon. It’s not unreasonable to expect that India will end preferential lending schemes, thereby capitalizing on the deepest benefits of a liberal economy, which are indeed self-reinforcing. 

Ultimately, a 4.5% growth rate is pretty shabby, and for many the outlook seems bleak. In five years, I imagine (and hope) that all the BRIC bears will wrong. But there’s cause for reason that India’s will be wrongest of all. 

 

Is “reset”. Ok, snark aside, I think Tyler Cowen is onto something here:

Fear the reset.  The world will continue to produce much more value, and much more gdp, but who will capture that value is already changing dramatically and will continue to do so.

The life cycle consequence of a falling labor-share of GDP is something I’ve been meaning to write about especially after reading a paper from Mark Huggett and Greg Kaplan that’s quite relevant, titled “The Money Value of a Man”:

This paper posits a notion of the value of an individual’s human capital and the associated return on human capital. These concepts are examined using U.S. data on male earnings and financial asset returns. We find that (1) the value of human capital is far below the value implied by discounting earnings at the risk-free rate, (2) mean human capital returns exceed stock returns early in life and decline with age, (3) the stock component of the value of human capital is smaller than the bond component at all ages and (4) human capital returns and stock returns have a small positive correlation over the working lifetime.

Huggett and Kaplan rightly suggest that this is of significant importance in portfolio allocation. To the extent human capital is our most valuable asset, the best investment advice requires an understanding of the relative magnitudes of stock and bond positions thereof. As they posit, this brings an interesting new light to the international diversification puzzle suggested by Marianne Baxter and Urban Jermann (1997):

Despite the growing integration of international financial markets, investors do not diversify internationally to any significant extent. We show that this “international diversification puzzle” is deepened once we consider the implications of nontraded human capital for portfolio composition. While growth rates of labor and capital income are not highly correlated within countries, we find that the returns to human capital and physical capital are very highly correlated within four OECD countries. Hedging human capital risk therefore involves a substantial short position in domestic marketable assets. A diversified world portfolio will involve a negative position in domestic marketable assets.

Huggett and Kaplan note that this is “unsolvable”, for wont of a better term, to the extent we don’t understand the decomposition of human capital in similarity to domestic stock returns. But the “reset” Cowen is concerned with strictly concerns this gem from the paper:

The mean return to human capital falls with age over the working lifetime. Moreover, the mean return greatly exceeds the return to stock early in the lifetime. Both of these results are related to our findings on the value of the orthogonal component. We show that the mean human capital return always equals a weighted sum of the mean stock and bond returns. The weights are determined by the projection coefficients from the value decomposition. These weights sum to more than one exactly when the value of the orthogonal component is negative. Thus, human capital returns exceed a convex combination of stock and bonds returns. Human capital returns and stock returns have only a small positive correlation over the working lifetime. This correlation is higher for high school than for college-educated males. 

The emphasized is of real importance considering the falling labor position of America’s uneducated youth to international and technological competition. (Indeed this might fall more acutely on the “middle-skilled” rather than blue-collar labor, but mechanics and technicians have always been better options than retail or sales). See below:Image

Contrary to what Cowen’s analogy with “tenured professors” and other insiders would suggest, the weight of the “bond share” in human capital decreases by age (until social security). The comparison is quite self-evident. Indeed, as a tenured professor himself, Cowen’s “human capital” is like a very valuable perpetuity. The risk is negligible, yields are (relatively but deservedly) lavish and predictable. Indeed for a tenured professor, the bond component is far higher than the above graph suggests. An important critique to the study is the rapid structural change the American economy has experienced over the past 40 years (note the entrance of robots and China). The comparison between t = 30 and t = 60 is not ceteris paribus.

The story with a high-class escort and street prostitute is the same. But unlike the unionized world of yore, job security is no sure thing, and the college premium might be increasing on the mean, but a surprising number of graduates will likely fall closer in bond component to earlier high school graduates than the mean college graduate. (Indeed the mean-median gap is likely to increase).

And one dynamic, noted in the Huggett-Kaplan paper, is also liable to change: “mean human capital returns exceed stock returns early in life and decline with age”. If labor share of income continues to fall at its current rate – though I doubt it will – the inequality implied by the above statement (note the work the word “mean” is doing) would be improbable.

The remedy here is something both far from ideal and practical: international capital endowments. (Note, I take the importance of improving education, not necessarily spending more money thereof, for poor youth as a self-evident necessity and as a given in any proposed solution).

Let’s call this a conditional capital transfer. Those who graduate high school will be given a lump-sum Vanguard Exchange Traded Fund, or something of that sort. Once you graduate college you’ll be given a little less. If you dropout, periodic such lump-sums can be granted by entry into vocational training programs and as an incentive to remain in the labor force. This can be a strong countervailing force to the increasing number of people living on disability benefits after cyclical downturns.

Liberals are often worried about job security and inequality thereof. Cowen is right, we need to spend more time understanding the mean-median spread in bond and stock returns to human capital as a life-cycle force rather than pure income itself. I am curious to see how a similar decomposition would fit Germany. I expect the secular change to be dampened relative to cyclical events.

Ashoka Mody, the former IMF mission chief to Germany and Ireland, is bearish on global growth prospects in the near-future. I’m by nature optimistic, but Mody makes some fair points:

Europe’s extensive regional and global trade networks mean that its internal problems are impeding world trade and, in turn, global economic growth. In 2012, world trade expanded by only 2.5%, while global GDP grew at a disappointing 3.2% rate.

Periods in which trade grows at a slower pace than output are rare, and reflect severe strain on the global economy’s health. While the trauma is no longer acute, as it was in 2009, wounds remain – and they are breeding new pathologies. Unfortunately, the damage is occurring quietly, enabling political interests to overshadow any sense of urgency about the need to redress the global economy’s intensifying problems.

[…]

But even the world’s most dynamic emerging markets – including China, Brazil, and India – are experiencing a sharp deceleration that cannot be ignored.

Consider India, where growth is now running at an annualized rate of 4.5%, down from 7.7% annual growth in 2011. To be sure, the IMF projects that India’s economy will rebound later in 2013, but the basis for this optimism is unclear, given that all indicators so far suggest another dismal year.

[…]

Indeed, as the effects of stimulus programs wear off, new weaknesses are emerging, such as persistent inflation in India and credit misallocation in China. Given this, the notion that emerging economies will recapture the growth levels of the bubble years seems farfetched.

It’s very easy to read the facts above as a gloomy predicament the global economy, but I think that interpretation betrays a somewhat obsolete late-20th Century understanding of growth: the primacy of free trade. I’m a strong proponent of trade liberalization, and don’t doubt it has a big role to play in the coming decades, but it by the fact cannot be as earthmoving as it was.

A little history, first. Consider the economic dynamic in the late ’70s, when the South Korean miracle was well underway. While Korea trumped America in growth rate, America’s total growth in real terms was greater than Korea’s. The large income gap meant Americans could easily absorb Korean exports, and Korea could focus on exports rather than domestic consumption.

When there’s one very rich country and many poorer ones, liberalization leads to bountiful dividends. But three things are very different today:

  • China’s total growth, in absolute terms, is greater than America’s.
  • The trade-oriented miracles of the 20th Century were relatively unpopulated. China, India, and Brazil represent a much bigger chunk of the world and its economy. There is no way their growth can continue to be financed by rich-world imports.
  • Trade as a per cent of global GDP has boomed, as the world liberalized. There are diminishing returns to further specialization. No doubt free markets are a good thing, but we’ve eaten most of our free lunch. (For example, tariff barriers around the world have plummeted since the ’60s).

For this reason when Mody defines “severe strain on the global economy’s health” as “periods in which trade grows at a slower pace than output”, the economy will be tautologically unhealthy. Imports and exports can only reach a certain level before facing diminishing marginal returns, issues of national sovereignty, and optimal specialization.

Consider China, which represents a staggering proportion of all global growth and is the primary trader with a majority of countries. Government officials are acutely aware that to advance development, China will have to move to a domestic consumption, rather than investment and trade, oriented economy. In the process, China’s exports and imports might both fall – keeping its very strong balance constant – while domestic consumption increases rapidly. Global output would increase more than otherwise, ceteris paribus, and trade would fall.

And this isn’t necessarily a bad thing. A pessimist’s read of Mody’s passage is as the end of liberalization. But an optimist sees that trade as a low hanging fruit has, largely, been eaten – but many useful reforms remain. Capital market liberalization at the top of this list. Both India and particularly China have hinted at freer financial markets. I would be curious what Indian indicators, exactly, suggest “another dismal year”. Surely its deficits and balance of payments aren’t desirable, but in recent years India’s growth rate has shown some volatility. There’s no reason to believe next year’s growth won’t be much higher as North American growth accelerates.

India and China both have remarkable room for institutional improvements. Regulatory and labor deregulation in the former, and democratic pulses in the latter are bound to increase investor confidence and potential for future growth. Indian workers are also profoundly unproductive. Usually because capital intensity is dismal (anecdotally, when we stayed in Goa, India’s richest state, the autumn leaves strewn across our lawn were picked up by the hand one-by-one, not even a simple, Medieval, rake). But this is a good thing, supply-side reforms have a long way to go which, if done correctly, will temper inflationary pressures.

India will also be joining the relatively small club of countries offering inflation-protected government securities. This will substantially decrease the trade deficit from imported gold, and allow savings to be allocated towards productive ends. Further, while in hopes of American and European revival I would support fiscal stimulus, I don’t know whether I accept Mody’s suggestion for rich-world fiscal policy as global revival.

American and European debts are to a large extent financed by emerging economies. Rather, growing countries like India should structurally reform its central banking system and institutionalize independence; thereby decreasing perceived risk of government default. Today, the Reserve Bank of India is by many considered complicit in runaway deficits. Credible government policy would reduce long-run yields, and hence improve prospects for economic growth.

At this point in American recovery, growth should be financed by minting all the money that’s fit to print. Perhaps we need a New York Times op-ed on this.

Perhaps one of my less orthodox beliefs is that we should have let Wall Street fail in 2007. Of course, the Bush-Obama administrations would be loth to let this happen, but I think there’s good reason to believe the just policy (as this self-evidently is) would not also create mass unemployment. And in an age where commenters inevitably spew hot air about “structural reform”, bank failure would set the stage for the most important adjustments in over a century.

James Tobin, Nobel Laureate and a little bit of an economic hero to me, once said “the linking of deposit money and commercial banking is an accident of history”. This has deep implications for our (broken) monetary transmission mechanism which is predicated on our weak financial system.

Weak, you say? America has the the world’s deepest credit market, but it thrives off well-documented subsidies encouraging debt and moral hazard through:

  • The implicit TBTF guarantee.
  • Deposit insurance.
  • Interest rate tax deductions.

By a free marketer’s own definition, Wall Street can not be efficient. And 2007 showed us that which can not, is not. Now, before you accuse me of sounding like an Austrian, note that what I’m suggesting would only work under strong state intervention, done right. Here’s all we need:

  • A federal employment guarantee program (a special form of the rare creature known as “fiscal stimulus”).
  • FedEx – or the Federal Reserve credit card!
  • FedEx Business

Now, let’s be clear about a few things. The government is a bad choice for an employer or a bank. (Aside from bureaucrats, local services, etc). But while the financial system stabilizes, aggregate demand will crash, employment will plummet, and credit will crunch. Then government ought to double up as the lender and borrower of last resort.

As spending crashes, employment guarantee programs (which can be coordinated with private enterprise via an “employee auction” market – which I will outline in a later post) should stimulate demand. Here comes your national credit card, with limits and interest rates set by the Fed. This will allow the Fed to increase limits and reduce rates during a credit crunch, thereby sidestepping the private banking system. During normal times the limit would either be absurdly low, or rates obscenely high allowing private banks to compete fairly for market share.

This is a piggyback on Miles Kimball’s Federal Line of Credit. My amendment would be a special loan for small businesses and startups that can’t easily sell corporate debt. This requires an unfortunate level of government bureaucracy, and in most times private banks would be much more efficient. But we’re trying to stabilize demand, here, without handing out money to bankers.

There’s a non-zero chance we won’t ever have to do something so nutty again. Once the government reneges it’s “implicit promise” to bailout “systematically important” banks, executives and shareholders will no longer expect relief, and will raise equity and deleverage appropriately. Matthew Klein and John Aziz have argued along these lines, but I’d add this wouldn’t just reform a risky practices on Wall Street, but challenge the very way we approach monetary policy, which is today tethered to the credit system.

Establishment of a central consumer banking network will allow the Fed to increase demand in a fair and just manner. And to the extent future recessions don’t threaten a credit crunch, open market operations will suffice. But our “exotic” quantitative easing policy has certainly benefitted the rich, asset-owning class than the still intolerably high number of unemployed.

In the near-term this would be more expensive. Government employment guarantee programs won’t be cheap (though wait for my post on the employment auction market which should substantially lower costs and increase efficiency), and will require sustained deficits. But if we credibly commit to irresponsibility – as they say – and let a government finance program take us through the lows of bank failure, the emergent credit system will be more efficient, effective, and morally just.

In almost every “run” there is. I’m making this post a) because of its relevance to my recent calls for steep land value taxation which was of (relatively) high interest and b) because Paul Krugman and Noah Smith beg to differ. (How often does a not Very Serious Person get to disagree with Krugtron, after all?)

There are obviously strong theoretical reasons to believe that land prices correlate well with population. Probably the simplest argument is a rising demand on a perfectly inelastic supply. More intricately, David Ricardo argued that an increasing working class would steadily increase the demand for grains increasing rents earned on fertile land, thereby the net present value of all future returns and hence the price.

In America, Henry George – perhaps not coincidentally after a failed attempt at finding gold – angrily argues for land taxation in his Progress and Poverty, not with arguments too far from what the classical economists made or what you might hear today.

Smith thinks it’s all about agglomeration:

In other words, New York City real estate is high-priced because New York City is an agglomeration of economic activity. It is not high-priced because an increasing number of people are being forced to live in New York City. That isn’t even the case! No law makes people cram themselves into NYC (except in that Kurt Russell movie!); you are legally free to move out to North Texas and get a nice ranch. People choose to live in the heart of New York City because of the economic (and social) opportunities offered by proximity to all the other people living there. So they’re willing to pay lots for land.

Krugman piggyback’s on Smith’s point and also notes that the city can always spread out into unused land:

Even if people want to stay in existing metro areas, they can hive off “edge cities” at the, um, edges of these metro areas, so that the relevant population density — the density that makes land in or near urban hubs expensive — might not rise even if the overall population of the metro area goes up.

And we have data! Via Richard Florida, new work by the Census (pdf) calculates “population-weighted density” — a weighted average of density across census tracts, where the tracts are weighted not by land area but by population; this gives a much better idea of how the average person lives.

Together, they make a strong argument that only in the longest of runs (and perhaps not even then) when a city can grow in size no more, is land price truly a reflection of population constraints. The logical conclusion of this eternally long run wouldn’t be far from America – the whole thing! – becoming a city state.

But there are a few important problems with the argument, mostly Krugman’s suggestion that the city can just “hive off”. The city is not a discrete blot as much a diffused core. The agglomeration economies then derive from the ability to commute efficiently to a well-recognized center. Now note, not all cities are monocentric, and polycentric models exist. Most business activity and, hence, economic output happens in the immediate vicinity of these centers. Indeed, variations of density can differ by over an order of magnitude and land prices in the core may be over 30 times that in the “hived” peripheries.

But cities are limited in the extent to which they can expand. A highly-developed rapid transit system with a commuter rail allows for cheap and quick commuting. As a new working paper notes:

This raises the issue of population density. When we compare cities cross- sectionally, at the same time but across different sizes, we tend to find that larger cities are denser. Nevertheless, in the United States and increasingly all over the world, we also find many modern urban forms, and especially many low-density large cities, such as Atlanta or Dallas. Are these lesser cities than the West Village that Jane Jacobs knew, or the walkable towns that Smart Growth planers advocate? The perspective of cities as interaction networks tells us how all these urban forms can co-exist: the spatial extent of the city is determined by the interplay between interactivity and the relative cost of mobility. When it is possible to move fast across space, cities become much more diaphanous and are able to spread out while preserving their connectivity. It is in fact the diffusion of fast transportation technologies, especially now in developing world cities, that is allowing them to spread out spatially, sometimes faster than they grow in terms of population (32). This, of course, creates possible vulnerabilities. For example, if the cost of transportation relative to incomes suddenly rises (e.g. because it is tied to oil prices) then cities may not be able to stay connected, leading potentially to a decrease in their socioeconomic production rates. Ideas for shrinking cities that have lost population apply the same ideas in reverse.

From the same paper (Bettencourt, 2013) we get confirmation of something I suspected earlier. There’s a greater flaw with assuming land prices aren’t causally related with population in the short run, but agglomeration economies. Population causes agglomeration. (This is theoretically and empirically founded). That is, on a log-log scale of population and income, the slope is about 1.13. Or a doubling of population increases total income by 113%. People get disproportionately richer. More money is chasing the same land because more people are chasing the same land.

This means land prices do associate well with population, in fact it’s about a 50% increase in rents for every unit increase in population:

There are two important consequences for general land use considerations. First, the price of land rises faster with population size than incomes. This is the result of per capita increases in both density and economic productivity, so that money spent per unit area and unit time, i.e. land rents, is expected to increase by 50% with every doubling of city population size! It is this rise in the price of land that mediates, indirectly, many of the spontaneous solutions that reduce per capita energy use in larger cities. Cars become expensive to park, and taller buildings become necessary to keep the price of floor space in pace with incomes, thus leading to smaller surface area to volume, reducing heating and cooling costs per person. These effects may also create the conditions for public transportation to be a viable alternative to automobiles, even when the price of time is high. Thus, larger cities may be greener as an unintended consequence of their more intensive land use. Policies that increase the supply of land per capita or reduce transportation costs (such as urban renewal), while addressing other problems, will tend to create cities that are less dense and that require higher rates of energy consumption in buildings and transportation.

Smith argues that agglomeration effects are path dependent, and that theoretically if land use restrictions were implemented there could be a chance that agglomeration would decrease and hence price would fall.

He’s right about most of it, but I take a much simpler view of agglomeration:

Image

In other words, it’s all the population. And by the way, the figures are pretty similar across the world (that’s actually what I’m working on for India). Read the paper if you want to convince yourself this just isn’t coincidence.

Smith talks about technology, but then oversimplifies the idea that there’s always unoccupied land nearby. The farther I have to drive to get to the center, the more I pay for gas and the more wages and leisure I sacrifice in commute. Transportation technology can mitigate this to an extent, after which point a city is largely stationary. Krugman’s point that the average American lives in sparser city today is well-taken, but also simplistic. We have more medium-sized cities than ten years ago. We don’t have more Chicago’s than ten years ago.

It’s kind of like saying “the average person in a medium or rich countries today is poorer than he was ten years ago”. That’s because a bunch of people just entered that “medium” category. But we don’t have a new America or Norway. In fact, it’s noted that initial urbanization happens in what happened to Delhi or Mumbai a few decades ago, but after a point the drive comes from the new and small places that are now classified as “cities”.

In any case, Smith’s point is actually causally linked with population. It always has been, and always will be.

P.S. Also read Bill McBride on why land prices will rise as population.