Thursday, July 30, 2015

Asset Pricing Part II

Asset Pricing Part II, the second half of my online PhD class in asset pricing, starts up next week. Part I and Part II are separate and independent courses, and you don't need a lot of the material of Part I to do Part II. This is a "summer school" session set up especially for PhD students in finance.


Week 1: a) The Fama and French model b) Fund and performance evaluation.

Week 2: Econometrics of classic linear models.

Week 3: Time series predictability, volatilty and bubbles.

Week 4: Equity premium, macroeconomics and asset pricing.

Week 5: Option Pricing.

Week 6: Term structure models and facts.

Week 7: Portfolio Theory and Final Exam.

Tuesday, July 28, 2015

Mankiw and Conventional Wisdom on Europe

Greg Mankiw wrote a week ago in the Sunday New York Times, ably explaining the  conventional view that the Euro is a bad idea, and that even countries as small as Greece (11 million people) need national currencies. Excerpt:
Monetary union works well in the United States. No economist suggests that New York, New Jersey and Connecticut should each have its own currency, and indeed it would be highly inconvenient if they did. Why can’t Europeans enjoy the conveniences of a common currency?

Two reasons. First, unlike Europe, the United States has a fiscal union in which prosperous regions of the country subsidize less prosperous ones. Second, the United States has fewer barriers to labor mobility than Europe. In the United States, when an economic downturn affects one region, residents can pack up and find jobs elsewhere. In Europe, differences in language and culture make that response less likely.

As a result, Mr. Friedman and Mr. Feldstein contended that the nations of Europe needed a policy tool to deal with national recessions. That tool was a national monetary policy coupled with flexible exchange rates. Rather than heed their counsel, however, Europe adopted a common currency for much of the Continent and threw national monetary policy into the trash bin of history.

Making matters worse, however, was the common currency. In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets. Easy monetary policy would have offset some of the pain from tight fiscal policy. Mr. Friedman and Mr. Feldstein were right: The euro has turned into an economic liability that has exacerbated political tensions. For this, the European elites who pushed for the currency union bear some responsibility.
I am a big euro fan. This seems a good moment to explain why I don't accept this conventional view, despite its authority from Milton Friedman to Marty Feldstein and Greg Mankiw and even to Paul Krugman.

Short: I am also a big meter fan. I don't think each country needs its own measure of length, or to shorten it when local clothiers are having trouble and would like to raise cloth prices.

Monday, July 27, 2015

Ben-Gad and the Minotaur

Michael Ben-Gad has a smashing review, "Into the Labyrinth", of Yanis Varoufakis' The Global Minotaur (Disclaimer: I have not read it and don't intend to.) It's a great piece of writing as well as a cogent analysis. Some excerpts:
"The idée fixe that dominates The Global Minotaur, and apparently dominated Mr Varoufakis’s squabbles with the other Eurogroup ministers of finance, is that some countries are inherently more productive than others and therefore always generate current account surpluses, while others always generate deficits, and fixed exchange rates or monetary unions only exacerbate this imbalance. Hence, for the world economy to function, the surpluses need to be recycled though a system of regular transfer payments from the core to the periphery.
Why do these imbalances emerge? According to the theory of comparative advantage as formulated by David Ricardo in the early 19th century, different countries specialise in the production of particular goods and then exchange them for others, and trade is mutually beneficial even if some countries are more efficient at producing all goods. Mr Varoufakis’s theory rejects all this. Instead, he argues, some countries are destined to specialise in the production of goods and services, while others on the periphery will forever specialise in consuming them. Put into layman’s terms, what this means is that the people of Germany, the Netherlands, and Finland produce cars, wooden clogs, or mobile phones and sell them to the people of Greece, who pay for it all with money – and to make this trade sustainable the cash needs to be regularly replenished in an endless loop by the people of Germany, the Netherlands, and Finland.
This is a story we hear quite often beyond Mr. Varoufakis -- that a currency union requires countries to be similar, with similar productivity. I'm glad to see it so effectively skewered. In Ricardo's famous example, Portugal sells wine to Britain, which sells wool to Portugal, even if one is better at both than the other. They were on a common currency, gold.

Wednesday, July 22, 2015

Monetary Testimony

I was invited to testify at the Subcommittee on Monetary Policy and Trade of the House Financial Services Committee on Wednesday. I had only done this once before and it was a very interesting experience.

The proposed bills my fellow panelists (John Taylor, Don Kohn, and Paul Kupiec) and I were testifying on  were the Centennial Monetary Commission Act of 2015 and the Federal Reserve Reform Act of 2015. The bills, transcripts, and all testimony are here.

Minimum wage and mechanization

A while ago I opined that higher minimum wages might lead companies like McDonalds to substitute to machines. A former student sends me:
here's a photo I took in the McDonald's on the Champs-Élysées, Paris, of the screens where customers can place their orders and pay. After a short wait, you pick up your burger and fries at the counter.
I did not ask just why he is eating at McDonalds in France!

Tuesday, July 21, 2015

A Capital Fed Ruling

The Fed just released it's latest missive to the big banks, and the answer is capital, lots more capital.

Three cheers for the Fed.

They are increasingly understanding that no matter how much they try to micromanage asset decisions, it's impossible to regulate away risk from the top. And "liquidity" will vanish the minute it's needed. Joke version -- liquidity standards are like requiring everyone on an airplane to carry a thousand bucks, so they can buy a parachute if the engines blow up. Just who will be buying "liquid" assets in the next crash?

So,  just raise capital, lots more capital, and slowly let the rest fade away.

A minor complaint: The Fed did it right but said it  wrong.
..under the rule, a firm that is identified as a global systemically important bank holding company, or GSIB, will have to hold additional capital...
No, capital is not "held." Capital is issued. Capital is a source of funds, not a use of funds. Capital is not reserves.  Please all, stop using the word "hold" for capital.
"A key purpose of the capital surcharge is to require the firms themselves to bear the costs that their failure would impose on others," Chair Janet L. Yellen said. "In practice, this final rule will confront these firms with a choice: they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system. Either outcome would enhance financial stability."
Issuing (not holding!) more capital does not make firms "bear costs." Firms never bear costs. They pass costs on to customers, workers, shareholders, or (especially for banks!) the government.  The slight argument for higher "costs" is that equity gets to leverage with less subsidized too-big-to-fail debt; that's not a cost, that's a reduction in subsidy. If (if) the cost of equity capital is high by some MM failure, then equity receives higher returns and borrowers pay higher costs. This is a surprising quote. Ms. Yellen is usually accurate in such matters.

But that's a minor complaint. I'd rather they raise capital and explain it wrong rather than the other way around. And of course, I'd rather they keep going. I'm also a skeptic that big banks are "systemic" and little banks are not, and thus should be allowed to continue with sky high leverage. But we'll get there.


A reader asks why I'm so persnickety about language. In this case, it's important. I think everyone recognizes that more capital leads to more financial stability. When an equity-financed bank loses money, share prices decline, but there are no failures or freezes. However, if you think capital is "held," and it "costly," then you think that banks shifting to issuing equity or retaining dividends to obtain funds has a cost to the economy, and regulators should require as little capital as possible. If you recognize that capital is issued, does not tie up funds, does not reduce the amount available for lending, then your mind is open to obtaining financial stability with lots and lots more capital.

Saturday, July 18, 2015

The other Smith on Growth

In a recent Bloomberg piece, "Growth Fantasy of Tax Cuts and Small Government" Noah Smith took on my recent blog posts on 4% growth. In the first, I outlined the historical evidence that yes, the US has grown at 4% quite often. In the second, I outlined the standard smorgasbord of free-market policies which I suggested would increase our growth, at lest by inducing a substantial level shift.

Noah's main point is that in my blog posts I did not make any substantive quantitative claims that moving our country from the Republic of Paperwork to Adamsmithia would return the US to the kind of growth we saw in the 60s, late 80s and 90s. True enough.

My surprise in reading Noah is that he provided no alternative numbers and no alternative policies.  Well, if you don't think Free Market Nirvana will have 4% growth, at least for a decade as we remove all the level inefficiencies, how much do you think it will produce, and how solid is that evidence? He rambled a bit about the predictive value of some state scoring efforts, but that's all quite beside the central point -- how much growth could the best imaginable economic policy, at a national level, produce?

More deeply, Noah suggests no alternative policies. He does not claim that more government wage controls,  unions, stricter labor laws (Uber drivers must be employees) heavier and more politicized regulation, cartelizing more industries beyond health and finance, raising taxes to confiscatory levels, larger welfare state, boondoggle public works and so on -- the alternative path in the current policy debate -- will get us back to 4% growth.

So, one must only conclude that Noah -- and others voicing the same it's-not-possible complaint -- believes 4% growth is not possible. 2% or less is the new normal. Sustained growth, of the sort that made us all healthier and wealthier, if not wiser, than our grandparents, is a thing of the past. So all we can do now is fight to carve up a shrinking pie, retreat from an increasingly chaotic world, and pretend that carving up the pie will not shrink it further.

I am surprised at this pessimism, both economic and political. If the absolute best economic policies anyone can imagine -- and, again, Noah offered no alternatives -- cannot return us to 4% growth and sustain that growth, why bother being economists? They do not call us the "dismal science" because we think the current world is close to the best of all possible ones, and all there is to do is haggle over technical amendments to rule 134.532 subparagraph a and hope to squeeze out 0.001% more growth. Usually, the role of economists is to see the great possibilities that every day experience does not reveal. ("Dismal" only refers to the fact that good economics respects budget constraints.)

Similarly, the next US presidential election looks to be an argument over growth vs. redistribution. I doubt that many Americans are so willing to abandon hope so soon.  Even Hilary Clinton's latest speech took the view that reducing inequality would raise growth -- a novel argument (relative to 250 years since Adam Smith) that invites similar theoretical and quantitative evaluation, but at least one that does not give up on growth.

Noah's tired pot-shot has been going on a long time. In 1980 Ronald Reagan announced some pretty radical growth-oriented policies, at least by the standards of the time. (Not much new since Adam Smith, of course.) The standard liberal commentators made the standard objections: voodoo economics, numbers don't add up, it will take generations of unemployment to lower inflation, the debt will explode, and so forth. (Plus, the Soviet Union will be there forever, we might as well get along.)  Reagan offered optimism; won, malaise ended, we won the cold war, and there was an economic boom. One would think the tired argument would have less force by now, or that the pessimists would have found a better one.

Thursday, July 16, 2015

Learning and New Keynesian Models.

John Barrdear at the Bank of England just posted an interesting paper, Towards a New Keynesian theory of the price level. Like Garcia Schmidt and Woodford, it changes the information structure of the standard model to avoid the standard model's problems.
Modifying the standard New-Keynesian model to replace firms' full information and sticky prices with flexible prices and dispersed information, and imposing mild and plausible restrictions on the monetary authority's decision rule, produces the striking results that (i) there exists a unique and globally stable steady-state rate of inflation, despite the possibility of a lower bound on nominal interest rates; and (ii) in the vicinity of steady-state, the price level is determinate (and not just the rate of inflation), despite the central bank targeting inflation. ... The model admits a determinate, stable solution with no role for sunspot shocks when the monetary authority responds by less than one-for-one to changes in expected inflation, including under an interest rate peg....
I haven't read this one yet either. I'm posting for anyone following these issues. Like Garcia Schmidt and Woodford, I also hope that others will read the papers and help to figure out if they really work as advertised.

Wednesday, July 15, 2015

Miles Looks Back

David Miles, retiring from the Monetary Policy Committee of the Bank of England, gave a fascinating speech on the occasion.  (Pdf with graphs here.) David's voice is particularly interesting since he's a real-world central banker, not an ivory-tower academic who can afford to have radical views. Many central bankers seem to evolve to the view that yes, they can push all the levers and run things just right. Not David.

Looking back: lessons from the global financial crisis
..the simplest, and arguably most effective, policy [to avoid financial crises] may well have low long run costs. That policy is to gradually change the funding structure of banks so that they are much better able to deal with shocks by relying less on debt and more on equity...

Behavioral Public Choice

In a number of blog posts, (here ) I've complained about the lack of behavioral public choice theory, and highlighted some efforts in that direction.

Much behavioral economics documents that people do stupid things, and then jumps to the conclusion that parternalistic government can do things for us better. But wait, those government functionaries are also human, also behavioral, and placed in group and social settings that psychology as well as economics warns us are particularly prone to bad outcomes.

Marginal revolution highlights an interesting new paper that breaks in to this field, Behavioral public choice: The behavioral paradox of government policy by Ted Gayer and W. Kip Viscusi. A quote:
In this article we examine a wide range of behavioral failures, such as those linked to misperception of risks, unwarranted aversion to risk ambiguity, inordinate aversion to losses, and inconsistencies in the tradeoffs reflected in individual decisions. Although such shortcomings have been documented in the behavioral literature, they are also reflected in government policies, both because policymakers are also human and because public pressures incorporate these biases. The result is that government policies often institutionalize rather than overcome behavioral anomalies.
I haven't read it, but it seems interesting, and the field seems wide open. The defense of freedom never was that freedom is perfect, merely that government control is worse.

I am interested that behavioral economics seems so focused on mistakes of individual decision making, as nicely summarized in the quote. In fact the most obvious thing about humans is that we are social animals, not that we are poor individual decision-makers. I would think that behavioralists would be bringing social psychology more than individual decision making to economics. But maybe this just reveals how little I know about either.

Tuesday, July 14, 2015

Garcia Schmidt and Woodford on neo-Fisherian economcs

Mariana Garcia Schmidt and Mike Woodford are lighting up the internet with a presentation on neo-Fisherian economics -- the proposition that, when we are satiated in money as at the zero bound or with interest on reserves, raising interest rates raises inflation. Noah Smith, Marginal Revolution, Brad DeLong, and indirectly at Mark Thoma's econbrowser.

This is a particularly important voice, as it seemed to me that standard New-Keynesian models produce the new-Fisherian result. i = r + Epi is a steady state in all models. In old-Keynesian models, it was an unstable steady state, so an interest rate peg leads to explosive inflation or deflation. But in new-Keynesian models, an interest rate peg is the stable/indeterminate case. There are too many equilibria, but if you raise interest rates, inflation always ends up rising to meet the higher interest rate.

What I can glean from the slides is that Garcia Schmidt and Woodford agree: Yes, this is what happens in rational expectations or perfect foresight versions of the new-Keynesian model. But if you add learning mechanisms, it goes away.

My first reaction is relief -- if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn't screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

But that's only preliminary relief. Schmidt and Woodford promise a paper soon, which will undoubtedly be well crafted and challenging.

For more on the issue, here is a a previous blog post. Section 3.1 ff of "Monetary policy with interest on reserves" has a full new Keynesian model with the Fisherian result. And a wry prediction: the Fed will raise rates to head off inflation, that will cause the inflation, then the Fed will congratulate itself on having headed off the inflation.  I also suspect that models with restricted liquidity (no interest on reserves) do give a temporary decline in inflation, but without that liquidity we now will get full Fisherian results. But that's just a conjecture so far.  My last foray into learning in new-Keynesian models, which didn't end well.

Why post now? Garcia Schmidt and Woodford clearly will have a thoughtful and sophisticated paper, on what I think is a deep and important point. I hope to encourage others to read and help to digest the paper.

Monday, July 13, 2015

Greece again

I read this morning's news of a deal -- we'll see how long it lasts -- with interest. Here's a video exchange with Rick Santelli on the subject on CNBC (I can't seem to get the embed to work, so you have to click the link.)

My main thought: what about the banks? The minute Greece reopens its banks, it's a fair bet that every person in Greece will immediately head to the bank and get every cent out. The banks' assets are largely Greek loans, which many aren't paying -- why pay a mortgage to a bank that's already closed and will probably be out of business soon anyway -- and Greek government debt; mostly Treasury bills that only roll over because banks hold them. They can't sell either, so the banks will instantly be out of cash.

The deal reported in today's papers really barely mentions that problem. But that is the problem of the hour.

Friday, July 10, 2015

Uber for Health Care

The Booth School's Capital Ideas made this really nice (well, I think so) video out of my blog posts on Uber and health care. Together we condensed the Uber for healthcare posts into a better essay, here, with link to the video.

We need supply competition, not just people paying their own money, to get innovative and lower cost health care. People paid their own money for taxis, but hailing a cab to the airport on a rainy friday afternoon was still no picnic. It took supply competition, in the form of Uber, to give us better service and lower costs.

The mergers of health insurance companies under the protections and regulatory fixed costs of Obamacare are, obviously, a step in the wrong direction. Three big, politically connected, health insurers, 6 big, politically connected banks, and you see where our economy is going.

Thursday, July 9, 2015

What next?

Source: Deutsche Bank Research 

The lovely flow chart comes from Deutsche Bank Research

It emphasizes the central point I am taking from all this -- how Greek banks are hostages in this negotiation. With banks closed and capital controls, the Greek economy can't function.

Monday, July 6, 2015

Can Greece Leave?

Is Grexit even possible?

It strikes me that the best Greece can do with a Drachma is to create a two-currency system, sort of like Cuba or Venezuela, or at best Argentina; countries whose politics the Greek government seems to admire, and whose economies its may soon resemble.

Calomiris and sticky prices

Charles Calomiris has a very interesting Forbes oped on Greece, with a much deeper insight.
My proposal begins with government action to write down the value of all euro-denominated contracts enforced within Greece. This “redenomination” would make all existing contracts – wages, pensions, deposits, and loans – legally worth only, say, 70% of their current nominal value. This policy would kill several birds with one stone. It would significantly reduce pensions, relieving fiscal pressure and satisfying troika demands for fiscal sustainability. It would do so in a way that would also mitigate the purchasing power consequences for pensioners, because an across-the-board redenomination would lower prices throughout the economy, making the reduction in nominal pensions more bearable. By applying redenomination to deposits and loans, banks’ health would be revived – their loans would now be payable and therefore more valuable, and their net worth would consequently rise. The 30% wage reduction would further reduce fiscal problems and make Greek producers competitive, and operate as an “internal devaluation” to raise demand for Greek products and tourism. Most importantly, this internal devaluation – by solving the problems of fiscal deficits, non-competitiveness and bank insolvency – would inspire confidence in Athens’ ability to stay within the eurozone, which should bring deposits back into the banking system to fuel a rebirth of lending.
I think this is about half right, but a very good idea lies in here.

"an across-the-board redenomination would lower prices throughout the economy"? Not necessarily. Why would any store lower prices just because it gets to lower wages and rent? Prices are not a "contract."

Thus, the redenomination should probably come with a (say) one week price control. Every price must be lowered 30% over what it was the previous day, for a week,  Just long enough for each store to see that its competitors and suppliers has also really lowered prices.  Then stores can do what they want.

China crash?

Meanwhile, on the other side of the world, China is doing everything in the textbook to ignite a "bubble."

I dislike that usually undefined term, which carries a lot of normative baggage. But there are a set of steps that governments often take unwittingly and are later criticized for. China's doing them on purpose. And these steps quite often precede large market declines.

Short sales ban: Financial Times: "opened a probe into market manipulation"  ... "The investigation is likely to focus on short selling."  The usual witch hunt, with Chinese characteristics. Owen Lamont has a splendid paper on what often follows short-sales bans. The weekend before TARP and Lehman, the US instituted a short-sales ban on bank stocks, just in case there was someone out there who did not know banks were in trouble and they should sell now. Europe instituted a CDS selling ban in the first PIGS crisis...

Lending to encourage highly leveraged speculation: Wall Street Journal: "Under the planned move, China’s central bank will indirectly help investors borrow to buy shares in a market that had already seen a rapid buildup in debt from so-called margin financing." Procyclical credit supply is named by just about every account of a "bubble" followed by a crash.

Prices depend on supply and demand. As well as increasing demand, limit supply: "A halt to new stock listings."

And more. Quartz offers "A complete list of the Chinese government’s stock-market stimulus (that we know about)" including  "People’s Bank of China will “provide liquidity assistance” to China Securities Finance Corp., a company owned by the stock regulator. The company will use the money to lend to brokerages, which could then make loans to investors to buy stocks."

This scenario often ends badly.

The only thing I can think of that can actually stop a crash is for the central bank to directly print money to buy stocks. And not just a little bit. A pre-announced and limited quantity won't work. The US QE took billions to alter bond prices a few basis points at most. One has to commit to a price floor and a "do what it takes" amount of money, no matter how large or inflationary. I don't know of it ever being tried. It will be interesting to see if China goes that far. They could hide the fact with extensive bailouts of people "borrowing" to buy stocks, or otherwise cover losses or promise to cover losses.

Of course, the right strategy is to leave it alone. The whole point of stocks is that they go down on occasion, without runs, without defaults, and without financial distress. Unless the people and institutions holding them are highly leveraged. Didn't we just learn this lesson?

Saturday, July 4, 2015

Greece vs Puerto Rico and what's "systemic."

How is a Greek default different from a Puerto Rican default?

Answer: because Puerto Rico doesn't have its own banking system. It can't shut down banks. Banks in Puerto Rico are not loaded up on Puerto Rico debt, so depositors are not in danger if the state government defaults.

Puerto Rico, like Greece, uses a common currency. But there is no question of PRexit, that people wake up one morning and their dollar bank accounts are suddenly PR Peso bank accounts. So they have no reason to run and get cash out.

Banks in New York are also not loaded up on Puerto Rico debt. US bank regulators haven't said that those banks can pretend Puerto Rico debt is risk free.

If a Puerto Rican bank fails, any large US bank can quickly take it over and keep it running.

A Puerto Rican government default will be a mess. Just like the default of a large business in Puerto Rico. But it will not mean a bank run, crisis, and economic paralysis.

So here is a big lesson of the Greek debacle: In a currency union, sovereign debt must be able to default, without shutting down the banks, just as corporations default. Banks must not be loaded up on their country's sovereign debt. Bank regulation must treat sovereign default just like corporate default. It can happen, and banks must diversified and capitalized to survive it.  Banks must be free to operate across borders.  A common currency needs a firm commitment that it will not be abandoned.

In financial regulation, the big debate rages over what is "systemic,"  with the latest absurd idea to extend that designation to equity asset managers. (More later.) All that discussion starts with statements that  sovereign debt or anything backed by sovereign debt or sovereign guarantees is safe and per se not "systemic." Sovereign debt still counts as risk free in almost all banking regulation.

Greece should reinforce the lesson: Sovereign debt is a prime source of "systemic" danger. That is especially true of small governments in a currency union. A government is just a highly leveraged financial institution and insurance company.

Wrong answers:

- Fiscal union. The US is not necessarily going to bail out Puerto Rico. Or Illinois. Or their creditors. People keep saying a currency union needs fiscal union, but it is not so.

- National deposit insurance is really not central either. The banks operating in Puerto Rico are not in danger, so they don't need deposit insurance protection.

Update: A colleague pointed me to this excellent article on banks holding their own sovereign debt by Lucrezia Reichlin and Luis Garicano.