Banking at the IRS

A while ago in two blog posts here and here I suggested many ways other than currency to get a zero interest rate if the government tries to lower rates below zero. Buy gift cards, subway cards, stamps;  prepay bills, rent, mortgage and especially taxes -- the IRS will happily take your money now and you can credit it against future tax payments; have your bank make out a big certified check in your name, and sit on it, don't cash incoming checks. Start a company that takes money and invests in all these things (as well as currency).

Chris and Miles Kimball have an interesting essay exploring these ideas "However low interest rates might go, the IRS will never act like a bank." Their central point: sure that's how things work now. But with substantial negative interest rates, all of these contracts can change. It's technically possible in each case for people and businesses to charge pre-payment penalties amounting to a negative nominal rate.

Reply: Sure, in principle. Nominal claims can all be dated, and positive or negative interest charged between all dates.

But this did not happen in the US and does not happen in other countries for positive inflation and high nominal rates,  despite symmetric incentives, and at rates much higher than the contemplated 3-5% or so negative rates.  Yes,  with large nominal rates there is pressure to pay faster,  inventory cash-management to reduce people's holdings of depreciating nominal claims, but this pervasive indexation of nominal payments did not break out. The IRS did not offer interest for early payment.

More deeply, what they're describing is a tiny step away from perfect price indexing. If all nominal payments are perfectly indexed to the nominal interest rate, accrued daily, then it's a tiny change to index all prices themselves to the CPI, accrued daily. If "how much you owe me," say to rent a house, is legally, contractually, and mechanically determined as a value times e^rt, and changes day by day, then e^(pi t) is just as easy.

So, price stickiness itself would (should!) disappear under this scenario.

Price stickiness has always been a bit of a puzzle for economists. As the Kimballs speculate how easy it is to index payments to negative interest rates, so economists speculate how easy it is to index payments to inflation. Yet it seems not to happen.

So this point of view strikes me as a bit of a catch-22 for its advocates, who generally are of the frame of mind that prices and nominal contracts are sticky and that’s why negative nominal rates are a good idea to "stimulate demand" in the first place.  If we can have negative nominal rates and change all these legal and contractual zero-rate promises to allow it, then prices won't be sticky any more!   Conversely, I should be cheering, as it amounts to a broad push to unstick prices. That has long seemed to me the natural policy response to the view that sticky prices are the root of all our troubles. It would allow negative rates, but eliminate their need as well.

Alas, the world seems remarkably resistant to time-indexing all payments.

Blanchard on Countours of Policy

Olivier Blanchard, (IMF research director) has a thoughtful blog post, Contours of Macroeconomic Policy in the Future. In part it's background for the IMF's upcoming conference with the charming title Rethinking Macro Policy III: Progress or Confusion?” (You can guess my choice.)

Olivier cleanly poses some questions which in his view are likely to be the focus of policy-world debate for the next few years.  Looking for policy-oriented thesis topics? It's a one-stop shop.

Whether these should be the questions is another matter. (Mostly no, in my view.)

As a blogger, I can't resist a few pithy answers. But please note, I'm mostly having fun, and the questions and essay are much more serious.

Arezki, Ramey, and Sheng on news shocks

I attended the NBER EFG (economic fluctuations and growth) meeting a few weeks ago, and saw a very nice paper by Rabah Arezki, Valerie Ramey, and Liugang Sheng, "News Shocks in Open Economies: Evidence from Giant Oil Discoveries" (There were a lot of nice papers, but this one is more bloggable.)

They look at what happens to economies that discover they have a lot of oil.

An oil discovery is a well identified "news shock."

Standard productivity shocks are a bit nebulous, and alter two things at once: they give greater productivity and hence incentive to work today and also news about more income in the future.

An oil discovery is well publicized. It incentivizes a small investment in oil drilling, but mostly is pure news of an income flow in the future. It does not affect overall labor productivity or other changes to preferences or technology.

Rabah,Valerie, and Liugang then construct a straightforward macro model of such an event.

Bachmann, Berg and Sims on inflation as stimulus

Rüdiger Bachmann, Tim Berg, and Eric Sims have an interesting article, "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence" in the American Economic Journal: Economic Policy.

Many macroeconomists have advocated deliberate, expected inflation to "stimulate" the economy while interest rates are stuck at the lower bound. The idea is that higher expected inflation amounts to a lower real interest rate. This lower rate encourages people to spend today rather than to save, which, the story goes, will raise today's level of output and employment.

As usual in macroeconomics, measuring this effect is hard. There are few zero-bound observations, fewer still with substantial variation in expected inflation.  And as always in macro it's hard to tell causation from correlation, supply from demand, because from despite of any small inflation-output correlation we see.

This paper is an interesting part of the movement that uses microeconomic observations to illuminate such macroeconomic questions, and also a very interesting use of survey data. Bachman, Berg, and Sims look at survey data from the University of Michigan. This survey asks about spending plans and inflation expectations. Thus, looking across people at a given moment in time, Bachman, Berg, and Sims ask whether people who think there is going to be a lot more inflation are also people who are planning to spend a lot more. (Whether more "spending" causes more GDP is separate question.)

The answer is... No. Not at all. There is just no correlation between people's expectations of inflation and their plans to spend money.

In a sense that's not too surprising. The intertemporal substitution relation -- expected consumption growth = elasticity times expected real interest rate -- has been very unreliable in macro and micro data for decades. That hasn't stopped it from being the center of much macroeconomics and the article of faith in policy prescriptions for stimulus. But fresh reminders of its instability are welcome.

At first blush, this just seems great. Finally, micro data are illuminating macro questions.

Unemployment insurance and unemployment

"The Impact of Unemployment Benefit Extensions on Employment: The 2014 Employment Miracle" by Marcus Hagedorn, Iourii Manovskii and Kurt Mitman is making waves. NBER working paper here. Kurt Mitman's webpage has an ungated version of the paper, and a summary of some of the controversy. It's part of a pair, with "Unemployment Benefits and Unemployment in the Great
Recession: The Role of Macro Effects" also including Fatih Karahan.

A critical review by Mike Konczal at the Roosevelt Institute blog, and a more positive review by Patrick Brennan at National Review Online are both interesting. Both are thoughtful reviews that get at facts and methods. Maybe the tone of the economics blogoshpere is improving too. Bob Hall's comments and response on the earlier paper are also worth reading. This is a bit deja-vu from the observation that North Carolina experienced a large drop in unemployment when it cut benefits. My post here, WSJ coverage, and I think there are some papers which google isn't finding fast enough at the moment.

The basic issue: I think it's widely accepted, if sometimes grudgingly, that unemployment insurance increases unemployment. If you pay for anything, you get more of it. People with unemployment insurance can hold out for better jobs, put off moving or other painful adjustments, and so on. The earlier paper points out that there are important general equilibrium effects as well. We should talk about how UI affects labor markets, not just job search.

Quick disclaimer. Let's not jump to "good" and "bad."  Searching too hard and taking awful jobs in the middle of a depression might not be optimal. Pareto-optimal risk sharing with moral hazard looks a lot like unemployment insurance.  Perhaps that disclaimer can settle down the tone of the debate.

But the question remains. How much?  How much does unemployment insurance increase unemployment? And the related macro question, just why did unemployment in the US suddenly drop coincident with sequester and the end of 99 week unemployment benefits?

Loggerheads

Government Debt Management at the Zero Lower Bound is a very nice and interesting paper by Robin Greenwood, Sam Hanson, Josh Rudolph, and Larry Summers.

Figure 1. Comparing Quantitative Easing and Treasury Maturity Extension, 2007–2014 ...the cumulative change in 10-year equivalents (scaled as a percentage of GDP) associated with the respective balance sheet policies undertaken by the Federal Reserve and the Treasury. Positive values increase the interest rate risk placed in public hands (Treasury policies), while negative values decrease it (typically Fed QE, but also Treasury maturity shortening in 2008–2009).

First point, what the Fed taketh away, the Treasury giveth. (Hence the title of this post). The Fed bought lots of long-term debt, with the idea that this would raise the price, lower the interest rate on the long-term debt, and thus stimulate the economy.

At the same time, however, the Treasury was selling lots of long-term debt. Interest rates are very low, and debts are high, so it's a great time to lock in low-rate financing. Homeowners and businesses are doing the same thing.

Level, Slope and Curve for Stocks

"The Level, Slope and Curve Factor Model for Stocks" is an interesting and important empirical finance paper by Charles Clarke at the  University of Connecticut.

Charles uses the Fama-French (2008) variables to forecast stock returns, i. e.,  size, book to market, momentum, net issues, accruals, investment, and profitability. \[ Ret_{i,t+1} = \beta_0 + \beta_1 Size_{i,t} + \beta_2 BtM_{i,t} + \beta_3 Mom_{i,t} + \beta_4 zeroNS_{i,t} + \beta_5 NS_{i,t} + \beta_6 negACC_{i,t} + \] \[ + \beta_7 posACC_{i,t} + \beta_8 dAtA_{i,t} + \beta_9 posROE_{i,t} + \beta_{10} negROE_{i,t} + e_{i,t+1} \] He forms 25 portfolios based on the predicted average return from this regression, from high to low expected returns.  Then, he finds the principal components of these 25 portfolio returns.

Source: Charles Clarke

And the result is... hold your breath... Level, Slope and Curvature! The picture on the left plots the weights and loadings of the first three factors. The x axis are the 25 portfolios, ranked from the one with low average returns to 25 with high average return. The graph represents the weights -- how you combine each portfolio to form each factor in turn -- and also the loadings -- how much each portfolio return moves when the corresponding factor moves by one.

No surprise, the 3 factors explain almost all the variance of the 25 portfolios returns, and the three factors provide a factor pricing model with very low alphas; the APT works.

Now, why am I so excited about this paper?

The Neo-Fisherian Question

On the "Neo-Fisherian" idea that maybe raising interest rates raises inflation, Nick Rowe asks an important question. What about the impression, most recently in a host of countries that seemed to raise rates "too early" and then backed off, that raising interest rates lowers inflation? (And thanks to commenter Edward for the pointer.)

Partly in answer, and partly just in mulling it over, I think I can boil down the issue to this question:

If the central bank pegs the nominal rate at a fixed value, is the economy eventually stable, converging to the interest rate peg minus the real rate? Or is it unstable, careening off to hyperinflation or deflationary spiral?

Here are some possibilities to consider. At left is what we might call the pure neo-Fisherian view. Raise interest rates, and inflation will come.

I guess there is a super-pure view which would say that expected inflation rises right away. But that's not necessary. The plot in Monetary Policy with Interest on Reserves worked out a simple sticky price model. In that model, dynamics were pretty much as I have graphed to the left: real rates rise for the period of price stickiness, then inflation sets in.

Now,  here is a possibility that I think might satisfy  Neo-Fisherism, Nick, and a lot of people's intuition:

In response to the interest rate rise, indeed in the short run inflation declines. But if the central bank were to persist, and just leave the target alone, the economy really is stable, and eventually inflation would give up and return to the Fisher relation fold. (I was trying to get the model of "Interest on Reserves" to produce this result, but couldn't do it. Maybe fancier price stickiness, habits, adjustment costs...?)

This view would account for the Swedish and other experience.

We don't see the Fisher prediction because central banks never leave interest rates resolutely pegged. Instead, they pursue short-run pushing inflation around.

FDA and the costs of regulation

The Wall Street Journal has had two recent articles on the FDA, "Why your phone isn't as smart as it could be" by Scott Gottlieb and Coleen Klasmeier on how FDA regulation is stopping health apps on your iphone, and Alex Tabarrok's review of "Innovation breakdown," the sad story of MelaFind, a device that takes pictures of your skin and a computer then flags potential cancers. The FAA's ban on commercial use of drones is another good current example.

One of our constant debates is how much regulation or the threat of regulation is slowing economic growth.  Over the weekend, for example, Paul Krugman, finding the New York Times itself too soft on libertarians,

QE and interest rates

Source: Wall Street Journal

In an August 3 article, the Wall Street Journal made the graph at left.

The US and UK have done a lot of "Quantitative easing," buying up long-term government bonds and mortgage-backed securities, to the end of driving down long-term interest rates. Europe, not so much, and the WSJ article quotes lots of people imploring the ECB to get on the bandwagon.

It's a curious experiment, as standard theory makes a pretty clear prediction about its effects: zero.  OK, then we dream up "frictions," and "segmentation," and "price pressure" or other stories. Empirical work seems to show that the announcement of QE lowers rates a bit.  But those theories only give transitory effects, and there is no correlation between actual purchases and interest rates. (p.2 here for example.)

So back to the graph.

Hedge Funds

I recently stumbled across the FT Alphaville collection on hedge fund performance.

The latest, "The hare gets rich while you don't: back the passive tortoise" reviews a Nomura report covering the performance of "alternative investments," private equity and hedge funds. (The report is here, alas behind the FT's very confusing paywall.) A while ago I put together a class and talk covering hedge fund literature, but haven't updated it in a few years so reviews with updates are particularly interesting.

The fact that hedge funds and private equity have a lot of beta -- often hidden by infrequent or inaccurate marking to market -- remains true:

Revolving Door

Source: Lucca, Seru and Trebbi

David Lucca, Amit Seru and Francesco Trebbi have an interesting working paper, "The Revolving Door and Worker Flows in Banking Regulation." (NBER working paper here, ungated ssrn link here.

They construct

"a unique dataset of career paths of more than 35,000 former and current regulators across all regulators of commercial banks and thrifts -- the Federal Reserve Banks (Fed), the Federal Depository Insurance Corporation (FDIC), the Office of Comptroller and Currency (OCC), the Office of Thrift Supervision (OTS), and state banking regulators -- that have posted their curricula vitae (CVs) on a major professional networking website." 

I found Figure 4, above, pretty interesting. 10% of people in this sample move from regulator to industry or back again each year. And this flow has doubled since the financial crisis and regulatory expansion.

AQR on momentum

Cliff Asness, Andrea Frazzini, Ronen Israel and Toby J. Moskowitz have a lovely SSRN paper "`Fact, Fiction and Momentum Investing."

The whole momentum literature is so huge, it's hard to know where to sum up, and this is a great place, especially if you're teaching an MBA class. Since they're obviously a bit conflicted (momentum + value is one of AQR's core strategies), their emphasis on the simple facts, which you (or your students) can replicate from Ken French's databse, is great.

Some "Myths,"

Myth #1: Momentum returns are too “small and sporadic”. Like any factor, it's not an aribtrage opportunity.

The return premium is evident in 212 years (yes, this is not a typo, two hundred and twelve years of data from 1801 to 2012) of U.S. equity data

So, to sum up, who you calling small and sporadic?

A writing style more bold than my own.

Stuff cheap, people expensive

Source: New York Times

This nice graph appeared in the New York Times (link). Of course they had to ruin it with a rant about inequality.

The deeper point is that things are getting cheaper and cheaper, and people -- services provided with their expertise -- are getting more and more expensive.

On the back of my mind: What does the economy look like when goods are essentially free, and all value consists of paying other people for their expertise?

I explored this a little in covering Larry Summers' Martin Feldstein speech.  But it remains, I think, an important question for deep microeconomic research.

In just about any transaction you name, from electronics to fashion to health care, most of the value comes from the expertise of the seller, not the physical good.

The characteristics of the production, value, and sale of expertise are completely different from those of the standard widget.  Just the measurement of GDP and inflation in such a world raise lots of open questions.

The cost of regulation

Gordon Crovitz has a nice piece in the Wall Street Journal, Monday May 5, titled "The end of the permissionless web" which sparks several thoughts.

What has made the Internet revolutionary is that it's permissionless. No one had to get approval from Washington or city hall to offer Google searches, Facebook  profiles or Apple  apps, as Adam Thierer of George Mason University notes in his new book, "Permissionless Innovation." [Available free and ungated here. - JC]  

The central fault line in technology policy debates today can be thought of as 'the permission question,' " Mr. Thierer writes. "Must the creators of new technologies seek the blessing of public officials before they develop and deploy their innovations?" 

Toward a run-free financial system

A new essay, expanding greatly on a previous WSJ oped and illustrated by a great comic. Here's the introduction, follow the link for the whole thing.

Toward a run-free financial system
John H. Cochrane
April 16 2014

Abstract

The financial crisis was a systemic run. Hence, the central regulatory response should be to eliminate run-prone securities from the financial system. By contrast, current regulation guarantees run-prone bank liabilities and instead tries to regulate bank assets and their values. I survey how a much simpler, rule-based, liability regulation could eliminate runs and crises, while allowing inevitable booms and busts. I show how modern communications, computation, and financial technology overcomes traditional arguments against narrow banking. I survey just how hopeless our current regulatory structure has become.

I suggest that Pigouvian taxes provide a better structure to control debt issue than capital ratios; that banks should be 100% funded by equity, allowing downstream easy-to-fail intermediaries to tranche that equity to debt if needed. Fixed-value debt should be provided by or 100% backed by Treasury or Fed securities.  

A mean-variance benchmark

"A mean-variance benchmark for intertemporal portfolio theory." Journal of Finance 69:1-49 (Feburary 2014) DOI: 10.1111/jofi.12099 (ungated version here.)

After all these years, it is still a thrill when an article gets published, and this being a bit of a personal day on the blog (see last post), I can't resist sharing it.

Two stories.

This paper started when John Campbell presented "Who should buy long-term bonds?" (with Luis Viceira, American Economic Review) in the late 1990s at the Booth (then, GSB) finance workshop.  John pointed out that long term bonds are the riskless asset for long-term investors, so we should build portfolio theory around indexed perpetuities, not one-month T bills.

I thought, "that's so obvious!" and, simultaneously, kicking myself, "why didn't I think of that?," a sign of a great paper. (I was also inspired by Jessica Wachter's "Risk Aversion and the Allocation to Long Term Bonds" which came out in the Journal of Economic Theory 2003.)

Predictability and correlation

Today another little note that I discovered while teaching. Warning: this will only be of any interest at all to time-series finance academics. I'll try to come back with something practical soon!

Does the predictability of stock returns from variables such as the dividend yield imply that stocks are safer in the long run? The answer would seem to be yes -- price drops mean expected return rises, bringing prices back and making stocks safer in the long run. In fact, the answer is no: it is possible to see strong predctability of returns from dividend yields, yet stocks are completely uncorrelated on their own.

I've been through three versions of showing how this paradox works. In  Asset Pricing the best I could come up with was a complex factorization of the spectral density matrix in order to derive the univariate process for returns implied by the VAR. In later Ph.D. classes, I found a way to do it more simply, by seeing that returns have to follow an ARMA(1,1), and then matching coefficients. This year, I found a way to show it even more simply and intuitively. Here goes.

Prices and Returns

Warning: this will only be interesting to academic finance people.

One of the fun things about teaching is that it forces me to look back at old ideas and refine them. Last week, I needed a problem set for my MBA class. It occurred to me, why not have them do for returns what Shiller did for dividends?

Here it is

MOOC

I will be running a MOOC (massively online) class this fall. Follow the link for information. The class will roughly parallel my PhD asset pricing class. We'll run through most of the "Asset Pricing" textbook. The videos are all shot, now I'm putting together quizzes... which accounts for some of my recent blog silence.

So, if you're interested in the theory of academic asset pricing, or you've wanted to work through the book, here's your chance. It's designed for PhD students, aspiring PhD students, advanced MBAs, financial engineers, people who are working in industry who might like to study PhD level finance but don't have the time, and so on. It's not easy, we start with a stochastic calculus review!  But I'm emphasizing the intuition, what the models mean, why we use them, and so on, over the mathematics.