The BOJ/MoF Put

People used to talk about a "Greenspan Put."  The idea was that if the markets fell too much, Greenspan, then the chairman of the Federal Reserve, would step in and prevent investors from losing too much money.  The effect was almost as if they had bought an option - a put - to protect themselves from a large drop in the markets.

These days, it is looking like there is a BOJ/MoF put for people interested in selling the yen. Selling the currency with the lowest interest rates, which in recent history has been the yen, is a popular trade because if markets don't move then the seller will make money*. 

Recently, the yen has actually been strengthening, but Japan's finance minister just announced that they were buying dollars and selling yen when the yen was trading around 83.  The Bank of Japan released a statement supporting these actions.

The Bank of Japan strongly expects that the action taken by the Ministry of Finance in the foreign exchange market will contribute to a stable foreign exchange rate formation.

Traders interested in selling the yen and buying the dollar are able to take large positions when they believe they have a central bank backstopping their trade.  Of course, this backstop only matters when the traders selling yen have been losing money, so the best way to trade it may be from a tactical perspective of fading yen rallies rather than a long term "sell and hold" approach.  

*Short term interest rates in the US are low enough that this isn't as profitable to do versus the dollar unless a longer term currency forward is used. If a longer term forward contract is traded, the trade is impacted by both movements in interest rates and in currencies. This isn't as popular as trading purely currency or purely interest rates because most traders like to take specific risks and avoid exposure to variables that they are less familiar with.

Monetary Policy and the Bubble

Senior vice president and research director at the Atlanta Fed, David Altig, has a post up at Macroblog discussing the connection between monetary policy and housing bubbles.  He is responding to John Taylor's comments at Jacksonhole where Taylor blames loose monetary for the housing bubble, citing a recent VAR study that found the deviation from the Taylor rule to be a large explanatory variable. Altig responds with points that deviations from the Taylor rule in the US are correlated with looser lending standards, and that this effect was not seen in Europe and in the UK, where the latter had a large increase in debt and housing prices similar to what happened in the United States.

My view of this debate is as follows:

1. You can prove many preconceived notions by carefully selecting your data set, or citing people who do. This applies to both sides.
2. The United Kingdom should be analyzed more like a large offshore financial center, so its own monetary policy's deviation from a Taylor rule would obviously be less important than exogenous variables.
3. Loose monetary policy might be behind looser lending standards. The banks that aren't relaxing their lending standards their lending standards when monetary policy is loose are likely to lose business. This argument is similar to the typical Austrian Economist's response to the rational expectations arguments against the Austrian Business Cycle Theory. Businesses that don't want to participate in the boom because it is unsustainable have to participate in some form because it is the only game in town.
4. Monetary policy was too loose and helped speed along a crisis, but the properties of the finance industry make bubbles and their subsequent crashes inevitable.

The Nurture Bias

Via Reddit, I came across an article about a new study by Eric Turkheimer that suggests that nurture may be more important than nature, at least relative to numbers suggested by previous studies. The newer studies are careful to include identical twins where one grew up broken homes, which has a very negative impact. So extremely bad development can have an impact on intelligence.  This raises the estimations of the nurture impact, but only for 

In the same article RIchard Nisbett, a psychologist who wrote the very excellent The Geography of Thought, shows how people will skew the results.

The findings will undoubtedly please those parents who already send their children to good schools, drive them to violin lessons in the afternoon, and then drag them around museums at the weekend. "So you haven't wasted your time, money and patience on your children after all," Nisbett says.

A lot of parents really want to believe that nurture is really important, so they are very quick to jump to conclusions so "not raising kids in a poor, broken home is important but once you are richer nurture differences matter less" gets turned into the parenting fallacy of "this study supports nurture, and therefore you are right to do everything that common sense tells us is good for children."

Pessimists and the Output Gap

Arnold Kling has a good post up responding to John Taylor's view of the Taylor rule. Arnold Kling highlights a key issue: The main disagreement between hawks (people who want the central bank to focus on fighting inflation) and doves (people who want the bank to focus on stimulating the economy)  is actually about the true nature of the output gap. Mainstream economists are more likely to use traditional measures, which are unstable but generally indicate that the Fed  is either about right or needs to engage in unconventional practices. However, those outside the mainstream are more likely to be economic pessimists about the potential of the overall economy (such as the recalculation theorists or others sympathetic to the Austrian school's idea of malinvestment), view the output gap as much smaller than traditional measures, and worry more about inflation than trying to stimulate the economy in its current form.

If economic pessimists believe there is a small output gap, that should mean that economic pessimists should be more worried about inflation than deflation.  What does that make economic pessimists who believe that deflation is the main problem? They either aren't pessimistic on the economic system in general and believe that policy stimulus will help but it won't be forthcoming (like Krugman), or if they are pessimistic on the system as a whole their approach will probably be to reject the framework of the relationship between the output gap and inflation entirely since it doesn't fit into their view of the world. 

Convergence and Beta

One thing that many people in finance do not fully understand is economic convergence. The dominant assumption seems to be that absolute convergence holds - the less developed a country is the more it will grow. The first decade of the 2000's has done little to dissuade this view. Investors focusing on the BRICs have been very profitable. Brazil, Russia, India and China have relatively functional institutions compared to the rest of the emerging world, and their resources and human capital have justified a level of bullishness on them. Other countries such as the Next 11 or the CIVETS (There is some overlap) are seen as the next group of countries for emerging investors to focus on.

Absolute convergence of these countries is basically taken as a given by investors looking at these groups*. In reality, the political instability in many of the countries makes the convergence of all of these countries unlikely. Some of these countries are probably going to grow at a high rate, but without improved institutions many will stagnate and some will regress in the face of economic and political instability. 

Investors counting on convergence to work like magic are comfortable with the framework of convergence in part because they are comfortable with the notion of beta. High risk countries are supposed to make them  money the same way that high risk stocks do. However, these investors don't realize that beta doesn't always work in the long run as even though there is an equity premium low beta stocks outperform high beta stocks. The same is likely true for convergence, so the countries with the highest room to converge really might be like high beta stocks - lottery tickets that will under perform.

This analogy suggests that those looking to go long emerging markets should at the very least err on the side of going long more developed emerging countries where the political risk is less extreme.

*The people who made the groups did try to pick countries with positive fundamentals but there aren't that many countries so they are bound to make some bad choices.


1. Teacher efficiency is analyzed in LA by the LA Times.  It turns out that what teachers are paid for are not related to their teaching effectivity.  The next step towards sanity would be to create these links, and to find some ways to actually fire the poorly performing teachers.

2. A survey from Fidelity suggests that a lot of people are borrowing against their 401(k)'s.  This is another factor keeping consumer spending high relative to private sector income.

3.  Tyler Cowen looks at whether it was the fiscal policy of Australia that has helped their economy avoid a deep recession. He mentions Australia's connection with China's economic demand, which seems to be the dominant variable. However, he leaves out their high trend inflation, which helps them avoid problems other central banks reach when they hit the zero bound.

4. A caricature of futurists. Not entirely inaccurate.

Inflation uncertainty

Tyler Cowen linked to two posts highlighting how high monetary policy uncertainty is today due to the high levels of inflation variability. The striking thing about these posts is that at our low inflation rate, the standard deviation of inflation is just as high as it was during the 70’s.

Using the month on month changes of inflation (bottom of top chart) instead of year on year changes (top of top chart) we see inflation variability spiking in mid 2006 rather than early 2009. Furthermore, the comparison the blogs make to the 70’s glosses over that by very similar measures, inflation uncertainty was much higher in the 50’s.

Of course, this may just be due to the crazy adjustment from the post war economy, so the policy uncertainty of the 50’s was probably low despite high the variability of inflation.

The high level of inflation volatility and therefore policy uncertainty can help explain why there are deficit hawks and gold bugs with nominal ten year yields at 2.6%.  Ignoring the increasing deficit, the US treasury is going to have to roll over 2.5 trillion dollars worth of debt* in the next year alone, so maybe there is something to be uncertain about.

*To look this up for yourself, go here. Download the excel file and look at marketable debt. There are over 1.7 trillion dollars worth of Treasury bills and .74 trillion worth of Treasury Notes payable in the next year. The amount of inflation adjusted notes coming due is under 40 billion and there are no long term treasury bonds coming due.

Links & Critiques

1. Michael Pettis has a post on why he thinks it unlikely that China will be able to rebalance their consumption. The main flaw is his analogy to Japan's economy. One of the main reasons Japan had trouble rebalancing was that Japan had almost fully converged with other developed economies except there were a lot of micro-inefficiencies in Japanese consumption markets. When houses are built one at a time and the retail market is still dominated by mom and pop stores the cost of consumption is rather high, reducing a household's willingness to consumer versus save on the margin. Growth stopped in Japan more because the convergence process was done and Japan couldn't overtake the rest of the world any more in places it was ahead.  To argue that the readjustment in China is going to have the same effect as it did in Japan, it would have to be assumed that China's economy has reached its steady state and will no longer catch up with the world.

2. Arnold Kling looks at momentum in employment. This is another reason why markets care more about the headline number.

3. Some school districts don't understand bulk discounts. No wonder they are running out of money.

More wasted money

The House recently passed a party line vote to spend more money on education and Medicaid. The $10 billion dollars to the states comes with many strings attached, notably that they do not get the money if they decided to cut spending on education as a share of total revenues. I’ve touched on the irrelevance of medical spending past a certain level before, so let’s look at the effectiveness of education spending.

Source: “Does Spending More on Education Improve Academic Achievement?” by Dan Lips, Shanea Watkins and John Fleming

Of course, the chart is somewhat misleading.  Education scores are range bound while spending is not, but it is notable that they often seem to be going in opposite directions*. 

Using additional cross country data from NationMaster, we see that government spending on education beyond a certain point doesn’t seem help very much anywhere in the world:


Total education spending as a percent of GDP isn’t any more correlated with scientific literacy, but at least the correlation isn’t negative.


So the government may be wasting money here, which just gives us more evidence that  α is very high.

*At younger ages there is some evidence of improved math scores, but these improvements are negligible by age 17. Click through the article for more charts.

And the links came to enlighten us all

1. Tyler Cowen tells a good story at his 2009 TEDx Midatlantic talk. (HT: Patri)  His point that thinking in terms of a narrative often makes things too simple, and many existing narratives are misleading.  

On non-fiction: "Nonfiction is in a sense the new fiction. The book may happen to say true things, but again everything is taking the same form as these stories" 

On a useful heuristic: "As a good rule of thumb just imagine that every time you are tell yourself a good versus evil story, you are basically lowering your IQ by 10 points or more."

On books about cognitive biases: "None of these books identify what to me is the single central most important way we screw up. And that is, we tell ourselves too many stories or we are too easily seduced by stories. And why don't these books tell us that? It is because the books themselves are all about stories."

Listen to the whole thing, as they say.

2. Bryan Caplan discusses the rising return to hours put into college education.  This research is a big part of why I don't believe the premise from other science research that things are changing mainly because it is harder to reach the frontier of science. Science is changing because on the margin education is no longer about education and research is no longer about research.

3. Scott Sumner has already reacted to the Fed meeting later today.  If the market doesn't go up, he doesn't like it.  Of course, I'm left to wonder whether he would be that upset if the market stays relatively neutral, since it appears that some form of quantitative easing or reinvestment in mortgage bonds, or cut in the interest paid on excess reserves has already been priced into the market.

4. Greg Mankiw points out some unfortunate estimates on the future performance of Medicare. The health care sector is one of the least efficient parts of society, yet it doesn't seem like the United States is on any path close to slowing down the amount of resources wasted there.