Impact of Greek Troubles

Greece has been in the news again recently. The 5 year credit default swaps have jumped from 344 basis points last Friday to 444 basis points today, surpassing Iceland as the most worrisome sovereign debt in Western Europe. One hundred basis points in one week is a relatively large move, so it is expected that the impact of a worsening situation in Greece should impact both currency and equity markets. 

The more trouble Greece is in, the more people worry about the future of the Euro. However, it doesn’t take a probability of a currency crisis to drive the currency lower; it only takes an expectation of a relatively weak monetary policy in Europe to support Greece.

The worry that the Greek crisis will spill over into the financial system, along with its effect on the currency, has made the S&P outperform the Euro Stoxx 50 in dollar terms whenever Greece’s CDS spikes.

The rolling two month differences correlations have been relatively steady at 0.2 and 0.3 for the past 4 months (0.4 and 0.5 when looking at financial stocks). There are obviously other factors affecting currency and relative equity market performance, but the change in Greek CDS has been having a definitive impact. Those who don’t like trading the Greek CDS directly might consider a currency hedged long short equity approach.

Consumer Credit Relative to GDP

The aggregate amount of consumer credit in the economy dropped by 11.5 billion dollars in February, the economists surveyed expected only a 0.7 billion dollar drop.  For those people thinking that the credit correction is completely over, the chart below puts the amount of consumer credit relative to GDP in historical context.  There is still further room for a decline in consumer credit.

Two Papers on the Capital Gains Tax and the Stock Market

I came across two interesting papers on capital gains taxes and their effect on the stock market.

The first paper, “Capitalization of capital gains taxes: evidence from stock price reactions to the 1997 rate reduction” was published in 1999 and was written by Mark H. Lang and Douglas A. Shackelford. 

This paper uses data from 1997 to try to get to the bottom of a few different views on capital gains taxes. The three theories are as follows:

  1. When capital gains taxes are reduced, shares are more valuable to individuals and so share prices rise.  Theoretically, this effect should be larger when share repurchases or liquidation of assets are expected. It should also be larger if stock holders are likely to be individuals who are subject to capital gains taxes.
  2. Capital gains taxes only tax assets that are sold, so they create a lock in effect on current owners. A reduction of the capital gains tax diminishes this lock in effect by reducing the tax on sellers, so a reduction of the tax should drive the value of stocks down.
  3. If stocks are valued as the sum of their future dividends, or if the marginal investors are unaffected by capital gains tax rates, then changes in the capital gains tax rate shouldn’t have any effect at all.

The study found that during the week of the announced 1997 capital gains but not dividends tax cut, non-dividend paying stocks outperformed dividend paying stocks. This result is consistent with the first theory, where lower capital gains taxes increase the value of assets and vice versa.  The paper also failed to find evidence of a lock-in effect, as stocks with prior gains didn’t decline after the new capital gains tax rate went into effect.

The second paper was published in 2001 by James M. Poterba and Scott J. Weisbenner wrote “Capital Gains Tax Rules, Tax-loss Trading, and Turn-of-the-year Returns” 

This paper combines an analysis of end of the year trading anomalies with tax-loss trading. One theory is that losing trades will be sold at the end of the year in order to counter the tax implications of realized gains in other parts of the portfolio. Unfortunately, this same behavior can also be explained by “window dressing”, in which firms sell losers so their investors don’t see bad stock picks in their year end statements.  The paper attempts to distinguish the two by looking at how end of the year effects react to changes in tax laws.  A capital gains tax change would only affect individual investors while it wouldn’t affect window dressing at all, as window dressing may be done by managers for untaxed institutions as well managers for individual investors.  

The study looked at three different regimes.

Regime 1: Six month short term holding period, long term losses 100 deducible against adjusted gross income

Regime 2: Six month short term holding period, long term losses 50 deductible against adjusted gross income

Regime 3: 12 month holding period.

Stocks with losses at the start of the year exhibited less year end anomalies when 6 months was the demarcation before short term and long term holding. The paper doesn't disprove window dressing, but it does show that tax laws impact year end trading.

Forecasting Wisdom from Scott Adams

Scott Adams, the creator of Dilbert, draws on his past experience with budget projections to give us valuable insight into what they guys at the CBO are really doing. His two rules of budget forecasting are:

1. You must assume that trends will continue
2. Trends never continue

While this isn't as true for demographic trends that involve the aging of a large portion of the population, point number two is generally correct. He also has some valuable insight about certain components of government spending.

The budget estimates for defense spending are obviously complete nonsense too. I can't imagine that the guy who handles that part of the forecast for the CBO includes, for example, an assumption that we'll invade at least two smaller countries per decade. I think there would be a lot of pressure on that guy to remove those assumptions, no matter how right he is.

In order to be nonpartisan the CBO has to follow some pretty explicit rules, so they can only forecast what bills say and not what it likely to happen. When it comes to partisan forecasting the bias is much more obvious, as even just forecasting a higher cost for a project can get a person kicked off the team, as Lawrence Lindsey realized in 2002.

The Consumer's Least Elastic Expenditures

Data from the Federal Reserve shows that debt service ratios have declined into the end of 2009. 

Debt service ratio looks at debt payments to disposable personal income while the financial obligation ratio includes other obligatory payments such as property tax, automobile leases, rental payments and homeowner’s insurance. These ratios peaked in the first quarter of 2008 and have each dropped about 1.3%.

Looking specifically at homeowners, the drop from 2008 is seen to have been driven equally by both consumer and household related payments.  However, it can be argued that mortgage debt has more to fall before it reaches historical averages.

Interestingly enough, the financial obligation ratio of renters is lower than its historical averages. This is probably due to selection bias, as many people with a predisposition for borrowing money figured out that becoming homeowners was the easiest way to access more debt. The higher average financial obligation ratio of renters can be explained by renters earning less because they are younger than homeowners and because a sizable fraction of homeowners don’t have any mortgage to pay while all renters have to pay rent.

Revisiting the median income chart, comparing it to per capita GDP

As I mentioned in my introductory post, the basic pessimistic chart of complete white male median income stagnation is very misleading.  However, the picture is bad enough that it does bear an explanation.

This analysis will focus on white male personal income in order to avoid complications from the change in household size and the impact of the changing gender and racial components of the workforce. Real median income growth from 1973 was negative, while real mean income growth occurred at only a rate of 0.6% a year. This means that mean income growth doesn’t come close to explaining the increasing gap to between per capita GDP growth and real median income growth. Unless GDP per capita growth has been completely disconnected from the well being of the average person in the economy, there should be some way to reconcile the two.

Some people think that the explanation is that the rich have rigged the economy in their favor so all of the improvements have gone to them. If this explanation was true, we would expect to see mean income diverge much from median income than it actually does.  If the rich getting richer is the reason for flat wages and it is not fully captured by looking at mean income instead of median income, then corporate profits are the next logical place to look. The below chart shows that there has been no drastic change in corporate profits/GDP since 1973.

While looking at GDP per capita we should acknowledge that there is a problem when comparing real GDP and real personal income from the census; these time series are deflated by different indices. The GDP deflator has not risen nearly as much as the CPI index, as the CPI Index counts the oil increase while the GDP deflator only looks at domestic goods.

Deflating the mean male income by the GDP deflator instead of CPI gets us a little bit closer to the increase in GDP per capita, but there is still a 55% difference that has yet to be explained.

A large part of the gap is explained by the changing nature of pay over time. In 1973, total compensation consisted of 73% of personal income and this dropped to 65% in 2008.  Wages and salaries consisted of 87.4% of total compensation, dropping to 81.4% in 2008.

If the wages had remained constant as a percentage of personal income, the median income would be 22% higher today. This approach yields a lower value to benefits that I found when looking at the employment cost index (Which by some measures has increased by almost 250% since 1981, explaining all the difference between median income and per capita GDP growth).  When the changing nature of pay is combined with the other factors, this helps close the gap between per capita GDP growth and the change in while male income since 1973.

Much of the rest of the difference can be explained by the changing workforce participation numbers.

When adjusting for this additional factor, the difference between median income and per capita GDP is almost fully explained.

At times, the adjusted factor is higher than the per capita GDP, but since white males earn on average more than females and other ethnic groups this is to be expected. The below table explains why median income differs from per capita GDP, but it also explains why real income has been flat in the census data since 1973.

From this table, we see that when looking at why median income and per capita GDP diverge, the changing nature of pay from total income to benefits is the most important variable, followed by changes in the distribution of income, differences in inflation calculation and the changing nature of the workforce. If the changing nature of pay is broken up into wages vs. total compensation and other forms of income, then benefits would account for 11% of the change with transfer payments and asset income explaining the rest.  Understanding why the real median income has been stagnant is interesting, but the situation is much more complicated than the simple graph would lead naïve readers to believe.

Underestimating Exponential Growth

"The greatest shortcoming of the human race is our inability to understand the exponential function." 
-Albert A. Bartlett

Exponential growth is often widely underestimated. Here are a few issues where many people make mistakes because they don’t understand the simple math of exponential growth.

  1. Economic Growth: When there are trade offs between efficiency and equality, many people today think that the taxes, regulation and redistribution are worth a slightly lower growth rate.  However, when this trade off is applied over a long time period, the results can be staggering. If the choice was made in 1870 to have more equality at a cost of 1 percentage point of growth a year, America in 1990 would be no richer than Mexico.
  2. Entitlement Spending and National Debt: As I have pointed out previously, the United States is headed for very high debt levels if entitlement spending is not reformed.  One very simple way to fix this is to index entitlement benefits to inflation and not income. The growth of the economy would make it easy to pay for a safety net at today’s living standards. Unfortunately, this would only work for Social Security and not Medicare as the medical system is structured in a way that leads to health care inflation greater than that of the real economy.  Additionally, there is another problem when the net national debt reaches 100% of GDP. If the market perception of the debt turns negative and nominal interest rates remain higher than nominal GDP growth, then there is no way for the economy to grow itself out of debt.  This is the current situation with Greece, and Japan isn’t doing too much better.
  3. Personal Finance and Pension Plans: If a prudent investor can make 10% real returns in a year, then they can turn 50 thousand dollars into over 1.6 million dollars after 35 years. This simple math explains how many of the rich people today consist of those who have saved and invested prudently. On the other hand, a supposedly fully funded pension fund planning on a world of 8% real returns that finds itself in a world of 4% real returns will find itself underfunded by over 75% 35 years later (In this case, the people making pension return assumptions are underestimating how much they matter, they just know that their books look better if they assume a higher return). Robin Hanson has been proposing that people don't give to the future because they don't care about it, but it may also be that they do not fully understand the impact of exponential growth*.
  4. Overpopulation and increasing Resource Consumption: Overpopulation does not seem to be the exponential problem that we once thought it was. Once become rich enough, their population growth rate slows down. The UK’s Ministry of Defense 2008 Strategic Trends report expects the population to level out at around 9 billion people between 2050 and 2100 (page 25).  While overpopulation is itself not a problem, the exponential economic growth of these emerging economies are coincident with an exponential increase in demand for resources and these limited resources present constraints on growth.

Having established that exponential growth rates are important, here is a handy rule of thumb that will give an intuitive understanding of exponential growth. To calculate the doubling time of an exponentially growing series, take 70 (or 69.3 to be exact) and divide it by the growth rate. This means that a 10% growth rate leads to a doubling every 7 years, a 7% growth rate is a doubling every 10 years and a 3.5% growth rate is a doubling every 20 years.

*It is also possible that someone who both cares about the future and understands exponential growth might think that there were existential problems for the current society that are significant enough to reduce the probability of a far future donation from ever paying off.

Also relates to the economic blogosphere

Eric Falkenstein has a great one-liner in his latest blog post on the irrelevance of most economic research and model building.

For fundamental constants, physicists argue about the 7-th digit, while economists argue about the sign.

Given that there is still a constant debate over whether the latest health care bill will push the cost curve up or down and if it will help or hurt the budget deficit, the quote is very apt.

Demographic Growth, Resource Constraints and Conflict

The UK’s Ministry of Defense has a Strategic Trends Programme that made a report in 2008 called “Global Strategic Trends – Out to 2040”. If you skim through the report, there are some very enlightening charts.

-Page 28 lays out the population growth and aging forecasts for the different regions of the world.

-Page 42 has a very interesting chart of global infrastructure and resources.

-Page 67 contains a map highlighting the areas with the most potential for conflict driven by frontier disputes.

One of the most interesting charts is on page 69 of the report. It highlights areas where there will be an overlap of at least two of the following: demographic growth, water and food shortage and crop decline. The top chart looks at the current situation, which shows that current stress zones are correlated with conflicts containing greater than 8000 fatalities since 1997. The bottom chart uses forecasts to identify where the future stress zones will be in 2040.

The forecast of larger stress zones in China is particularly interesting. China is going to have water management issues that they will have to deal with as they try to keep their economy on course. Water treatment facilities are a large part of this solution, but since they require a lot of energy, this will add to China’s energy demand.