The Equity View of Two Bubbles

While debt levels in both Japan and the US got to comparable heights, it is interesting that it would be very difficult to pick out the US housing bubble from a chart of their relative nominal USD equity market returns.

Source: Palantir Finance

There are a few possible reasons as to why this might be the case.

  1. A larger fraction of the profits in the United State’s bubble went directly to highly paid individuals rather than corporations.  This would be more likely if corporate profits didn’t reach 12% of GDP in 2006, levels not seen since the 1960’s.
  2. The US housing bubble was focused on the leverage in housing, which was residential in nature. Japan’s financial bubble was also to a degree about the real estate, but a lot more of this real estate was owned by companies who were on a whole more directly involved in their bubble.
  3. The technology bubble of the late 1990’s prevented the valuation of US equities from getting too disconnected from their earnings so soon after the last bubble.
  4. The United States’ bubble drove equity markets all around the world while Japan’s bubble was focused on Japan.
  5. Japan was benefiting from China driven growth the same time US assets were benefiting from the housing bubble.

Number 5 could be a coincidence or it could be seen as similar to #4 if the theory is that US consumers helped China’s exporters who created demand for Japanese imports.

Trading the Long Term Government Trend

In the United States, betting that government is going to grow is what some people might call a “positive carry trade”. A positive carry trade is a trade that makes money as long as things stay the way things are currently priced.  The growth of government under current conditions can easily be seen in data on projected spending levels from the CBO.

As spending levels increase, revenues are not at this time projected to rise to keep pace with earnings. There are a few ways that this extra revenue can be found.

1. More debt: The CBO currently projects that under current policies the US will have much higher debt levels in the future.

The trade based on these projections would be to sell short US government debt, as an increase in supply without a subsequent increase in demand should lower the price of an asset.

2. Inflating away the debt: A lot of people worry that the debt won’t be an attractive asset, so the government will have to raise money from seigniorage (issuing new government currency). The trades that make sense in this current situation are to buy gold and sell bonds. This scenario is what most people who worry about government spending often decide they need to focus on, so there is a question of whether there are too many people buying gold and selling bonds in the absence of any present fiscal crisis. However, if a fiscal crisis does occur it may be too late to put on any of these trades so it isn’t completely illogical for a person who thinks there is a higher probability of a fiscal crisis than other people admit to try and hedge their portfolio against the possibility.

3. Higher taxes: This is the least extreme case, though there are still investments that can be made if this occurs. Although the average US voter loves low taxes, they may decide that they like their entitlements more. The recent healthcare policy is a shift in the direction of more entitlements and higher taxes. This negatively impacts domestic growth while not having much of an international impact.  The fact that companies with more international exposure have outperformed companies with domestic exposure even when the dollar was strengthening could be attributed to the wave of new regulations in the US.


Source: Palantir Finance. For International/Domestic Index: GS International Growth Theme Index (68% of revenue from sales outside the US) divided by GS Domestic Sales Basket (less than 1% of its revenue from international sales)

4. Repeal of future entitlements: I’m not sure that this scenario is likely enough absent an inflationary shock to make it worth considering, but the basic scenario would make gold less attractive and while bonds might sell off due to higher future growth they would not be at risk of a major sell off.

Links worth reading

1. Megan McArdle has some interesting predictions about what won’t happen after yesterday’s healthcare vote.

2. Arnold Kling discusses why Modigliani-Miller just doesn’t apply in the real world. It is interesting that many of the differences happen to favor leverage.

3. Eric Falkenstein highlights the difference between a popular account and an accurate account of the recent bubble. It is too bad that people are seemingly hardwired to prefer stories with heroes and villains.

4. Scott Sumner vs. Paul Krugman on US policy as it regards China and its currency.

5. Michael Pettis looks at the potential impacts of a revaluation of China’s RMB.

In the footnotes

Bernanke’s latest testimony has an interesting final footnote (Emphasis added):

9. The authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Federal Reserve to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements. Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation. The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

What costs? In June 1993 The Federal Reserve published a paper on this topic called Reserve Requirements: History, Current Practice, and Potential Reform by Joshua N. Feinman.

Reserve requirements are not costless, however. On the contrary, requiring depositories to hold a certain fraction of their deposits in reserve, either as cash in their vaults or as non-interest-bearing balances at the Federal Reserve, imposes a cost on the private sector equal to the amount of forgone interest on these reserves—or at least on the fraction of these reserves that banks hold only because of legal requirements and not because of the needs of their customers.The higher the level of reserve requirements, the greater the costs imposed on the private sector; at the same time, however, higher reserve requirements may smooth the implementation of monetary policy and damp volatility in the reserves market.
The Federal Reserve could resolve this policy dilemma by paying interest on required reserves, or at least on the part of these reserves that banks would not hold were it not for legal requirements. Paying an explicit, market-based rate of return on these funds would effectively eliminate much of the costs of reserve requirements without jeopardizing the stable demand for reserves that is needed for open market operations and for the smooth functioning of the reserves market.

In general, I am very much in favor of reducing taxes. However, these companies should probably be paying something extra for their free put options, and yet the current tone of the federal reserve is still geared towards finding ways to help banks get away with paying even less.  Furthermore, the consequence of 0% reserve requirements are rather interesting, as someone reading this  primer written by the New York Fed in May 2007 might figure out:

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

They go on to explain that taking these calculations to their logical extreme is incorrect, since time deposits and savings accounts don't have these requirements and yet don't multiply as much as a zero percent reserve requirement would imply. Still, it is rather worrisome that the Federal Reserve is thinking of switching the whole banking system onto a system that would support extremely large money multipliers*.  The primer also mentions paying interest rate on reserves.

The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed because of the revenue loss that would result to the U.S. Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on reserves would, of course, be an additional expense to the Fed.

Scott Sumner (and presumably other economists) have often wondered why the Fed started paying reserves on interest in the middle of the crisis since it effectively tightened monetary policy by reducing the bank's incentives to lend even further.  The Federal Reserve might have realized that during a time of crisis they would be given whatever they wanted to fix the crisis, so they asked for something they've wanted for a long time even though they could have done more to stimulate the economy with quantitative easing than with their long ability to pay interest on reserves.

*The formula for calculating the money multiplier is (1+c)/(c+R). c is the rate at which people hold cash instead of depositing it. If everyone deposited their cash and reserve requirements were zero, then the money multiplier would be infinite.

Inflating the Enemy's Power: The Status Explanation

In the last post I mentioned some interesting research about the psychological tendency to fixate on enemies, inflate their powers and imagine that they are behind most of our problems.

There is an obvious status explanation for these phenomena.  Admitting that you are struggling against the chaos of life can appear as very low status since each aspect of the chaos is generally some minor obstacle that by itself should not be much of a problem. However, if the problems are all caused by a great enemy plotting against us then it is higher status both because the powerful enemy decided to focus on us and because the problems are not a combination of minor issues.  Even if this was only going on inside a single person's head (as opposed to being a constant theme of the media and blogosphere), lying to others starts with self deception.

The Asian Distraction

New research supports the notion that we fixate on enemies, and inflate their power, as a defense mechanism against generalized anxiety.

This provides another interpretation for why some people believed that Japan in the late 1980's and early 1990’s might take over the world.

A research team led by social psychologist Daniel Sullivan of the University of Kansas reports on four studies that suggest people are “motivated to create and/or perpetually maintain clear enemies to avoid psychological confrontations with an even more threatening chaotic environment.”

Without the threat of the Soviet Union, the American public had to focus on something to take its place.  After Japan’s spent two decades without significant economic growth, growing government debt and an aging population they are no longer much of a bogeyman. The next bogeyman is China, as people now believe that China is going to eventually take over the world.  China’s growing economy is competing with America’s economy on numerous levels, but the areas where the US is struggling are caused more by structural problems inherent in the US economy than the emergence of China’s economy from poverty.  If there is a tendency is to inflate the enemy's power, that would explain why a large fraction of people are apparently blind to the unsustainable high levels of government driven investment fueling China's current growth. They just figure that China has a long term plan that they will have no trouble bringing about. The article elaborates on the conditions causing this tendency.

Those who were forced to contemplate their lack of control over significant life events “reported a stronger belief in opponent-led conspiracies,” the researchers report.

This can explain why protectionism with regards to China might get more popular the worse unemployment becomes.  If it is seen as a way to thwart China’s plans, it can very easily become popular with an American population worried about keeping their jobs.

In our third study, we showed that if people perceived the broader social system as ordered, they were more likely to respond to a threat to personal control by boosting their faith in the government, rather than by attributing more influence to an enemy.

So if the government solution to a perceived problem is protectionism, this will solve the problem for both types of people worried about their personal control.  Too bad this won't solve any of our real problems and will make the economic situation even worse. 

HT: Marginal Revolution

Gold's Relative Tax Rate

Considering the implications of the last post, I thought some data would be helpful. Remember, the government doesn’t see gold as an investment but as a collectible.

Source: Tax Foundation

When capital gains taxes were cut for most financial assets other than gold, gold underperformed the market, although the subsequent maneuverings of the twelve to 18 month capital gains tax rate had less clear effects:

The effects of the next relative tax cut for the market and gold is unclear, as it happened during a time period when central bankers were still mildly worried about deflation. Bernanke’s helicopter speech was only 6 months before. The dollar had been falling for a year, and would continuing falling for a year and half more. In an environment like that even an increasing tax disadvantage can get overwhelmed pretty quickly.

In general, it is rather difficult for a casual look back to accurately the determine market impact. There is a lot of noise preventing the market watcher from knowing what is being priced in at any one moment. Looking at past news stories, unless the story is about a specific announcement, would only help in the rare cases where the financial journalist knows what they were talking about.  In these cases, falling back on theory is probably the best approach.  When the opportunity cost of holding an investment has decreased, then when all other things are held constant it becomes a more attractive investment.  Whether this is already priced in and whether this signal is greater than the general noise of the market are the next two questions.

The tax hike and the anti-investment

It is important to note that gold isn’t going to be impacted by the upcoming change in the capital gains tax rate. Gold is already taxed more than other assets because under current tax law gold is a collectible. The capital gains tax on collectibles is 28%, 13% higher than the current tax rate of other assets. With a hike in the capital gains tax rate from 15% to 20% at the end of 2010 this spread decreases to 8%.  If the healthcare bill passes the senate and the house in its currently proposed form then this spread will be reduced even further at the end of 2011.

Gold has always been one of the closest things to an anti-investment; people invest more in gold when they aren’t sure that other investments are a good way to preserve their capital. The current trend in policy of taxing other forms of investment more while not taxing collectibles at a higher rate is only going to make the anti-investment look relatively more attractive.

This Gold/S&P 500 chart helps put the relative performance of gold and equities (unadjusted for dividends) in historical context. Gold’s best relative performance occurred during the deflationary crash of 1929 and the inflationary scare of the 1970’s.

Source: Palantir Finance

Digging Deeper into the Household Situation

In my last post, I mentioned that the lack of children might be a signal that society isn’t looking forward to the future.  There are a few problems with this, mainly that as societies become richer they naturally have more children. This inclination isn’t because people aren’t focused on the future, but because wealthier societies have children that are more likely to survive they don’t need to have that many. On top of that, each child requires greater investment in education so in an advanced society increased investment in fewer children looks like a better strategy than less investment in more children.  With birth control, families are able to make that choice.  So less children per household wouldn’t be a signal of a hyper-present oriented society, but less children overall would still be suggestive.  If less people have children then the pleas to “think of the children” will be more likely to fall of deaf ears.  Data from the U.S. Census Bureau is helpful in digging deeper into these questions.

As mentioned above, the people per household and family have shrunk over time.

Looking at the breakdown of household sizes, this gradual decrease is due to the disappearance of large families and the emergence of the single person household.

In order to determine whether the one person households have been increasing purely due to an aging population, the breakdown in one person households by gender is informative.  If the trend is age driven, single female households should be increasing at a rate much higher than single male households due to the greater female life expectancy.  This is not actually the case, so the increase in single person households is likely preference driven.

The preference for single households increases the nonfamily households as a percent of total households.


Non-family households have increased even faster than the percent of one person households.  This may be due to an increased preference of cohabitation over marriage or due to a rising economic necessity for people to have roommates.

It isn’t just nonfamily households that are saving money on rent, a larger percentage of married households than before do not have their own household. These households are most likely living in the house of one of their parents. In bad economic times, this trend is likely to continue.

Even though household sizes have remained relatively constant, families with young children have also decreased as a percent of the total. This is due to both to the aging of the population as well as a decrease in the propensity of the average couple to have children.

Overall, it does look like the decrease in children in our society is due both the decrease in family size and the increasing prevalence of one person households.  The decrease in family size may be a reallocation of investment, but the decision not to have children is more likely to be both a cause and a symptom of present oriented behavior.  

Another Way to Measure Time Preference

The time preference of a society is important to understand because if there isn’t much future oriented activity, then the future is going to be worse than the present.  There are many ways to look at the time preference of a population. The rate of interest, the savings rate, survey data, or even trying to gauge the propensity of the population to engage in short term unproductive activities.  Some people point to the obesity rate as a measure of inability of the average American to think about the future.  One interesting and underappreciated method of looking at the time preference of society as a whole is to see how many people have life expectancies lower than twenty years. Life expectancy is a better measure than pure age because an aging healthy population is more likely to look to the future than a young population that dies early. The population data was taken from the UN World Population Prospects 2008 database* and the life expectancy data is from U.S. Decennial Life Tables at the US Census Bureau. For the life expectancy data, I used basic linear interpolations and projections to create estimates of life expectancy in 2010 and 2030 and created the following chart.

If people with kids are more future oriented than people without children, then the situation is actually much worse than it appears. The below chart doesn’t adjust for the change in average household size, but it does show that the amount of children in society is dropping.


By both of these metrics and assuming that there isn’t any breakthrough in life extension technology in the near term, the U.S. is going to become more short term oriented in the future. On a demographic basis, the US is in a better position than Japan and much or Europe, so the problems there can be assumed to be even more severe. Compared to Europe, the US even has a higher life expectancy after the age of 65. The pattern of developed countries using short term solutions that only address the symptoms of actual long term problems is going to get worse. 


* The population data has age groups in 5 year increments, and when the cut off for 20 year life expectancy was between these 5 year increments it was assumed that each year contained one fifth of the total in that age group in order to simplify the calculations. Voting age was assumed to be twenty and up to both simplify the calculation and to partially adjust for the lack of participation of younger voters.