Irresponsible investors

These investors think that they are backstopped by the American people.  Having found themselves in a bad position, these investors are shifting their assets into riskier assets knowing that if they screw up someone else will pick up the bill. Nope, I'm not talking about wall street banks, but public pension funds. As the New York Times states:

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

Meanwhile, more and more corporations have been moving their assets into safer assets.  On top of that, these pension plans have very optimistic return expectations.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

Considering the current valuation of the market and the outlook for GDP growth, 9.5% equity return expectations are quite unrealistic. They'll be lucky to get 5%. But it's okay, the people living in these municipality will pay for the rest.

Is it a stock picker's market?

The below chart shows the average 60 day correlation of equities within four different sectors. It looks like many of the sectors are reacting to company specific news again, not just news about the business cycle.  If correlations stay low, this is good news for stock pickers who can try and pick the outperforming stocks instead of having their particular stock act like every other stock in the market.

Source: Palantir Finance

However, if there is a downturn in the market then correlations between equities will jump. This is because of data sampling issues – even if two assets are driven by the same major underlying trends, they won’t move together unless the major trend is changing. One way to look at this effect is to look at the correlation between the stock market indices for the United Kingdom and Japan.

Weekly returns of UK’s FTSE vs. Japan’s Nikkei when the VIX, the stock market volatility index of the US’s S&P 500 market, is under 20. When things are calm in the world the correlation is rather low at 0.29.

Weekly returns of UK’s FTSE vs. Japan’s Nikkei when the VIX is over 20. When the VIX is over 20, signaling that the US market is adjusting to a significant information flow, then the correlation between these two markets is much higher at 0.52.  In more volatile time periods, stocks and stock markets are more likely to be reacting to the same information so their correlations are going to be higher.

Source: Palantir Finance

Right now, the VIX is a bit under 18, helping explain why correlations are low again.  In a market downturn, stock pickers will be hit with the double whammy of falling prices and a smaller diversification effect. Stock pickers can partially avoid this problem by picking lower beta stocks which have tended to outperform in the long run due to their relatively strong performance during downturns, but then they would be missing out on a lot of the returns of the recent rally.

Thin Tails... relative to the hype

A lot of people think that this last recession was caused by fat tails in the market. When they think of the market, they are generally thinking about a stock market like the Dow Jones Industrial Average or the S&P 500.  Fat tails refers to a distribution of returns with more extreme points than suggested by a simplistic approach that only looks at the standard deviation and assumes a normal distribution.  The below chart shows the kurtosis (The higher the kurtosis, the fatter the tail) and volatility of the S&P 500 market over the past 80 years. Click on the chart to enlarge.

Source: Palantir Finance

It is interesting to note that the returns of the S&P 500 during the downturn didn’t have fatter tails than past market meltdowns. While it is true that deleveraging and liquidity events caused some positions popular with leveraged quantitative funds to all move in the same direction and models with uncorrelated and always rising house prices banks used to asses their risk were quite unrealistic, the popular myth that quants just didn’t understand that general market returns are not normally distributed is not true on many different levels.

Correlations between Greece and California

They each have tax receipts that vary with the economy along with fixed expenditures. The recent downturn has made their expenditures far higher than their receipts. Neither California nor Greece have control of their money supply, so printing money is not a solution.  Both live in a union where capable workers can easily leave, so raising taxes won't help much either.  Therefore, they have to make cuts.  This leads people on the receiving end of cuts in each area to periodically riot in protest of realityMegan McArdle's comments on the California students can be equally applied to government workers in Greece.
...I'm not sure what they think is supposed to happen.  There's no money.  This is not some question of reallocating resources from bad uses to good--everything is being cut because their institutions are under serious financial duress.
California is a little bit better off than Greece, at least they weren't caught lying about their finances.

Ignoring the supply side

Looking at the above chart, it is clear that either markets don't clear or the cost of becoming or being a doctor in the U.S. is much higher than it is in other countries. Instead of addressing the supply issue, the plan is to raise the capital gains tax will be raised to 22.9% to address the demand side of the health care issue.

The capital gains tax is 15% right now and will revert to 20% next year. Already this will have a noticeable impact on the market.
Assets that have gone up in value over the lifetime of a person's holdings give the owner an incentive to sell going into the end of the year.  While most stocks have gone nowhere this past decade the few stocks that have done well might reverse their course close to year end.  Long term commodity investors sitting on gains might also decide to take profits. When commodities start falling for no particular reason near year end, look for an increase in the number of stories about how China is slowing down.

The possibility of an additional 2.9% hike in 2011 should have a similar effect, with its impact slightly decreased because the hike isn't as large and because investors who reacted in 2010 will have less incentive to react in 2011.  Still, it is interesting that the markets didn't really react to the news of a new capital gains tax*. If stocks today are valued less for their future appreciation than their current expected income stream then this reaction makes sense.

Higher capital gains taxes, less investment in organizational capital and a muted reaction to future capital gains taxes are all related, they each imply that many of the decision makers aren't going to be as focused on creating an economic future that is much better than it is today.

*It is always difficult to tell why markets are moving unless they have a large jump on data releases or pre-planned announcements where the expected number is relatively well known.  There is a real issue in separating the signal from the noise. In this case, economic news releases, earnings reports and news coming out of Greece might have created enough noise that any impact of a possible new capital gains tax was masked. Also, there are many cases where the market will go up on bad news because it expected the news to be even worse.

Net Interest Payments and Reflexivity

While thinking about the CDS model in general and the Greek situation in particular, I realized that I left out a key variable from my previous analysis: Net Debt Interest Payments.

This variable should be very useful, as it implicitly measures net debt as well as the part of the deficit that isn’t changed by fiscal policy.  It also measures interest rates in the previous time period, so the information content contains last year’s CDS prices as well. While using data on which countries were considered at risk last year’s will give us a good idea of which countries are at risk this year, it only helps so much because it doesn’t explain why the country was in trouble in the first place.

However, this is a good example of Soros’s theory of economic reflexivity.  Countries that the markets see as having problems have to pay higher interest payments, making their fundamentals deteriorate further, which in turn drives interest rates even higher.  It will be interesting to see how Greece breaks out of this vicious cycle.

Countercyclical capability?

Garett Jones had a very interesting econtalk with Russ Roberts. He mentions that one the more interesting features of this recession is that productivity has been pro-cyclical rather than counter cyclical.  The graph below shows that during recessions productivity has generally gone down.

Source: BLS, NBER

As Garett Jones points out, this is rather intuitive to the person who thinks about companies cutting the fat in hard times and laying off the least productive workers.  In really hard times, companies might also cut workers who are focusing on projects that might create future revenue. Garett’s original tweet on the topic phrased it this way:

Workers mostly build organizational capital, not final output. This explains high productivity per 'worker' during recessions.  

In order to understand the significance of counter-cyclical productivity, I looked at a paper published in October 2000 by the Federal Reserve called Why is Productivity Procyclical? Why Do We Care? by John G. Fernald and Susanto Basu.  They analyze the four main reasons why productivity is usually procyclical.

  1. Procyclical technological development, where new technologies are invented during the boom rather than the bust.
  2. Imperfect competition and increasing returns means that when the economy is doing well then productivity is rising.
  3. Capital and labor are utilized more than is actually reported during a boom and less than is reported during a bust, so the procyclical productivity doesn’t actually exist but is caused by cyclical measurement problems.
  4. The reallocation of resources across uses, so as cyclical sectors with higher markups utilize a larger percentage of resources productivity goes up.

The study found that explanations #3 and #4 are the most important.  If the recent boom and bust cycles were not quite as procyclical as before, it could be due to many reasons.

  1. Better measurement of labor and capital.
  2. This boom was more financial in nature with the reallocation of resources going less to industries with naturally higher markups and more industries subsidized by cheap financing
  3. More firm specific capital creation in an increasingly globalized world.

Two and three are the most convincing. However, just because productivity doesn’t drop during recessions doesn’t mean that productivity is now countercyclical.  The relationship has merely weakened somewhat from the 1990’s onward, as this rolling ten year correlation between quarter on quarter changes in real GDP and nonfarm business output per hour demonstrates.

Source: BEA, BLS

Political Nonsense from Scott Sumner

Scott Sumner prefaces a very interesting overview of the German Crisis of 1931 with a political non sequitur:

First I’d like to make a few comments on this amusing video.  My favorite line is when Joe Biden prays to God.   I didn’t know that politicians talk to God in the same dishonest way they talk to voters.  Bloggers on the right and on the left who think the other party is a bunch of lying weasels are half right.  They are a bunch of lying weasels.  But so is their own party, which they somehow overlook.  Above the fray independents have the right attitude toward most politicians of both parties—contempt.  

BTW, in my view Bush was right and the Dems were wrong in 2005, and Obama is right and the GOP is wrong today.   The filibuster makes no sense.  Indeed I’d like to see a parliamentary system in this country, where something like the German Free Democrats was in the center, determining what got done.  Some people seem to believe the filibuster favors small government, but I find that unlikely.  Size of government is just as likely to shrink as to grow, otherwise government would head toward 100% of the economy in the long run.  So in the steady state there will be equal number of proposals to shrink government as to expand government. 

When 59 people disagree with 41, the 59 are more likely to be right.  If they were more likely to be wrong, we ought not have democracy at all.

OK, enough political nonsense.  On to 1931:

His first paragraph is actually spot on. Most partisan squabbles consist of pots calling kettles black. People fail to recognize this for various reasons, perhaps because politics is a mind killer. The second paragraph where he asserts that the size of government is just as likely to shrink as grow is where he goes wrong.  While federal government expenditures have remained at a pretty constant percent of GDP, there is a pretty clear upward trend when the outliers of the world wars are excluded.

The conservative revolution that started with Reagan in the 1980’s is interesting not because government shrank (Bill Clinton and his republican congress did see total government spending shrink by about 3% of GDP), but because throughout that time period government remained pretty constant as a percent of GDP.


While federal government spending as a percent of GDP might have been more constant than total government spending, their partial funding of joint programs with the states has encouraged the large increases in state level spending.  Furthermore, a steady state government wouldn’t be growing at the same rate as the general economy. Assuming zero efficient gains, it would grow with population and with wages.  If the government took care of the same tasks and had even slight productivity gains, its size relative to GDP would shrink as the rest of the economy grew so the mere fact that it is keeping track with GDP spending suggests that government has a tendency to grow instead of shrink.

Outside of pointing out the empirical trend of increases in government spending, there are very clear public choice reasons as to why new programs will generally lead to more spending. In this regard, Bryan Caplan asks a very interesting leading “extra credit” question that almost answers itself.

Suppose you had a billion dollars to spend in Washington to advance liberty.  What's the biggest libertarian policy reform your billion could buy?  How precisely should you spread your money around?

Remember: Many obvious strategies would lead to bad publicity and serious pushback.  Your answer should take account of this feedback.

Extra credit: Suppose you had a billion dollars to spend in Washington to advance statism.   How does the optimal strategy change?  If there's a big asymmetry, explain its source.

As for wondering why a straight up majoritarian approach isn’t always the best legislative approach, Will Wilkinson has a good post on how simple head counting systems excludes any measure of the intensity of the voter’s preferences.

The government isn't trying to create more unemployment, but...

Alex Tabarrok makes a very important point about some of Obama’s plans to help the middle class. 

From today's NYTimes  

The Obama administration is planning to use the government’s enormous buying power to prod private companies to improve wages and benefits for millions of workers, according to White House officials and several interest groups briefed on the plan....

Because nearly one in four workers is employed by companies that have contracts with the federal government, administration officials see the plan as a way to shape social policy and lift more families into the middle class.

At a time of 10% unemployment when real wages need to fall this is bad business cycle policy.  I am more worried, however, about the long term consequences of creating a dual labor market in which insiders with government or government-connected jobs are highly paid and secure while outsiders face high unemployment rates, low wages and part-time work without a career path.

Long-term unemployment is at shockingly high levels which in itself creates a dynamic of persistence because the longer a worker is unemployed the less employable they become (in part due to loss of human capital and signaling problems). Thus, getting these workers back to work is going to be hard enough as it is.  Labor regulations which raise wages and make hiring and firing workers even more costly will make re-employing the long-term unemployed even more difficult.

Moreover, once an economy is in the insider-outsider equilibrium it's very difficult to get out because insiders fear that they will lose their privileges with a deregulated labor market and outsiders focus their political energy not on deregulating the labor market but on becoming insiders--see Blanchard and Summers on hysteresis in unemployment and more recently Larry Ball here.  Many European economies found themselves stuck in the insider-outsider equilibrium and as a result unemployment levels in places like France and Italy hovered at 9% or more for decades.  

This is a neat explanation of the type of second order effects that people who are only trying to help usually tend to ignore.  Surprisingly, even Brad Delong agrees that creating an insider-outsider dynamic is bad.  The insider-outsider dynamic is even worse when it is the outsiders who are doing jobs that are the most productive.  Garett Jones points out that the effect of workers queuing for the higher paying insider jobs also exacerbates unemployment.

Current Drivers of Sovereign Risk

In a follow up to yesterday’s post, here is an analysis of what is currently driving sovereign risk.

Net liabilities as a percent of GDP have a relationship with current CDS spreads.

The 2010 OECD projected government fiscal balance also has a relationship with current sovereign CDS spreads.

The current account deficit also matters, as countries with current accounts deficits are less likely to be net savers and an investor would be more worried about getting their money back from a country that doesn’t have money coming in each year:

In all of these charts, the larger countries such as the US, Germany, Japan and France have lower spreads than smaller countries with similar statistics.  So in a simple linear regression I included:

  1. The log of a country’s 2009 GDP
  2. The 2009 current account balance as a percent of GDP
  3. The government’s 2010 projected net liabilities

With the dependant variable being the current CDS spreads. I didn’t use the fiscal balance factor because it is too correlated with the other explanatory variables. The results are in the chart below.

The relationship is even cleaner if the net liabilities variable is set to zero when the variable is negative.

While there are other factors that are mentioned in the headlines everyday that are also driving these CDS prices, it is interesting how a few variables can neatly explain the market’s current view of sovereign risk.