Unpleasant Facts and Other Musings

Arnold Kling has many interesting posts on recalculation.  His theory about this recent recession is that it is driven by a need to figure out what is happening next.

Imagine a central planner who decides to radically change plans. He has a huge recalculation to make in order to figure out where to allocate labor and capital. He says to some people, "Wait a minute. I am thinking. Some of you just have to stand idle while I figure this out."

The market economy is like that central planner. We are undergoing a Great Recalculation

 An interesting application of this theory is that the economy will recover more slowly if is more difficult than normal for a business to invest in what is happening next within the United States.  The CBO’s 2009 long term budge outlook has an interesting chart that is not good news for most US companies focused on domestic sales.

Source: Long Term Budget Outlook, CBO p 32.

Their forecast is that the only spending that will increase on a per capita basis is healthcare spending. This forecast was partially made by forecasting the current excess cost growth in healthcare into the future, assuming that these costs grow less quickly past 2020 (less than half the healthcare spending is Medicare and Medicaid).  There are definitely going to be changing markets and increased productivity within the “all other spending” category, but without healthcare this is a pie that is only really growing at the rate of population growth.

This is an increase in the size of the economy where profits are nonexistent or seen as evil.  The nature of healthcare makes it very hard to earn money in the sector. The supply of labor is restricted by licensing and thus the returns to labor are high relative to the return on capital.  In less service oriented healthcare areas the FDA approval process that doesn’t shield companies from liability increases the costs and risks to investors. The uncertainty surrounding healthcare regulation makes investing in the sector even less unfriendly than it is already.

If the recalculation story is true and the CBO’s projections on this matter can be trusted, the United States’ market economy might remain confused and below potential for some time to come.

Menzie Chinn has a chart up at econbrowser that seems to hint that republican presidents have a predilection for deficit spending.  Using a similar time series, I created a chart that looks at debt and which party is controlling congress instead of the party in charge of the executive branch.

Sources: Federal debt from FRED, using data from the CBO for Q4 2009. GDP data from is from the BEA.

Scott Sumner and Arnold Kling have been having a very interesting blogosphere debate about the causes behind the recent recession. Scott believes that the Fed made a mistake by letting GDP fall 8% below trend and that when the monetary authorities allow such a large fall in nominal GDP a severe recession is unavoidable.  Arnold thinks that the recession is a symptom of a great recalculation in which the actors in the economy realized their previous investments were actually unprofitable malinvestments, but aren’t sure where to allocate resources towards next.    This post is mainly focused on one of Scott Sumner’s arguments, while next week I will take a deeper look into the recalculation story.

One of Scott Sumner’s ways of demonstrating the excessive tightness of the Fed has been to focus on the TIPs yield, which showed deflationary expectations in the end of 2009.  The 5 year inflation rate that TIPs priced in was at times as low as negative 0.8% a year, and the 5 year 5 year forward rate was as low as 0.42%

The blue line is the time series of 5 year forward 5 year inflation expectations, from The TIPS Yield Curve and Inflation Compensation by Refet S. Gürkaynak, Brian Sack, and Jonathan H. Wright. The green line is the 5 year forward 5 year inflation rate calculated from the real and nominal 5 year yields. The bottom orange line is the five year breakeven inflation calculated as the spread between the nominal and real rates.

One of the reasons that breakevens got to be so extreme is that with the decline in leverage it became a lot more expensive to hold onto TIPs with borrowed money. Furthermore, the flight to liquidity meant that for many funds TIPs were among their most liquid assets and as such had to be sold while for others TIPs were no longer liquid enough to safely hold in such a volatile environment.  In this environment, market inflation expectations were probably not as volatile as they appeared and the methodology of Gürkaynak, Sack and Wright created in 2007 a forward inflation measure that never dropped below 2% during the crisis. This may be partially because when they modeled the TIPs curve the left out the particularly illiquid front 18 months.

That the Fed wasn’t forecasting deflation is also shown in the Taylor rule chart that accompanied Bernanke’s speech earlier this month.  The Fed saw the signs in the market to cut rates before their forward looking Taylor rule told them they should.  Of course, in the Taylor rule chart below the only forward looking component is inflation, not the output gap.  The Fed cut rates in advance of a declining output gap but after the financial panic. Furthermore, once rates approached zero they started paying interest on reserves in order to keep their attempts from saving the financial sector from spilling over as inflation into the rest of the economy. In effect this tightened policy just as the forward inflation looking Taylor rule was hitting the zero bound and possibly going negative. 

Of course, the chart from Bernanke’s presentation doesn’t go negative (Perhaps to avoid questions from angry senators who were wondering why he wasn’t doing everything possible to promote full employment).  However, when this chart is compared with other Taylor rule charts it is obvious that the Taylor rule is suggesting something below zero even now, which implies that the Fed may be too early in withdrawing quantitative easing. For example of these rules, take the work done by Glenn D. Rudebusch at the SF Fed in May of 2009 in which he forecasts a negative rate far into the future, which was updated by Krugman here.

Source: FRBSF Economic Letter, 2009-17; May 22, 2009

As a side note, Menzie Chinn at Econbrowser has an interesting post about how the fed funds futures are pricing in a policy rate much higher than anything the Taylor rule is currently predicting under a wide range of assumptions.

 "If the government is to tell big business men how to run their business, then don't you see that big business men have to get closer to the government even than they are now? Don't you see that they must capture the government, in order not to be restrained too much by it? Must capture the government? They have already captured it."
Woodrow Wilson, 1913

A common meme is that with the increase in government there will be so much regulation coming out of this administration that it will be a mistake to own stocks.  As much as Republicans would like to pretend otherwise, increasing regulation is not always bad for the stock market. The stock market consists of the existing capital stock and new regulations often affect the incentives for capital formation more than the existing capital stock.  Increasing regulation means an increasing risk of regulatory capture, where the agencies designed to regulate a sector end up protecting the existing businesses more than the consumers the regulations are designed to protect.

There are a few ways that corporations can benefit from an increasingly politicized environment:

1. Regulatory Standards: Companies with connections to lobbyists can try hard to make their current best practices the regulated industry standard.
2. Higher Cost of Entry:  Having to deal with red tape can discourage new entries into the industry.  Less competition means higher prices for the existing companies.
3. Economies of scale and red tape:  The larger the company, the more capable they will be at minimizing the cost of the red tape. The intrapreneurs who are creating new businesses inside of an existing corporation will have a large leg up compared to the smaller companies and entrepreneurs who aren't equipped to deal with bureaucracies. Political rhetoric favors small businesses, political actions often do the opposite.
4. Government contracts are much more likely to be awarded to the existing players. Even outside of the personal connections, some bidding contests are outright biased against newcomers by giving points to businesses that have done similar projects in the past.

So unless the government seems determined to destroy an industry, the analyst needs to weigh the effect of increased regulation's on short term earnings versus the decline in the long term earnings volatility.  With lower volatility comes higher returns, especially if leverage is increased*.  If increased regulation, lower volatility and higher leverage sounds like an unlikely combination, think back to Fannie Mae, Freddie Mac and the recent housing bubble.

It could be said that these reasons explain why the stock market outperforms during Democratic presidencies, but that's not actually true.

*Of course, with the banking sector in its current state, an environment of increased leverage is likely a long ways away.

One of the constant themes of globalization is that many people feel like the developing countries are hurting them.  While in most cases the benefits to consumers outweighs the opportunity cost of the people who have just lost their jobs, there are some cases where the emergence of the developing country can hurt the developed country overall.

Take the following three country model, each country producing two goods (Tech and Resources), at times one and time two:

Time 1:

A: 100 Tech, 20 Resources 
B: 20 Tech, 100 Resources
C: 5 Tech, 5 Resources

Time 2:

A: 110 Tech, 20 Resources
B: 20 Tech, 100 Resources
C: 30 Tech, 5 Resources

In this example country A is the developed country, country B is the commodity producing country and country C is the developing country.  At Time 1, both country A and country B benefit from trade, while country C doesn't need to trade since it doesn't have any comparative advantage relative to countries A and B.  At time 2, technological progress has enabled more Tech goods to be produced by countries A and technological catch up has allowed country C to drastically increase their Tech production, but resource constraints have prevented any increase in Resource production.  In this scenario, Country A is damaged by country C's arrival on the global trade scene, even though this damage is mitigated by its benefits to countries B and C.

It is important to note that short of measures preventing technological knowledge from getting to country C in the first place, there is no economic policy that protects country A from this globalization driven negative terms of trade shift.

Robin Hanson has some interesting thoughts on Conan O'Brien's parting message.

All I ask of you, especially young people … is one thing. Please don’t be cynical,” O’Brien said. “I hate cynicism — it’s my least favorite quality and it doesn’t lead anywhere. Nobody in life gets exactly what they thought they were going to get. But if you work really hard and you’re kind, amazing things will happen. I’m telling you, amazing things will happen.

He has an interesting take on why this anti-cynicism strategy might work for young people more than older people.

When you are idealistic about how others will treat you in your relationships, you become more attractive as a relation partner.  This helps you attract better partners.  Later in life, when you are attached to particular others via relations, you are better off being suspicious and cynical, as this gives you a negotiation edge when threatening to leave your partners, and discourages them from exploiting you.

If cynicism correctly applied involves closing potentially negative doors and idealism correctly applied helps to open potentially positive doors, then someone young still searching for their niche should not be quick to engage in the former over the latter.  Of course, there are actually more direct signaling reasons to act age appropriately. A cynical point of view is often an attempt to signal knowledge and experience, and may people would find this signal to be in-congruent coming from a young person.  The cost of sending this signal is the doors that it closes and the benefits that accrue to a young cynic are generally small if people don't believe the young cynic is  capable of adding value.  So the real lesson is that young people should be wary of spending resources signaling something that isn't going to work.

The Census also has voter participation data broken down by age or race, but not both.

This chart shows us what everyone knows: Old people are more likely to vote. This chart also explains why social security reform is not likely to happen, as old people won’t vote to give away their benefits and they may even vote against other reforms that only affect the young out of paranoia. The same could be said about programs that might have knock-on effects to Medicare down the road.

A little bit more surprising is the contrast between turnout in presidential election years and congressional election years:

I repeated the study using age based voter turn out numbers from the last two years as a guide, also adjusting the Hispanic voting population down by one third to adjust for the illegal immigrants who are unable to vote.  One surprising effect was that the slightly lower age of the growing minorities was not enough to affect the general thrust of the voting pattern.

Next I looked at the race based voter turnout.

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And again, I compared it presidential election turnout with turnout from the previous year:

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The results were rather extreme, showing how off year elections had a much bigger impact when voting by race was taken into account than when voting by age was taken into account.  This is because more whites vote during off years, with their off year voting at 75% of presidential election voters while only 66% of minority voters in presidential elections decide to vote during off years.

No model is ever truly complete, and this model is still lacking in numerous ways.

1. The predilection for the youth to vote for democrats has not been taken into account. An older population might be more conservative in nature, which would be a boon to the republicans.
2. Secondly, the recent data on black voter turnout was driven upwards by Obama’s election and it remains to be seen whether or not this recent shift will revert to the mean. 
3. Gerrymandering and state based Electoral College make national projections of the total popular vote less important than close analysis of swing states.
4. Short term economic fluctuations and personality politics means that the above charts are at best vague projections to show the direction of things to come where the emergence of a larger minority population makes republicans fall behind by an average of 0.1% or 0.2% of the population each year.

Furthermore, this analysis assumes no large shifts in party politics that might change racial voting preferences.  It does suggest that any big move towards the center is likely to be made by the republicans and not the democrats, as the democrats are riding a trend towards more power and while they may occasionally get ahead of themselves as they have with the healthcare legislation, the voting population is drifting further left every year.

I'd rather entrust the government of the United States to the first 400 people listed in the Boston telephone directory than to the faculty of Harvard University.
William F. Buckley, Jr.

Patri and Arnold point to an interesting piece in The Economist. The article provides an overview of a series of studies attempting to answer the question of whether power corrupts.

They found that not only does power corrupt, it also causes hypocrisy. People primed to think of themselves as more powerful not only judged the morality of others cheating more harshly, they themselves were more likely to cheat.

In the dice game, however, high-power participants reported, on average, that they had rolled 70 while low-power individuals reported an average 59.

However, an interesting result occured when the subjects were primed to think that they were more powerful but underserving of power. They were more lenient on other people and rated cheating by themselves as far wose than others, the opposite of people who believe that they deserve their power.  The theory is that people who don't feel like they deserve power will be far less likely to abuse it for fear of being brought down by the truly powerful.

This research puts the wisdom of William Buckley Jr. and 45% of the American public in an interesting context. A random group from the phone book would be more likely to feel like they didn't deserve to govern and therefore would be less likely to abuse their power.

 

One of the basic ideas in finance is that if something is widely known, then it is already priced in by the market. This leads to the contrarian style of investing, as pictured below:

 

 

If an idea isn’t believed by the market, then taking a position against the market view generally leads to a better risk/reward pay off because the idea can’t be priced out of the market when it is already priced in.  Of course, it is often very difficult to determine what market positions are contrarian because figuring out why the market is moving outside of earnings announcements, economic data and changes in government policy is a full time job in itself.

 

One way to clarify this is to focus on what people don’t like thinking about.

 

 

 

Trading based on what people don’t like thinking about can consist of taking the long term point of view, or just the politically incorrect point of view. An example of a politically incorrect view is that of vice stocks, stocks in industries that could be considered questionable. These types of stocks outperformed the S&P up until the start of 2008, by which time the idea that investing in vice outperforms could be said to no longer be contrarian.

 

Another area that investors avoid is the long term.  Investors may acknowledge long term trends are important but their incentives are short term. They are paid and allocated capital based on yearly performance. This leads to a focus on the short term, where earnings reports and economic data more than a year away are seen as insignificant. This is partially why the value based investor strategy works (in the sense that value stocks have consistently outperformed growth stocks in many basic quant models) – if a company is cheap relative to its price then the investor will make money in the long term despite the lack of a positive story in the short term. Of course, sometimes the stock is cheap because it has a negative story in the short term, so the value stock is also a contrarian idea.