Thursday, July 2, 2015

The naive rentier economy

Bill McBride notes that multi-unit housing starts are peaking.

Here is one of his charts.  Notice they are peaking at about the same ceiling level they have peaked at since the 1990s.  As I have pointed out in my housing series, rent inflation started rising in the 1990s, and most of that inflation is due to just a few cities.  You can see in this chart how much more housing expansion was allowed back in the 1970s and 1980s.  This is a huge supply constraint.  And, this is why residential investment in single family homes was so high in the 2000s.  There is nowhere else to go.

We are hitting this ceiling while vacancy rates are at all time lows - down to 7.1% nationwide in 1Q 2015.  And guess what the vacancy rates are in LA (3.8%), NY (3.1%), San Diego (4.6%), San Francisco (3.6%), and Washington (4.6%)?

Here is an article that talks about insider buying at Real Estate REITs.  One thing that I find interesting is that real estate financial insiders seem to view real estate entirely through an income lense.  And, since we don't have a long history of easily tracked real bond yields, there is not a tradition of marking returns in real estate to market yields.  I think this is why there was such a large cottage industry of small-scale real estate speculators in the 2000s.  Between the low real long term rates on low risk alternatives and the high rent inflation that was coming out of supply constraints, there were speculative gains to be captured.  But, insiders who might have positioned institutional money to take advantage of this shift just don't look at real estate with that paradigm.  The financial institutions built around real estate, including the complex set of capital arrangements and organizational management, aren't set up to be speculative.

Even today, I think large real estate financial institutions have their capitalization rates set too high.  They present their investment values in terms of getting a high yield.  I have even seen presentations where analysts have explained that they might review market conditions and reduce the target capitalization rate.  But, they don't seem to account for the fact that reducing the cap rate on a real asset with a 50 year (or more) life is a bold speculative statement to make.  They seem to just see the changing cap rate as a way to calibrate fund discount rates to properly capture income from the available pool of investment opportunities.

This is reasonable.  Transaction costs in real estate are high.  Real estate investment institutions should be built around long term holdings.  Core competencies will be built around very localized information.  Over the long run, aggregate property values should roughly rise with inflation.  This leads to a peculiar outcome where insiders are not in a position to capture speculative gains that are the greater factor on the aggregate value of real estate in our current low interest rate, constrained supply environment.

Part of the problem is probably that there is no way to know how permanent the constraints on retail mortgage funding will be.  If the banks start lending freely again, nobody wants to be sitting on millions of dollars of apartments in Phoenix.  So, builders and landlords capture excess rents because that uncertainty keeps potential housing out of the market, even in cities that don't have artificial political constraints on housing.

Wednesday, July 1, 2015

Wages, profit, overtime pay, and "rights"

Warren Meyer posted a reminder of the Obama administration's proposed overtime rules, that would expand workers who are covered to anyone with income up to about $50,000.  According to Meyer, they are not making him or his employees very happy, despite the hopes of Jared Bernstein and his Washington Post headline writer:
President Obama’s new overtime proposal could make a lot of people happier
I think this is a great example of the "What's the Matter with Kansas?" problem.  Progressives place a bunch of constraints of the lives of the working poor, then they expect to be hoisted triumphantly into office on the shoulders of people they have harmed.  When a worker making $800 on 50 hours of work has to go home and tell her family she is now making $600 on 40 hours of work because new federal rules on overtime pay make the 50 hour arrangement uneconomical, she doesn't need to understand the theoretical subtleties of economics to understand what's happened.  Bernstein and the president's other supporters believe workers will be pleased about this constraint.  They seem to think that someone making $15/hour for 50 hours of work will now have the same schedule, but with an extra $75 for the week.  Or, alternatively, that they will be reduced to 40 hours and $600, and be happy about it, because they were only coerced into those extra hours by their employers.  And, this has the added bonus of creating more jobs, to replace the lost hours.  (I wonder if anyone has ever written on the troubling trend of workers who have to hold multiple jobs to get by.)

Of course, the president and Mr. Bernstein's confidence notwithstanding, it's not really a question of whether all workers are happy about this or not.  Some will be happy and some won't.  There are a lot of activists in the Democratic Party that will not be affected by this policy who will be slightly more motivated to support the party, because they will consider this a victory.  Among those affected, there will surely be a decline in support ("What's the matter with Kansas?" the activists will ask.)  Some portion will be less happy with the new pay and time schedule than they were with the old one.  And, there will be no question where to place the blame for the change, since the supporters of the policy are quite proud of themselves.  The idea that some number of workers will be happy appears to be based on the notion that the base wage will remain unchanged and that the overtime premium will simply add to the worker's compensation.  Nominal rigidities in wage markets may prevent employers from immediately simply docking the base pay to resettle back at the original total cost, but even in the best case scenario, for a worker who might be averaging 50 hours, a few changes to work requirements and some reductions in planned pay increases would re-establish the total compensation cost fairly easily.  For workers who have been salaried, wouldn't we simply expect the new hourly wage level to be set so that the total compensation level remains unchanged, but now the employee and the employer have to deal with a discontinuous 50% cost factor in their weekly production plan?

The oft-heard description of departures from arbitrary wage rules as "wage theft" is a particularly useful rhetorical weapon in the cause of replacing open economic discourse with hatefulness and pop-moralizing.  This issue is a great example of the "curious task of economics".  The combination of an interventionist bias and confidence in a particular world view can be dangerous.  Here we see the sort of Marxian priors that inform so many progressive attempts at helping - the idea that power imbalances are the overwhelming factor in price setting, the idea of just prices and just wages, the idea that employment contracts are generally exploitative, especially for low wage workers, etc.  Supporters imagine that a given set of voluntary labor arrangements must be skewed in favor of the employer.  People don't like to work more, all else equal, so it is not hard to imagine that they are coerced, due to their lack of negotiating power, into working more than they would prefer.  But, it is not difficult to imagine other explanations.  In fact, simply asking workers would provide many reasons - Meyer and his workers, for instance.

One obvious reason workers might prefer a salary arrangement with some uncompensated overtime is management of income risk.  One of the fundamental services employers provide to employees is the assumption of tentative risk - volatility in income from seasonal or cyclical fluctuations in sales.  If one approaches this subject with the bias that employment arrangements are exploitative, these sorts of obvious issues may not be so obvious.  This change in policy will put many workers in the position of meeting regular fixed expenses in their household budgets with earnings that will now come in fits and starts, depending on the work load of their employers.  In fact, I would expect total compensation to rise slightly as a result of this policy change, because this sort of income management is very valuable to workers, and is costly for employers.  The fact that this policy prevents employers from providing this income smoothing service to their employees means that employees will require some compensation, and employers will be willing to pay it.  But, the marginal worker will be worse off for this change, even with the higher compensation level.

Of course, we hear all the time how insecure workers are - how employers are increasingly forcing unpredictable and unsustainable schedules on them.  With a worldview that views labor contracts as exploitative and imbalanced, this can be blamed on employers, almost by definition.  And, even though it seems obvious that imposing hourly pay with overtime rules on salaried workers would exacerbate the problem of weekly wage insecurity, this problem can simply be assumed away through an imagination blinded by its own assumptions.  So, one can believe that, not only does an imposed, arbitrary 50% discontinuity in wage rates for hourly workers have nothing to do with short term wage insecurity, but employers who avoid imposing it are engaged in Wage Theft.

Corporations aren't capturing potential wages.

The idea that workers will get a raise from a policy like this also comes from this sort of worldview.  This chart from Mian and Sufi has become a sort of mascot of the idea that corporations can capture huge gains by underpaying low wage employees - "The Most Important Economic Chart".  The idea is that the median worker has not been granted their portion of productivity growth since 1980. (The trend shift looks like it happens in about 1969, but Mian & Sufi, oddly, set the indexes = 100 in 1980, where the median income series looks like it is already below the productivity series by at least 10 points, relative to 1969.)

According to Mian and Sufi, the two reasons are:
First, owners of capital are getting a bigger share of GDP than before. In other words, the share of profits has risen faster than wages. Second, the highest paid workers are getting a bigger share of the wages that go to labor.
There are some other issues, such as number of earners per household, that have significant effects here.  But, for the purposes of this post, I want to concentrate on the two factors M&S mention.  I have posted a lot about the growing returns to risk and skill, among both capital and labor.  And, in fact, I think M&S's second factor is very important.  After adjusting for other factors they don't mention (like household size), high incomes of digital entrepreneurs and changes in distribution of labor income explain basically all of it.

So, it's a problem that they mention this first factor, that capital is getting a bigger share of GDP.  It's simply not a significant factor.  But, because M&S, Picketty, and other observers keep inserting this notion into the consciousness about this issue, this labor vs. capital mindset creeps into all sorts of issues, like this overtime pay policy issue.  It feeds this idea that corporations, in the aggregate, have immense power to claim producer surplus.  When proponents of these sorts of policies can't imagine that laborers collect any of the producer surplus, they don't have to be concerned about the effect of their policies on producer surplus, because they see the elimination of producer surplus as a virtue.  So, these policies end up destroying producer surplus, and if in reality much of that is going to labor (which I think is true), then these policies end up cutting the incomes of the laborers they are intending to help.  Proponents can't imagine that current labor agreements have developed to meet laborer's intrinsic marginal demands, so they end up making it illegal for labor agreements to meet laborer's intrinsic marginal demands.

Here is a graph of compensation and of capital income as a portion of GDI.  Capital includes all returns to ownership (profit, interest, and proprietor income).  They are very stable over time.  Looking at the M&S graph, median family income looks like it is more than 40% below where it would have been if it tracked their productivity measure.  So, I have included three indicators in this graph:

1) The range of actual capital income since 1980 (Blue).

2) The trajectory capital income would have taken if labor income had declined by 40% since 1980 and this was explained by increased capital income (Red).

3) The range of capital income that would be required to increase compensation by 10% through policies that transfer income from capital to labor (Green).

First, there is a very tight range of relative total capital income over time, even through business cycles.  Overwhelmingly, total compensation correlates with GDP growth.  Real compensation per laborer since 1980 is up around 60%, while incomes as a proportion of GDI move in very tight bands.  The top dark orange line adds homeowner implicit rent to compensation.  Even the small decline in compensation since 1980 has very little to do with wages, but instead is related to housing issues.

The housing supply problem tends to benefit high income households at the expense of low income households, and, as I mentioned, there are plenty of ways we might look at how compensation is distributed among labor.  But, since this idea that corporations are somehow capturing a bunch of surplus from laborers is so enticing, policy fights about ways to help low income households keep being waged about a problem that doesn't exist.

The red lines show how much capital income would have grown if it had been responsible for the missing household income from M&S's graph.  We would have noticed.

If a low-level salaried laborer working 50 hours a week was paid overtime on those 10 hours with no other change in wage level or hours worked, this would represent about a 10% increase in compensation.  The green lines show where income to capital would have to go if this could actually happen - if we could engineer a 10% wage increase through public policy.  Since the BEA began tracking incomes in their current format, going back to 1929, capital income has never fallen in that range.  This simply isn't a potential source of labor income.  Impositions like overtime pay regulations simply force laborers into second-best wage arrangements.

Bernstein's Claims

A portion of the Washington Post article reads:
Especially in weak labor markets, there’s lots of anecdotal evidence of people having to accept work schedules that make it impossible for them to balance work and family, completely vitiating those pristine “equilibration” assumptions.
Hamermesh et al also talk about “rat race” models “in which workers put in sub-optimal excess effort to distinguish themselves from slightly inferior workers.” I myself have worked in offices where if someone sees you leaving at five, they look at their watches and shake their heads. Again, in such cases, the classical assumptions do not hold.
So in the real world, many people don’t choose their hours of work. Moreover, the folks with the most flexible schedules tend to have the highest incomes, which is again upside-down when you think about who has the toughest time balancing work and family

Anecdotes don't prove market failures.

There are lots of stocks that lost more money than the market indexes did last year.  There are lots of stocks that did a lot better than the indexes.  Neither of these outcomes overturns the efficient market hypothesis.  In any market outcome, there will be examples on both sides of a distribution.  A question to ask yourself would be, would an anecdote from the other side of the distribution be a convincing argument for a biased market?  What if Bernstein had said, "Look we all know people who shirk on the job.  We all see workers standing around at work sites or surfing Facebook at work or who go golfing on Friday afternoons.  Clearly workers should be working more.  So much for those pristine 'equilibration' assumptions."  Outcome variance could, in some cases, signal the opportunity to improve efficiency through better information and more precise individual price-setting.  But, it is not evidence of biased outcomes.

The fact that Bernstein chose to work in an office where part of the complex set of communications and expectations included an expectation of working past five may tell us something about Bernstein's personal choices, but it doesn't tell us anything about biases in work schedules.  In fact, most workplaces are divided between salaried and hourly jobs, where everyone knows the tradeoffs between those career tracks.  And, between workplaces or job types, even within salaried career tracks, there are myriad different tracks with different work expectations.  The existence of some tracks which call for more hours than some others says nothing about a bias in any direction.  The existence of so many different careers with different characteristics suggests otherwise, unless we just consider any constraint that employers carry with them into the complex set of ongoing negotiations about typical labor contracts to be a bias.  Is our baseline for a balanced life painting landscapes for 3 hours a day, and then meeting friends for tea, and any deviation from this is a bias imposed by corporations on our ideal work-life balance?  Surely Mr. Bernstein had options for hourly work that he could have taken in lieu of having those co-workers glaring at him at 5pm.  Have we come to a place where the existence of tradeoffs is considered a market failure?

At the base of all of this is the reality that if workers would work less if they could, in the aggregate, then they would also earn less.  There is no way around it.  And, there are significant life cycle issues with career tracks.  Even if the workers who are putting in the longest hours are the ones who report the least satisfaction with their work-life balance, this is not a sign of bias in workplace trends any more than the high satisfaction of the 60 year old playing golf and going on cruises is a sign that we don't work enough.  We make tradeoffs with ourselves, our employers, and our families.  We are rarely at the margin.  Bernstein says that many people don't choose their hours of work.  They don't personally negotiate the price of paper towels or the size of roasted chickens, either.  What does that have to do with market failures?

Work weeks have long been declining.

Bernstein refers to a study in Korea and Japan that finds a correlation between happiness and reduced hours.  To his credit, he notes that there may be cultural differences.  Korea and Japan have a cultural history of longer work weeks, and Korea especially has very long work weeks which are declining rapidly as their economy grows.  As a comparison, the US has an average work week of about 34 hours, which is similar to Japan and to the OECD average.  Korea has an average work week of about 42 hours, down from 48 hours as recently as 2000.  The US hourly work week has also declined over time.  As early as 1965, it was about 39 hours per week - still far below the current Korean level.  There is very little about Korean workweeks that would apply to American worker preferences.
And, since workweeks have been declining without tweaks in overtime labor rules, doesn't this suggest that labor trends incorporate worker demands without political coercion?  But, low income workers work the most, right?

The red line above is for all workers.  The lower blue line is for production and non-supervisory workers.  Here is Gallup data about workweeks.  Workweeks increase with income, education, and and age (until retirement).  This graph suggests that a large majority of the workers that would be covered by the new rule change don't work overtime, even without these rules.  And the trend is for more leisure time among low income and low education workers.

And, self-employed people work longer hours than employees.  All of these data suggest that there is significant value in long workweeks and that less productive workers are already engaged in an emergent set of negotiations setting norms for work-weeks which lead to shorter workweeks for employees, especially less productive employees.

I just find this to be astonishing.  There is a strong and clear correlation between people having more choices and control over their lives and people choosing to work longer.  And, the Obama administration and its supporters are specifically targeting the categories here that have the shortest workweeks, and they are making it illegal for them to choose the work-life balance that everyone else is choosing.  For those who earn below average wages, the Obama administration wants to put a 50% surcharge on their choice to work harder, even temporarily, to earn more money or to prepare for a potentially more rewarding career path.

I suppose those unbalanced, problem workers who are drawn to long work schedules (I mean, not as long as, say, your typical Washington Post columnist or White House staff, but still, I'm sure, too long for a healthy life balance.) could just become self employed.....well, if they don't need a license for their occupation.

One More Question About Market Failure

Why is this a presumed market failure to begin with?  If workers really don't want to work more than 40 hours, and if this overtime surcharge would cause employers to limit their hours and hire more workers, why wouldn't employers already be doing this?  What kinds of Dickensian hellscape do we work in that employers are widely forcing workers into job descriptions with more hours and more income those workers want, when they could hire more workers, and have a more healthy and happy labor force?

Here's another Bernstein piece for the Economic Policy Institute:
These provisions are important for covered workers, including 75 million hourly-wage workers, who value having a 40-hour workweek and earning extra pay when they work overtime. The right to a limited workweek provides time for leisure, civic participation, commuting, self-improvement, and tending to family and friends.
You have "the right to a limited workweek".  Put that in your pipe, huh?  There are debates about positive rights and negative rights.  I'm not sure what category this fits in.  How about imaginary rights?  The square root of a negative number.  Seems about right.

As Meyer points out, the junior management positions that might be moved from salary to hourly because of these rules are a typical stepping stone for low income, less educated workers to move into managerial career tracks.  All of the subtle signals involved in the difference between hourly workers and salary workers are an important, emergent part of the ongoing discovery process between workers and employers.  Overtime policy supporters can't imagine that low income workers want these choices, so those workers are stuck with these imaginary rights - the right not to do what most high income workers did do, but that some have decided low income workers shouldn't do.

This is the subtle problem that comes from the oppressed-oppressor paradigm that Arnold Kling associates with the progressive point of view.  Bernstein, for instance, has been confronted with many choices and tradeoffs in his life - some more difficult than others - some difficult enough to induce guilt or doubt.  One of the trickiest tradeoffs is work-life balance.  The life cycle of a modern American spouse/parent/worker has a peak in time demands in the 25 to 45 age range.  All of these factors are pulling at us.  We have a natural inclination to feel and show support for our families, so the work portion of these demands does not enjoy a rhetorical bias.  So, when we settle on our priorities, we naturally have a rhetorical bias against our work demands, and we sincerely have misgivings about choices we make that favor work.  These are difficult choices, not least of which because sometimes choosing work is in the best interest of our families, even when that means we sacrifice some of the other demands our families have on our time.  But, this is "near" stuff, as Robin Hanson would describe it.  This is the context of reality and tradeoffs.  So we make our decisions, and we carry the consequences in our consciences, never knowing if we chose correctly.

Where the oppressed-oppressor paradigm comes in is that this allows us to look at other people and remove those tradeoffs from the picture.  Jared Bernstein worked long hours because that was the difficult tradeoff required to be a sought after voice in the halls of power.  But, we can imagine low income workers as oppressed, so that their decisions are not based on tradeoffs, they are based on demands which we can presume those workers had no means to negotiate.  Removing tradeoffs from the picture pulls us away from the insights of economics, which deal with the difficulty of accounting for, or even knowing, tradeoffs.  And, it pulls us from the "near" to the "far", where we can imagine that reality is shaped by our ideals, instead of the other way around.  So, this paradigm, which begins with a sincere desire to empathize and help marginalized people, ends up creating a sort of elitism.  They are different than us, so we need to impose our ideals on them.

And, our ideals are imposed in a way that we would have never stood for in our own lives, lived in the "near".  A 50% jump in cost is huge.  There are arguments on the margin about 5% or 10% increases in the minimum wage.  But 50% is clearly not a cost factor that firms can simply swallow.  So, it is very common to see workers who have employers that are obsessive about keeping their hours under 40.  In the "far", 50% increases in cost don't have tradeoffs.  They are just a means to capture income from employers.  For many workers, who must live in the "near", this is effectively a ban on overtime, and to the extent that it extends the barrier between hourly and salary positions, it is a glass ceiling for workers who don't carry a set of credentials that pushes them over the threshold.

Supporters tell themselves it's for the best.  We had to live our lives in the "near".  It's refreshing to manage the lives of others in the "far".  The President's most recent announcement of the new rules contains no hint of the "near".  His world is the world that lies above accountability.  There are no tradeoffs - it is only greed and moral weakness that prevents us from creating the ideal world he imagines that we should.  The difference between high wage jobs and low wage jobs simply reflects the moral standing of the employer.  Employees are innocents, helpless but for the "hard work" of the social justice brigade.  And they will right this moral wrong by...instituting a 50% surcharge on employers of low wage workers who work a minute over 40 hours a week and putting obstacles between low status workers and salaried career paths.

This is why it is strange to associate progressivism with liberalism.  This is more akin to the worst sins of conservatism - the tendency to ascribe moral import to those things we most strongly choose not to understand.  Someone might take issue with some of the inputs that inform my pushback on this policy.  The President's rhetoric doesn't rise to that level.  It couldn't.  It lives in the "far".  To acknowledge debate - to enter the "near" - would undermine the position itself.  This is a cue to listen for when supporters of this rule speak, to separate the serious from the sectarian.  Bernstein's position might be wrong, but the President's rhetoric is simply banal.

So, by assuming income mobility away, we ignore the cost of  policies that destroy the seeds of that mobility.  Why can't the working poor accept that they have no ability to manage their own moral agency and that there are certain arrangements we can't let them accept?  Is being kept in your place with misplaced pity any better than being kept in your place with misplaced disdain?  Maybe that's the question Kansas was answering when we wondered what was the matter.

Tuesday, June 30, 2015

The era of idiosyncratic risk?

Previously, I referenced this blog post by Aswath Damodaran.  He was discussing the effect of cash holdings on the PE ratios of firms.  This first graph was from that post.  One of IW's perceptive readers noticed that the Damodaran chart seemed to imply a much higher level of cash holdings than seemed feasible.  Damodaran clarified that the chart included financial firms, which can have very large cash and cash-equivalent holdings, which did inflate the difference, relative to non-financial firms.  But, he noted that the trends were the same.

Since then, he has added another post, where he has included the effect of debt on PE ratios, and he also posted his data from the first graph, which includes non-financial firms and also separates the data between profitable firms and all firms (including those with losses).  His first graph only included profitable firms, because PE ratios can become incoherent when earnings are very low or negative.

I have used his data to create this second graph, which has PE ratios (both unadjusted, and adjusted for cash) for only non-financial firms.  Also, I have included the PE ratios for both all firms, and for only profitable firms.

I think there are a couple of interesting things to consider, here.  First, we can still see Damodaran's original point, though to a lesser extent.  For non-financial firms, this is inflating the aggregate PE ratio by about 2 points, and it is generally a new phenomenon of the past 15 years or so.  I suspect this is largely due to the large cash holdings typically seen in the tech sector.

But, possibly the more interesting issue to note here is how much of a difference it makes to filter out the unprofitable firms.  This is also a recent phenomenon, although it goes back more like 25 years.  I suspect this is also related to the digital revolution.

This suggests that before 1990, there were very few unprofitable firms.  Scott Sumner and I touched on this in our National Review article.  There is widening inequality among capitalists.  The digital revolution has created a winner-take-all dynamic that creates a much wider set of outcomes for firms than traditional industries experienced.  This also means that organizational life cycles have been shortened tremendously, and losses incurred by new entrants are at larger scales.  Think of the record-breaking IPO's in the 1990s of firms that don't even exist any more.

Returns to risk and variability of incomes have risen, globally, and among both human and physical capital.  Returns to a college education continue to rise, even as college attendance expands.  Super-firms like Apple have high returns based almost entirely on intangibles.  This is much more of a product of an emergent technological context than it is of some left-vs-right policy shift or tax regime.  One idea I hope to look at some more is the idea that increased variance and returns to risk may be an ingredient in the persistently high equity risk premium, low risk free rates, and high home prices.  In this context, safety demands a premium.  Could variance in capital outcomes become large enough that frictions in markets prevent the practice of efficient modern portfolio theory?  So, non-corporate low-risk securities take on more importance when diversification of equity portfolios is more difficult?  Could the inherent inability to diversify our human capital be a reason that American students seem to under-populate many STEM fields, in spite of their higher compensation potential?  Could it be that American students who can earn higher incomes in more generalized fields aren't willing to take on the high risk of the human capital imbedded in technical fields, but the payoff to foreign students with lower alternative income options is worth the risk?  The two trends themselves - significant numbers of firms with negative earnings and high levels of cash holdings - are probably also related.  Firms facing extreme levels of idiosyncratic whisk may be taking on large risk-free asset positions, within the firm structure, for the same reasons that savers are taking on large low-risk asset positions outside of firms.

Here is a chart of the number of profitable and non-profitable firms from Damodaran's data.  Today, profitable firms represent 86% of market capitalization, but only 39% of firms.  The total number of firms and the total number of profitable firms peaked in the late 1990s.  This seems like potentially bad news.  I would speculate that some of the increase in small, unprofitable firms could be due to changes in firm structure, so that modern financial innovations are allowing more early R&D to be done in new, small firms, instead of being incubated within large conglomerates.  But, if that were the case, I would hope that the total number of firms would be growing.  But this does suggest that we are in a stock picker's paradise, where there are thousands of potential turnarounds and home runs to find.

Recent research has found that "much of the 1970s-2010s increase in earnings inequality results from increased dispersion of the earnings among the establishments where individuals work. It also shows that the divergence of establishment earnings occurred within and across industries and was associated with increased variance of revenues per worker".  And, boy, doesn't this graph point to an obvious source for this change?  How many of those unprofitable firms are populated with development staff loaded up with stock options and working for the big payoff?  No wonder households want to load up on treasuries and real estate.

Even among profitable firms, there has been a re-characterization.  Compare Apple today to GM 50 years ago.  Apple has outsourced and offshored all the capital intensive, standardized, low-risk portions of its business, leaving high value-added, high payoff, high risk positions in the US within its corporate identity.  This is why Apple is practically nothing but intangible value.  They have only retained the pure value-added portion of the firm, and sent the rest of the business to the developing world that now has a competitive advantage in capital intensive production.

These sorts of optimizations can create benefits for everyone when there aren't frictions to obstruct them.  Our history of functional commercial institutions has created a context of relative safety and high incomes.  The developing world is improving its commercial institutions, but they aren't there yet, so wages are still low there, but rising quickly.  An interesting question for us to ask is, if variance in incomes is increasing, why aren't more Americans students majoring in fields with higher wages?  Maybe the impediments are too complex for us to solve.  Does more education funding solve the problem?  There appear to be opportunities in these fields that are going unclaimed now.  One solution to this is to import skilled technical labor help create America's technical advantage where we don't have local skilled labor to do it.  But, if that's a trade for a more efficient global economy, the other side of that trade isn't going to happen.  Low skilled laborers from the US aren't going to emigrate to Malaysia to find factory work.

These are all speculative ideas, but regime shifts like this could be creating many of the trends in investment and consumption that seem baffling or nefarious when viewed without accounting for changing context.

Thursday, June 25, 2015

Higher asset prices are not a Wall Street giveaway.

The value of a financial asset is the present value of future cash flows.  That value can generally be simplified to (1) current cash flows, (2) the growth rate of future cash flows, and (3) the discount rate applied to future cash flows.

I have been arguing that, for corporate assets, at least (of which equities are our proxy), the discount rate tends to be fairly stable over time, and most of the cyclical and secular changes in equity values are from changes in cash flows.

There seems to be a widespread belief in the idea that balance sheet expansion at the Fed has injected cash into asset markets, and has been a "bailout" of financial interests.  This is usually paired with the idea that the alternative would be some sort of fiscal injection or Federal transfer. In effect, the idea is that fiscal injections would increase consumption (ergo, current cash flows) while monetary injections increase asset prices instead of consumption (ergo, decrease the discount rate).

What if I am wrong about the relatively stable discount rate, and monetary injections are just inflating asset prices (reducing the discount rate)?  This is still not a "giveaway" to Wall Street.  Asset prices resulting from changing discount rates are simply a transfer from new owners to current owners.  Cash flows have not changed.  In the end, after all cash flows have been received, the only difference will have been that an owner that sold at t=0 would have received a one-time transfer from the new owner.  So, to the extent that this transfer leads to consumption from asset holders, there would be no net wealth effect, all things considered.  There would only be a transfer of consumption from the future to the present.

Now, I don't believe this is the primary result of monetary injections.  It certainly wasn't the case in the one undisputed period of loose monetary policy - the 1970s.  Both monetary and fiscal injections increase current corporate cash flows.  We can argue about which is the best policy and which types of injections do the best job of maximizing future growth while mitigating short term dislocations.

But, without getting into all of that, I am just pointing out that if any policy is a Wall Street giveaway, the interpretation of events that does not describe a Wall Street giveaway is the one where monetary injections "artificially lift asset prices" above the "fundamentals".

This is how some people characterize the housing boom of the 2000s.  I agree that there was a wealth effect during that period (although I disagree that it was artificial or based on a deviation from pricing fundamentals).  But, notice how in that scenario, where middle class households are the protagonists in the narrative, the narrative treats the wealth effect as a transfer through time, that had to be matched with reduced consumption in the bust.  But, when the narrative has "Wall Street" as the protagonist, the wealth effect is treated as a giveaway, or a bailout.

We like to populate our narratives with dupes and villains - "smart money" and "dumb money".  I think these sort of preordained narrative biases become self-fulfilling, leaving many with an attitude that there is some greatly over-estimated cabal of financial power mongers who have a "heads I win, tails you lose" stranglehold on the economy.  The erosion of trust this sort of narrative building creates leads to so much poor public policy, such as the supply constrictions I have been discussing in housing.


If discount rates are stable, then Wall Street gains from the other interpretations of cyclical policies are mainly the result of broad-based expansion of spending across the economy and higher expectations of future broad-based expansion.  Looking at profits + interest income + proprietors' income, total returns to corporate and non-corporate capital only have cyclical fluctuations of 2% or less, and haven't moved outside of a band of 4% since WW II.  In other words, even if all of the fluctuations in capital income were a product of some pro-Wall Street cyclical policy, it could only amount to a total capital price appreciation of about 10% between valuation bottoms and tops.

In fact, even that small amount of fluctuation is almost entirely the product of corporate profits recovering from the dislocation created by the contraction.  Once this dislocation is reversed, long term levels of capital income appear to be a very stable product of complex social inputs.

I have been commenting on the unusually high corporate earnings, relative to valuations, in the 1970s.  In the first graph here, we can see total capital income share bottoming out in 1970, after the long period of cyclical stability in the 1960s, and growing until it peaks in 1984.  But, even here, we are looking at an increase in share of GDI to capital of only 4% over a period of 15 years.  And, this was during a period of very low equity valuations.  The secular growth in capital income share during that period was more likely a product of slowing growth expectations associated with pro-consumption policies, a poor capital environment, and some amount of misattribution of the inflation premium portion of interest income.  (The inflation premium of nominal interest payments on corporate debt causes interest income to be overstated and profit to be understated.  On mortgage debt and consumer debt, the inflation premium overstates interest income and understates real savings for households.  But, the overstatement of interest income due to mortgage and consumer debt should tend to amount to less than 2% of GDI, with relatively little fluctuation over time.)

There is simply no modern era evidence of massive relative income grabs by capital.  It is probably impossible, or at least highly unlikely, for that sort of income transfer to take place in a modern liberal society.  Except for the exceptional burden equity holders accept of absorbing negative cyclical shocks, long term growth in capital income is a reflection of the rising tide of abundance.  We are the 100%.

Wednesday, June 24, 2015

The end of QE and the first rate hike

Since we hit the zero lower bound, there appears to have been a basic rule of thumb regarding forward interest rates.  When QE's have been in effect, the date of the initial rate hike has been stable.  When QE's have not been in effect, the expected date of the first hike has generally moved forward in time.  So, when QE3 was terminated while we were still firmly at the zero lower bound, one question I had was whether this pattern would continue.

So far it seems like it is continuing.

Now, there is something arbitrary about this, because it looks like the Fed will use interest on reserves to raise short term rates while there are still significant levels of excess reserves outstanding.  I presume that this will cause short term rates to rise more swiftly than if they were planning on simply raising rates with  open market operations.  I think there would be some deflationary effects of open market operations, even at the zero lower bound, as the balance sheet would be reduced.  Please correct me in the comments if I have this wrong.

In any case, even given the monetary tactics that have been proposed, which will begin with a hike in the policy rate target while there are still large quantities of excess returns, the expected date of the first hike has begun to move ahead in time as QE3 was tapered, and then finished.

In the second graph, which covers the time since the beginning of QE3, we can see that,  in February of 2015, the expected rate of the first hike was around 5 months away, in June 2015.  That's about when the expected date of the first rate hike was when QE3 began.  The expected first rate hike is still about 5 months away - in November 2015.

Before the taper began, the expected date of the first rate hike moved around quite a bit, even though it basically ended up where it began.  So, this idea isn't exactly pristine.

So, it will be interesting to see what happens over the next few months.  Will the expected date of the first rate hike stabilize?  Or, come December, will we be debating about whether the first hike will be coming in the summer or fall of 2016?  This will be data driven, as the Fed says.  One curiosity will be if Core CPI inflation moves up to around 2.5%, but this is composed of, say, 4% shelter inflation and 1.5% non-shelter inflation.  Will the Fed consider this a signal to raise rates?

Of course, I see mortgage expansion as the key, and if we see mortgage expansion then I think we will be very likely to see the date of the first hike stabilize.  The expected slope of rate increases is also near the low levels we saw at the beginning of QE3.  (The red line in this last chart is the slope of the yield curve - the rate of future rate increases.  The blue line is the expected date of the increase.  It is an inverted version of the green line in the chart above.)  If the expected date continues to move forward in time, I expect that the slope will continue to fall, as doubts build about the possibility of leaving ZLB.  The effect of a positive surprise in interest rates will probably mostly play out in an increase in the slope of the yield curve, and this is probably still the factor to watch on a speculative short bond position.  If mortgage levels continue to limp along without some sort of monetary stimulus or revolutionary change in the way we fund the housing stock, then interest rates and real GDP growth will continue to muddle along.

Tuesday, June 23, 2015

The difference between taxes and bonds, fiscal stimulus, and the 1970s equity puzzle.

In the previous post, I included this graph comparing the federal budget deficit with GDP growth over time.  And, it got me thinking more about the puzzle of low P/E ratios in equities in the 1970s.  In this graph, you can kind of visually see how high inflation can ease fiscal constraints.  Even though budget deficits were large in the 1970s, nominal GDP was growing fast enough to compensate.  The deficit didn't grow that much in the 1980s, but the end of high inflation policies meant that the nominal economy wasn't keeping pace any more, so public debt grew relative to GDP.

One issue I have been touching on lately is the extremely low P/E ratios of equities in the 1970s.  From a discounted cash flow perspective, equity values are a product of current earnings, earnings growth expectations, and the discount applied to those earnings.  These low valuations appear to have been related mostly to low growth expectations.  But, I don't see an obvious reason in the data why growth expectations would have been low.  (The mood of the time certainly conveyed low expectations, however.)

The effect of such high inflation on de facto tax rates could explain some decline in expected earnings growth, since firms would expect to be paying future taxes on what would amount to inflated return of invested cash.  But, I think this only explains a small portion of the unusual valuations.

I wonder if some of the dislocation of the time could be related to inflation in another way.  I find the debate over public deficits to be a little bit unsatisfying.  To me, when all is said and done, the main question at any point in the business cycle regarding public spending is, "Is it useful?"  I don't see much difference between tax-supported expenditures and bond-supported expenditures.  In either case, cash is being taken from the private economy and applied to some public expenditure.  In the case of the bond, I think this is most clearly thought of as a combination of two transactions.  The first transaction is the equivalent of a tax.  Cash (representing use of scarce resources) is transferred from private investment to a public expenditure.  The bond represents a promise of a future transfer.  If the government defaults on the bond, then we are left with just the tax, and the transfer is cancelled.

In the case of an inflationary policy, the bonds are paid back with devalued dollars, so it is, in effect, a partial default.  So, compared to the original set of promises, in the inflationary scenario the government is engaging in public consumption, investment, or transfers with funds that had been earmarked for capital repayment.  This could represent a significant negative shock to the capital base.  In effect, the government had pre-committed to re-injecting cash into capital markets, but ended up only injecting a portion of that capital into those markets.

A 20 year bond purchased in 1965 would have only received about 60% of its expected value back in real terms.

Since the inflationary policies of the late 1960s and 1970s reduced the expected commitment of repayment, they were like a one-time tax on capital.  It would take a lot of work to figure out treasury holdings by duration, inflation expectations, etc., to come up with a good estimate of the total, so I'm not sure I will get past the theoretical here.

Corporate enterprise values were stagnant during this period, both because of the very low equity capital levels and because of slower growth of debt capital.  We also see a sharp uptick in dividend yields in the 1970s, which we might associate with lower reinvestment and lower growth expectations.

But, on the other hand, private fixed investment was relatively high in late 1970s.  I don't have an explanation for that.

When corporate profits are taxed directly, the consequences are more subtle.  After tax profits are a product of complex social inputs which will tend to find their equilibrium, so higher universal corporate taxes tend to mostly lead to higher corporate pre-tax profits.  Here, we can see how after tax profits have been fairly stable over time (except for the large bump in the 1970s), while pre-tax profits have fallen as corporate tax rates have declined.  I think a similar outcome is true in terms of profit as a proportion of GDP, but to see it capital movement between proprietor and corporate, debt and equity, and domestic and foreign all need to be accounted for.

But, the tax burden of high inflation could not be passed on.  The terms of nominal repayment had been set by bondholders when the bonds were purchased.  This was a case where capital could be taxed without the ability to pass the cost on.  It seems plausible that this could be a significant factor in the high capital income levels of the time, relative to valuations.  There was simply a dearth of capital to re-invest.  And, this coincides with a period of low GDP growth per worker.

And, I suppose the opposite effect happened 20 years later when persistently lower inflation led to excess gains for treasury bond holders, and there was a period of unusual growth expectations.

There appears to be a correlation of high government expenditures with low real growth rates, over time in the US as well as across countries.  Outside of short run effects and adjustments, I doubt that it matters much whether this spending is funded through taxes or deficits.  But, to the extent that it is funded through fixed rate, nominal bonds, I think regime shifts in inflation levels might be correlated with a similar and significant change in growth rates that is not as easily noticed.

It is interesting that the positive (negative) inflation shock was associated with low (high) growth expectations, low (high) real interest rates, and high (low) equity risk premiums.  It might have been reasonable to expect real interest rates to increase in the high inflation 70s.  There was a real income shock in the low risk, fixed income market.  So, we might have expected to see capital pulled from risky investments like corporate equity, to rebalance portfolios, but not completely, because of frictions in asset allocation adjustments.  This would leave bond and real estate prices low (real yields high).  But, the rebalancing included an over-correction, so in the 1970s, portfolios included less equity and more fixed income. Albeit, rebalancing that went into housing did provide an inflation hedge that would have had value at the time.

The opposite happened in the 1990s, where the fixed income windfall didn't lead to an excess of fixed income investment.  Real interest rates were high and housing price/rent ratios were low in the 1990s.  Not only did some of those gains go into investments with cash flow risk; apparently all of the gains and more went into investments with cash flow risk.

And, given this over-rebalancing, we might expect that total required returns on corporate capital (the risk free rate plus the equity premium) would have gone up during the 1970s (down during the 1990s), as the dearth (excess) of risk-seeking capital would have bid down (up) corporate assets.  We do see valuations move down (up) relative to earnings, but the change in valuations appears to be explained by changing growth expectations, not changing total expected returns.

The over-rebalancing may be due to the possibility that low risk investments are a sort of financial Giffen good.  As the price of homes and fixed income securities rise, relative to their cash flows, demand for them increases.  Since rent and supply are relatively stable in housing, this happens naturally in home equity and mortgage levels as implied yields change.

Maybe, thinking in terms of low risk interest rates as a sort of discount from a relatively stable at-risk required rate of return, there is a sort of market segmentation, and there is a relatively inelastic demand for a set amount of low risk real income.  When the relative rate of low risk income declines, this segment of the market has to swap more capital with the risk-taking segment in order to maintain its level of income.

Maybe the transfer of capital from private markets to public expenditures, either through the inflationary fixed income shock or through changes in relative Federal spending levels, change growth expectations, and this is what causes valuations to fluctuate through growth expectations instead of through at-risk return requirements.

As usual, please post references in the comments if you know of good literature on this idea.

Friday, June 19, 2015

The 2013 Austerity Debate

Scott Sumner went into the issue of the 2013 austerity debate some more, at Econlog.

Here is some of what, Russ Roberts, Simon Wren-Lewis, and Paul Krugman, have added.  Others have weighed in.

This whole episode began in early 2013, when Krugman said: Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens... Sorry, guys, but as a practical matter the Fed - while it should be doing more - can't make up for contractionary fiscal policy in the face of a depressed economy.
This was in response to the sharp fiscal consolidation that was legislated in late 2012.  Here is a letter, signed by 350 economists at the time, which included the following comments:
As Great Britain, Ireland, Spain and Greece have shown, inflicting austerity on a weak economy leads to deeper recession, rising unemployment and increasing misery....Public outlay for jobs and recovery come first, growth is restored, and revenues follow...We can also stimulate recovery without increasing deficits by increasing taxes on the wealthy and pumping the proceeds directly into the economy...At the end of the year, we face a congressionally-created "fiscal cliff," with automatic "sequestration" spending cuts everyone agrees should be stopped to prevent a double-dip recession.

Suffice it to say, after significant fiscal consolidation was indeed put in place, economic and employment growth in 2013 pushed ahead at about the same pace that they had been.  The market monetarists took a victory lap.  But, Krugman's response was:
Incidentally, these other factors are why I don’t take seriously the claims of market monetarists that the failure of growth to collapse in 2013 somehow showed that fiscal policy doesn’t matter. 
In Krugman's latest post on the matter, he says:
And while it’s true that there was limited direct evidence on the effects of fiscal policy 6 or 7 years ago, there’s now a lot, and it’s very supportive of a Keynesian view.
Here is a close-up graph of the periods, using Quarter-over-Quarter GDP growth (annualized).  Below is a picture of long term GDP growth (real and nominal, Year-over-Year) and the Federal budget deficit.  One can easily see how worrisome the 2013 budget would be to anyone who believed that it would have a strong effect on growth.  Many of the changes in the fiscal budget in the past have been the product of shocks in GDP.  It looks to me like this is an unprecedented incidence of a sharp contraction in the Federal budget during a period of stable GDP growth.  And the contraction was, indeed, very sharp.


The quarter-over-quarter numbers are a bit noisy, so there has been some argument over start and end times, but, basically nominal GDP growth had been between 3 1/2% and 4 1/2% since 2010 and has continued at that pace during and since the sharp consolidation period.  Krugman implies that there was some exogenous factor that would have made growth in 2013 more like 5% to 6 1/2% in 2013, which I guess implies a multiplier of about 0.4, since the consolidation was about 3.5% over 2 quarters.  Actually, annualized GDP growth was around 5-6% in 2013 3Q and 4Q, but as I said, the quarterly numbers are noisy.

Wren-Lewis produces this chart, where the "no austerity" counterfactual is based on 2% growth in federal expenditures, and he assumes a multiplier of 2, which produces a hypothetical growth rate similar to the pre-recession level.  Presumably, this means that Wren-Lewis thinks that NGDP growth would have jumped to 11% in 2013, if not for the sharp fiscal consolidation.  (edit: Wren-Lewis has a new post up, calling Sumner a liar.  It looks like Wren-Lewis is using a multiplier of 2 for government consumption and investment, and a 0 for taxes and transfers.  That's why his counterfactual looks so straight through 2013.  So, by this model, there was nothing special about 2013, since most of the consolidation was from transfers and taxes.  So, I guess Wren-Lewis' position is that "austerity" in 2013 was not really any different than the previous couple of years.  This would seem to be a third position, different from both Sumner and Krugman, since by this measure, there wouldn't be anything particularly definitive about 2013.  So, Wren-Lewis would apparently object to some taxes on fairness grounds, but not on cyclical grounds.)

Much of the consolidation was from tax increases.  So, maybe those who think the test failed don't think that tax increases are as damaging as spending cuts.  But, then, why were they so worried to begin with?

But, keep in mind, on the argument of federal expansion vs. contraction, this suggests that both spending and tax changes are subject to monetary offset.

If we look at inflation over the post-recession period, it seems to corroborate the monetary offset point of view.  During QE1 and QE2, treasury rates rose as QE was implemented, mostly due to higher expected inflation.  Then, with some lag, consumer inflation would also rise.  Then, as each QE was phased out, inflation, expected inflation, and treasury rates would subside.

I was taking a short bond position when QE3 was implemented.  But, I didn't fully account for the effect of austerity.  Here we can see how fiscal consolidation might explain the difference between QE3 and the earlier QEs.  Inflation expectations rose during QE3, pretty much as they had with QE1 and QE2, but actual inflation was flat, and treasury rates remained flat until 2013 Q3, when treasury rates suddenly rose.  That just happens to be when consolidation stopped and the federal deficit settled in at the new, lower level.  The missing inflation during QE3 is right about 1.5-2% compared to QE2, which is about how much of a fiscal drag Krugman seems to have been expecting.

Even if there was monetary offset here, a question might be whether the Fed would have done QE3 anyway.  So, maybe we are seeing monetary offset, but if the fiscal consolidation hadn't taken place, we would have been looking at 5-6% NGDP growth in 2013 and 2.5% rates on 5 year treasuries.  Maybe we would be off the zero lower bound by now, if that had been the case.  Sumner points out that the Fed is tightening now, even in the face of recently declining inflation and GDP growth, so it seems unlikely that they would have continued with a strong QE3 policy if NGDP had risen above 5%.  Home prices were appreciating by 5% to 10% annually during QE3.  If fiscal accommodation would have pushed that up higher and if consumer price inflation had been higher, it seems likely that they would have pulled back on monetary accommodation sooner.

Could the outcome here have been any more in line with market monetarist expectations?  And, looking at the first large graph above, is there any justification for saying that holding the fiscal deficit at nearly 10% for 5 full years as an economic stimulus has undeniable empirical support?

Here are two posts by Mark Sadowski on the issue, and some more of his analysis, via Scott Sumner.  A while back, I looked at some IMF data that suggested the main issue regarding the fiscal balance was having a positive budget level before the recession with a follow up showing the difference between Euro countries and the rest of the developed world..

Thursday, June 18, 2015

May 2015 Inflation

It looks like CPI measures across the board took a breather this month.  Year-over-Year measures are moving generally sideways.  Core inflation is at 1.7%, which is a combination of Shelter inflation running at about 3% and Core-minus-Shelter inflation, running at about 1%.

This has been the pattern since the mid-1990s, except for the 2003-2005 and 2012-2013 periods, which were the only periods where aggregate housing supply was expanding strongly enough and monetary policy was accommodative enough for housing inflation to fall and non-housing inflation to rise to the ostensible target of 2%.

Constrictions on building in the major California and Northeastern metropolises mean that target-level monetary policy is associated with significant home price appreciation (10% and higher).  It seems to me that until the large metro areas fix their housing problems, it will be difficult for monetary policy to hit our targets over the objections of those worried about home prices.

Wednesday, June 17, 2015

Housing Tax Policy, A Series: Part 40 - Yellen on 2004-2006 and More Notes on Rent Inflation

From the Dow Jones news feed from today's press conference:

Federal Reserve Chairwoman Janet Yellen said Wednesday it's possible the central bank might have needed to raise rates more quickly in the 2004-2006 period to prevent overheating in housing and financial markets. "Conceivably I think with the benefit of hindsight it might have been better to raise rates more rapidly or more during the 2004 to 2006 cycle.
You know, I'm not certain of that judgment but I think there is a case to be made." Ms. Yellen said during her press briefing.
That was a shift in tone for the chairwoman, who has previously dismissed claims that low interest rates helped fuel the housing bubble and subsequent crash.

By the end of 2006, the Fed Funds rate was 5.25%, the 10 year treasury rate was at 4.56%, and YOY currency growth was falling below 3%.

In the inflationary 1970s, forward rates would tend to rise along with short term rates.  After the 1990 contraction, rates again followed the same pattern, but the upward movement during the recovery was weaker than the downward movement had been during the contraction.  Inflation remained low as the yield curve flattened in the last half of the decade.  But, after the 2000 contraction, while long term treasury rates began to rise, in anticipation of Fed rate hikes, the forward rates failed to show a consistent move upward.  So, instead of seeing rates move up with the Fed Funds rate, across the yield curve, short term rates were moving up but long term forward rates were stagnant.  By the time the Fed started moving the target rate up in 2004, forward rates were declining.  As far as I can tell, there isn't a precedent for this.  Forward inflation expectations were stable during this time.  This was a decline in real long term forward rates.

I wish that forward rates were more commonly used and tracked.  Looking at forward rates makes it much easier to separate long term expectations from the effects of short term target rate behavior.

My poor-man's estimate of the forward 7 to 10 year treasury rate in this Fred graph fell from 5.6% in June 2004 to 4.6% in February 2006, while the Fed Funds rate rose from 1% to 4.5%.  All rates then moved together as the Fed Funds rate rose to 5.25% by July 2006, after which the yield curve inverted and 7 to 10 year rates fell back to around 4.6%.

In the next graph, I have pulled future expected rates from the Office of Thrift Supervision Asset and Liability Price Tables , which I think are only available from 1997 to 2011.  I have just shown the numbers here for June 30 of each year.  (I included rates up to 360 months, but 30 year treasuries weren't issued from 2002 to 2005, so the 360 month number from those years may have a wider potential error.)  This also shows falling forward rate trends for the entire period, including the period where the Fed Funds rate was rising and the Fed was supposedly dangerously accommodative.

As Scott Sumner points out, the Fed has just been following economic consensus, and in the quote above, we can see Yellen being pulled in this direction.  Is there any basis for claiming that monetary policy is accommodative during a period where long term inflation expectations are level and forward real rates are declining?  Yet this is what everyone claims.  Even those who are with me in fingering monetary contraction as the cause of the financial crisis and most of the housing default crisis tend to accept that there was some period where the Fed was imprudently accommodative.

The singular source for this idea seems to be the strong price appreciation in housing.  I had originally suggested that it was the long-running trend of tight monetary policy that had caused home prices to accelerate in the 2000s by pulling down long term interest rates.  Low real long term rates were increasing the intrinsic value of the homes while low inflation expectations were lowering the monthly payment on mortgages and removing an obstacle to demand.  During the housing "bubble", those real rates were probably mostly an exogenous factor, but at this point their continued decline is a product of market distortions coming from the crisis and disastrously tight policy.

But, as I have proceeded through my series on housing, I have been coming more to the point of view that our housing supply problem is mostly to blame.  In this graph, I constructed a simple model of home prices based on actual rent inflation and interest rates, and compared that to counterfactuals with stable inflation and real interest rates.

All the indexes begin in 1995 at around 80.  In 2006, the Case-Shiller National Index had grown to 184 and the 10 city index had grown to 225.  My modeled home price indexes (based only on rent levels, rent inflation, and real interest rates) tend to be a little noisier than the Case-Shiller indexes, and they come in a little low in 2006, at 173 and 196.

The counterfactual home price index with stable real interest rates and no excess rent inflation (rent inflation equal to core inflation ex. rent) rises to 99 in 2006, and the counterfactual that uses actual real interest rates but without the excess rent inflation rises to 116.

That suggests that only 1/4 of the price increases during the boom were related to low real interest rates.  Three-quarters of the excess price increases, according to this model, were related to rent inflation - to the housing supply problem.  (A small amount may also have been related to lower barriers to home buying demand because of the low inflation premium on mortgage payments, but I think this was small compared to the other effects.)

So, the housing supply problem has caused consensus demand for tight monetary policy because it has caused inflation to be higher due to persistent supply problems.  But, indirectly, it has led to a consensus for tight money because of the tendency to blame the home price "bubble" on speculative demand.  If the house price "bubble" was largely a supply phenomenon, the evidence overwhelmingly points to a general position of tight monetary policy throughout this period.  As I have pointed out, Core CPI inflation less Shelter has been consistently below 2% since 1998.  Currently Shelter inflation is running at 3% and Core minus Shelter inflation is at 1%, YOY.

Since the crisis, the low real rates that have been created by the crisis have become the overwhelming factor in pushing up the intrinsic value of the national housing stock.  But, this is a disequilibrium.  If we allow the home market to recover, rates will rise.  The supply problem will not be solved, so the prices paid in the 2000s will be vindicated.

The question is, how many decades will it be before we stop calling it a bubble?

Tuesday, June 16, 2015

Looking some more at an at-risk based interest rate model.

In the previous post, I discussed the possibility of using the at-risk rate as the starting point for discount rate models instead of the risk-free rate.  This rate seems to be fairly stable over time, allowing it to be a useful benchmark.  From this we would first deduct a "fixed income" discount.  This would get us to a simple version of the Capital Asset Pricing Model, where required returns on equity are equal to the risk free rate on long term bonds plus an Equity Risk Premium (ERP).  I would treat the ERP as a discount from the at-risk rate for avoiding cash flow uncertainty, rather than a premium added to the risk-free rate for taking on uncertainty.  This is semantic, but I think it is a first step toward a more coherent framework for thinking about market values over time.

Then, there is a further discount within fixed income for maturity, which is the discount one accepts for avoiding duration risk.

Cyclical Movements in Long Term Interest Rates

Imagining discount rates in this way gives a different flavor to monetary policy, I think.  The Fed tends to focus on short term rates.  But, if we look at, say, the iShares Core Aggregate Bond Fund, a benchmark for the high quality bond market, it has a long-running average duration of around 5 years, which is between the duration of 5 year and 7 year treasuries.  This is the duration of the typical fixed income security in the US economy.  So, the movement of rates among these durations is a more accurate measure of credit markets than movement of overnight rates.

One signal of cyclical disequilibrium is the discount accepted for avoiding duration risk.  It seems like, if we are using interest rates as a measure of monetary policy, a better signal of optimal policy would be a quickly recovering short term yield, which would be reflected in compression of rates among the higher durations.

Here is a graph of several durations of treasuries.  Note that 5 and 7 year treasuries move more closely in line with long term bonds than with short term bills.  Deviations in short term rates tend to reflect steep short-term yield curves, where rates are expected to fairly quickly recover (excepting the recent zero lower bound problem).

Before 1990, 5 and 7 year rates remained very close to long term rates throughout the cycle.  And when short term rates rose, long term rates tended to rise also.  In the 1991 contraction, we began to see periods where 5-7 year rates pulled down below long term rates, reflecting an expectation of slow recovery.  A lack of any inflation recovery during this time suggests that short term interest rates were not below the natural rate.  (It is worth noting that throughout the 1980s, the yield curve was fairly steep at the very short end, and flat at the mid and longer ranges, even while inflation was plummeting and remaining low.  Rates at the very short term range don't have that much of an effect on at-risk investment.)  But, when short term rates did rise in the 1990s, long term rates compressed and the full range of durations rose with them.

In the 2000s, we continued to see these extended periods where 5 to 7 year rates fall below long term rates.  And, in the 2004 recovery period as well as today, the Fed is raising short term rates while that separation remains.  And, long term rates did not rise with short term rates.  So, compression happened, not as a function of recovered long term risk perceptions, but because of Fed tightening.  By the end of 2005, after the recovery of inflation from the very low levels of the recession, much of the excess inflation was coming from this premature tightening, which cut the bottom out of new housing starts, and sent rent inflation soaring.  Core inflation (less shelter) never crossed above 2% except for a couple brief periods in 2008 and 2010.

There is an assumption that the low short term rate was funneling cheap credit into risky investments, but a steep yield curve at short durations had been the norm for 20 years in a declining inflation environment, and, if we look at this from the long-term at-risk point of view, with discounts for risk aversion, the unusual spread between 5-7 year treasuries and long term rates was signaling risk aversion among savers.

Today is even worse than in 2004, because then the brief housing recovery did reduce shelter inflation before the tightening undermined new building.  Today we are already dealing with rent inflation and a lack of building.  A bold loosening in mortgage markets could counteract monetary policy now, but while there have been some signs of that, a full recovery of mortgage growth might require several fundamental shifts in the banking sector that would give borrowers with less than perfect credit access to the market, and this portion of the market seems totally blocked out right now.

So, looking at this from a bottom-up perspective, the Fed could raise short term rates to 2%, compressing long term rates from the bottom.  And, they could be looking at 2.5% inflation that is really 1.5% after factoring in the lack of housing supply, and they would think that low long term rates are stimulative, and high inflation is a sign of overheating.  If we are using interest rates as our monetary communication device, wouldn't it be nice if the Fed announced that they wouldn't begin to tighten until 7 year rates converged toward 30 year rates?

Secular Movements in Long Term Interest Rates

I had speculated that there could also be a secular benefit to seeing rates from this perspective, and that high long term rates and a low ERP (reflecting a low fixed income discount) would change the shape of investments, pushing investments into longer-focused, more risky projects.  Qualitatively, this seems to have been the case in the late 1990s, where a very low ERP was coincident with the internet boom.

Of course, the 15 years since then have not exactly been heralded as an era of high growth.   But, if we look at real GDP / Labor Force growth, there is actually a seemingly tight relationship between stock returns and GDP/LFP growth.

My proxy here for bond returns is based on the interest rate of Moody's AAA corporate bond yields.  There is not a systematic relationship here because long-term persistent trends in inflation have had a large effect on the real returns on fixed rate nominal bonds.  Although, the return on real bonds doesn't necessarily look like it would have any more systematic relationship to GDP growth.

The lack of a bond relationship suggests that my speculation doesn't hold.  Even if the theory can be defended, it looks like future growth is overwhelmed by real and nominal shocks.  So, it is the real GDP growth that is the causal factor in the relationship between equity returns and GDP/LF growth.

GDP growth is on the right scale and stock returns are on the left scale.  Long term stock returns follow pretty closely alongside GDP/LF growth rates, but with a scale about 10 times larger.  Over time, equities gain (lose) from the proportional rise (fall) of GDP, but much of the gain in returns should be coming from related higher (lower) growth expectations, since required total returns are fairly stable.  Here is a graph of total required returns to equity, based on Damodaran's measured ERP.  There is a bit of a dip in the early 70s and a bump in the early 80s, but this is partly due to the difficulty of estimating real bond rates during volatile inflationary periods.  Inflation expectations would be somewhat backward looking, and would depend on expectations of Fed behavior.  I have simply deducted GDP inflation from bond rates, here.  Inflation expectations were probably a little lower than actual inflation in the early 70s and slightly higher than actual inflation in the early 80s.  So, there was probably a brief period of higher required returns in the early 1980s, but not as pronounced as it looks in this graph.

To the extent that there was movement in the required total return, a low discount rate in the 1970s would have called for a higher relative valuation and the high rate in the 1980s would have called for a lower relative valuation, so this was working in the opposite direction of equity price trends and growth expectations trends, at any rate.  The idea of a low ERP being a policy target that would raise future growth levels appears to be weak.  ERP levels appear to be a lagging indicator.  So, they tend to decline when business cycles have been long and shallow.  Low ERPs are less a guarantee that we will do well than a sign that we have been doing well.

Equity Risk Premiums and Capital Income

But, even though low risk aversion either doesn't improve our capital allocation decisions or doesn't overcome the uncertain noise of real shocks, in the here and now, where the future has not yet been manifest, it still has an effect.

"dlr" left some great comments on the previous post, and put some firm doubts on the idea that corporate income wasn't down as sharply in the late 1990s as the BEA suggests.  But, I believe that there is still evidence that stability and high real growth expectations are related to current high compensation levels.

I don't ascribe to the notion that transfers from capital to labor are something good, in and of themselves.  Labor income is measured in terms of time, but capital income is measured in terms of time and risk.  So, this is a sort of free lunch.  In times of low perceived risk, capital owners gain the same level of utility from less income.  Naional income has risen, even if we don't have a simple way of describing or measuring it, because the rise is coming from a change in capital's denominator (risk).  Some of that unmeasured extra income accrues to labor.

These are a couple of graphs that I have shown before, along these lines.

And, real wage growth moves pretty strongly with the unemployment rate.  Here are a couple of graphs comparing real wage growth and the unemployment rate, first in a scatterplot, then in a line graph.  Nominal stability leads to higher growth expectations, lower ERP, lower unemployment, and higher wages.  And, these are hourly wages of production workers, so confusion caused by stock options and returns to entrepreneurs in the 1990s should not have an effect on this measure.  In fact, I would argue that real wage growth has been understated since 1995, since some of the inflation is coming from the supply problem in housing.

The Beveridge Curve moved to the right in the 1970s and early 1980s and appears to have shifted back to the right again recently, due to persistent unemployment.  Job openings during these high ERP periods appear to remain at normal levels, but unemployment rises.  That suggests that job openings per unemployed worker is not as large of a factor in real wage growth as the unemployment rate is.

One common bit of wisdom that I think is mistaken is that low unemployment will lead to inflation from rising wages.  But, I think employers are too forward looking for this.  They don't tend to raise wage rates in an inflationary response to temporary labor supply factors.  There are too many frictions related to their many cost considerations for this to happen.  The lack of a wage response to job openings corroborates this idea.

Instead, real wage growth is related to unemployment levels because the growth in wages is coming from labor supply.  In a low risk environment, employees are more free to move to higher productivity positions and better matches for their skills and characters.  Real wage growth comes from better job matching and more fluid labor markets.  In a way, the unemployment rate is a proxy for labor's "ERP" - the Employee Risk Premium.  And, this ties into the idea that lower ERPs lead to higher wages.

Another way to look at this is to think of an employment contract as having an embedded interest rate swap, where the employer naturally takes on the residual cyclical risks.  When ERPs (both kinds) are low, the discount that employees must accept in their employment contracts is lower, and wages are higher.  But, again, this comes from a complex foundation of risks, so the higher wage it leads to is higher in real terms.  The employer does not need to compensate with higher revenues because they are being compensated through lower perceived risk.