Binky Chadha: Non-investors are overweight stocks

With the Dow closing near 12,000 today, I thought I'd peruse the CNBC (First in Business Worldwide) webpage to see what analysts were talking about. I'm not sure why I do this...I am almost always left scratching my head afteward. A deficiency on my part, no doubt. Maybe some of you out there can lend me a hand.

Take this, for example. Here is a CNBC segment entitled "Pick a Pro's Brain," a short interview with Deutsche Bank's Binky Chadha labeled "Investors Are 'Very Underweight' Stocks." The entire interview sounds like gibberish to me. The man is speaking in a language that I trouble understanding.

What does it mean, in particular, for investors to be underweight stocks?

I think we can all agree that the outstanding stock of equity shares is owned...by someone, at least. It is therefore impossible for the population as a whole to be under or overweight in stocks. It is only possible for different groups holding different positions to be considered  under or overweight.

Now take the set of potential owners. It appears that this set can be divided into two subsets: investors and non-investors. I'm am not entirely sure what governs this division.

In any case, the claim is that investors are underweight stocks. Fine. But simple arithmetic then implies that non-investors must be overweight stocks.

So I am wondering: Is this, in fact, what Binky is saying? And if it is indeed what he is saying, then why is knowing this interesting, and how is knowing this important?

Holier than thou

Took a bit of a break from blogging lately. (I do have a day job, after all.) Unfortunately, I peeked into the blogosphere. Couldn't help it. Big mistake!

Exhausted by economic analysis, Paul Krugman has decided to stump from another pulpit these days. See here: A Tale of Two Moralities (via interfluidity).

Ah, the moral high ground...how intoxicating!  The conscience of a liberal...I am reminded of Gordon Liddy's gem:

A liberal is someone who feels a great debt to his fellow man, a debt which he proposes to pay off with your money.

According to Krugman, there is a "great divide" in America today. What defines this boundary?

One side of American politics considers the modern welfare state — a private-enterprise economy, but one in which society’s winners are taxed to pay for a social safety net — morally superior to the capitalism red in tooth and claw we had before the New Deal. It’s only right, this side believes, for the affluent to help the less fortunate.

The other side believes that people have a right to keep what they earn, and that taxing them to support others, no matter how needy, amounts to theft. That’s what lies behind the modern right’s fondness for violent rhetoric: many activists on the right really do see taxes and regulation as tyrannical impositions on their liberty.

There’s no middle ground between these views.  

Is this really an accurate characterization? To me, the divide seems to be defined more over the issue of who (or what body of institutions) should be trusted with the job of redistributing wealth. On the left, we have those who believe that a central authority is best suited for this job. On the right, we have those who believe that local governments, or private philanthropic institutions, are better suited for this job.

I do not believe that those with a libertarian streak (like myself) appreciate being demonized for, say, opposing a tax hike by the central government. I might oppose such a tax and at the same time favor a tax hike at the state or local level (if I thought the funds are to be put to good use). I might be against a tax hike altogether, and be in favor of redistributing existing government expenditures away from the military and to the disadvantaged. Or, I might just want to keep more of my money so that I have greater control over how to disburse it among competing charities. The "liberal" attempt to construe any of these positions as "immoral" along some dimension is, well, simply shameful, I think.

AIG Repays the Fed

New York Fed Ends AIG Assistance with Full Repayment
For release at 12:25 p.m. EST on January 14, 2011

NEW YORK – The Federal Reserve Bank of New York (“New York Fed”) today announced the termination of its assistance to American International Group, Inc. (“AIG”) and the full repayment of its loans to AIG as a result of the closing of the recapitalization that was announced on September 30, 2010. As of today, AIG will no longer have any outstanding obligations to the New York Fed.

Today’s closing represents a substantial step toward achieving the Federal Reserve’s dual goals of stabilizing AIG and ensuring its repayment of government assistance. It reflects the significant progress AIG has made in reducing the scope, risk and complexity of its operations and stabilizing its operating results. The accelerated repayment of the New York Fed frees up collateral that will enable the company to access private debt markets, an essential step toward facilitating the U.S. Department of the Treasury’s future sale of the common stock it owns.

"This concludes an important effort by the Federal Reserve to stabilize the financial system in order to protect the U.S. economy" said William C. Dudley, President of the New York Fed.

With today’s closing of the recapitalization, the New York Fed’s revolving credit facility has been fully repaid, including interest and fees, and its commitment to lend any further funds has been terminated ahead of the credit facility’s scheduled expiration in September 2013.

In addition, the New York Fed has been paid in full for its preferred interests in the AIA and ALICO special purpose vehicles. A portion of those interests has been redeemed with proceeds from AIG’s sale of ALICO to MetLife, Inc. The remaining interests have been purchased by AIG through a draw on the Treasury Department’s Series F preferred stock commitment and transferred to the Treasury Department.

The closing of AIG’s recapitalization also marks the termination of the AIG Credit Facility Trust, which was established to hold an approximately 79 percent controlling equity interest in AIG for the sole benefit of the U.S. Treasury, the general fund of the U.S. government. The Trust’s equity interest in AIG is being exchanged for common stock of AIG and transferred to the Treasury.

“We are grateful to Jill M. Considine, Chester B. Feldberg, Peter A. Langerman, and Douglas L. Foshee for their invaluable contributions and commitment to the execution of their responsibilities as Trustees,” Mr. Dudley added.

About the Federal Reserve’s actions related to AIG

In September 2008, the Board of Governors of the Federal Reserve System authorized the New York Fed to provide AIG with an emergency loan of up to $85 billion to prevent its disorderly collapse, which could have had catastrophic consequences to the U.S. economy during the most damaging financial crisis in 70 years. The assistance provided by the Federal Reserve was restructured over time, and was supplemented in November 2008 and April 2009 by additional financial assistance from the Treasury Department under the Troubled Asset Relief Program.

As part of the November 2008 restructuring of the government’s assistance to AIG, two special purpose vehicles, Maiden Lane II LLC and Maiden Lane III LLC, were created with loans from the New York Fed to purchase various mortgage-related securities in order to address AIG’s capital and liquidity strains. The loans extended by the New York Fed to the Maiden Lane II and III facilities remain outstanding and are being repaid from the assets in those facilities. The fair values of the portfolios well exceed the balances of those loans.

Irrational exuberance over the balanced budget multiplier

Christmas time is the most magical time of the year. A time to believe in elves, talking reindeer, snowmen running amok, and...for some economists, the Keynesian cross.

The Keynesian cross. We (the economics profession) like to etch it deeply into the minds of fresh undergraduates, one cohort after another, year after year. Is it any surprise that for most educated laypeople, this is the only macroeconomic language they understand?

And here is a Christmas gift--from Professor Robert J. Shiller--to those of us who have been primed since youth to be receptive to this sort of message: Stimulus, Without More Debt. The argument for why a tax-financed increase in government spending will work is summarized as follows:

The reasoning is very simple: On average, people’s pretax incomes rise because of the business directly generated by the new government expenditures. If the income increase is equal to the tax increase, people have the same disposable income before and after. So there is no reason for people, taken as a group, to change their economic behavior. But the national income has increased by the amount of government expenditure, and job opportunities have increased in proportion.

In other words, the Keynesian cross (formal exposition available here). Econ 101 in action, kids!

So what, pray tell, is your beef with this, Mr. Grinch?

First, it's not that I have anything against the Keynesian cross, per se. I can appreciate the basic idea it is trying to convey. And it's just a simple model, after all--it seems silly to hold a personal grudge against an inanimate object. What I am against is in placing it (or any other economic theory, for that matter) on an exalted alter. Models should not, in my view, be worshipped in this manner. And while I'm on the subject of religion, I'm also against beginning an argument with a preordained conclusion (in this case, that more stimulus will certainly be needed, because unemployment is high).

Having said this, I think that the Keynesian cross is a delightfully perverted object. It can be (and has been) used to support almost any type of government appropriation. In fact, I feel like writing a letter myself to this end.

Dear Congressman:
The economy is in dire need of help. It needs to be stimulated. I am willing to stimulate it, with your help.
To this end, I ask that you appropriate a sum of $X from my fellow citizens and divert this money to me.
As this money does not belong to me, I promise to spend it...to return it to my fellow citizens, so to speak. Of course, I will make them work for it...given the clear want of work in our present economic climate. The income so earned in exchange for their idleness will undoubtedly be spent--adding income to the pockets of everyone. No one will even notice the initial appropriation, as all of the money borrowed will be returned in the manner just described.   
Signed (your name); noble servant of society.

Now, try to imagine everyone writing this letter and that Congress acts accordingly. I hope you can see as well as I how nothing but good can come of this. Whatever the ailment, the cure, evidently, is to increase spending. Indeed, to force people to spend if they refuse on their own. When the Keynesian cross is your hammer, every macroeconomic problem nail looks like deficient demand. 

Second, it's not that I don't believe that an increase in G will lead to an increase in Y. There is evidence that it can. Heck, even standard neoclassical theory says it can. Whether it does or not in a given set of circumstances is a different matter. And even if it does, it is not entirely clear that increasing Y in this manner is socially desirable. It may be. Or not. It depends on a lot of things. I do not view the proposition as self-evident and beyond critical examination. In contrast, according to Shiller:

But the balanced-budget multiplier is simpler to judge: If the government spends the money directly on goods and services, that activity goes directly into national income. And with a balanced budget, there is no clear reason to expect further repercussions. People have jobs again: end of story.

(Don't you love it when you are granted license to stop thinking? End of story, indeed.)

Third, its not that I'm against increasing (components of) G. Public works projects of the sort mentioned by Shiller (building highways and improving our schools) were advocated by sensible economists long before Keynes (as evidence of this, note that public works were implemented in the Depression well before publication of the General Theory). What I have a problem with is in using some silly theory to support the notion, for example, that taxes should be raised to finance a large public capital expenditure. Shiller has been rightly celebrated for his work in the theory of finance, and on asset price bubbles in particular. But is this not a rather odd stand to take for a professor of finance?

Now, I'm no expert in finance myself, so maybe I should be careful in what I'm about to say. But it seems to me that a large capital expenditure should be financed with debt. The debt service could be supported by toll revenue (on bridges and roads) and user fees in general, backed by the Treasury, if needed. The use of tax finance advocated by Shiller in his balanced-budget exercise implicitly assumes (among other things) lump-sum taxes. For some thought experiments, the assumption of lump-sum taxes is innocuous enough. But this is not one of those cases. Taxes are distortionary and to the extent that they are needed to support public spending, they should be spread out over time. This is a standard principle of public finance (I think).

Maybe Shiller believes in this standard principle, but views it as politically infeasible (given the current appetite for debt reduction). Possibly. But if so, I would rather have expected a rousing defense of these standard principles. Americans are not necessarily against debt; they are against wasteful spending.  Given that America has an infrastructure (crumbling as it may be be) should be taken as evidence, I think, that people are generally willing to support worthy public enterprises--where worthiness is judged by a project-by-project cost-benefit analysis.

And speaking of standard principles, what ever happened to the quaint idea of evaluating the merit of public capital expenditure on a net present value basis, instead of some magic-multiplier concept? There is probably a good NPV case to be made for implementing such projects in a recession, even in the absence of positive externalities. Indeed, if what we read about America's "crumbling infrastructure" is true, these projects should have been started several years ago. Perhaps they were not because the economy was at that time judged to be "overheating." After all, the same Keynesian cross logic suggests decreasing G during a boom (crumbling infrastructure be damned). D'oh!...dang Keynesian cross.

The Great Canadian Slump: Can it Happen in the U.S.?

The large decline in U.S. employment has had me reminiscing about Canada's similar experience in the early 1990s. I remember Pierre Fortin's presidential address to the Canadian Economic Association in 1996, entitled The Great Canadian Slump. Fortin seems to place much of the blame for this episode on the Bank of Canada; a claim hotly contested by Chuck Freedman and Tiff Maclem of the BoC here. I see that Stephen Gordon of WCI was reflecting on this episode in Canadian economic history as well; see here.

Let's begin by looking at employment-population (E/P) ratios. Population for Canada is 15+; for the U.S., it is 16+ civilian, noninstitutional (sample period 1976:1 - 2010:3).

The two series are similar up until about 1990. Then the recession hit. And it hit much harder and longer for Canada.

In 1990, E/P dropped by less than 2 percentage points in the U.S.; and dropped by about 4 percentage points in Canada. Now take a look at 2008; it is exactly the opposite. Canadians, apparently, don't need a world financial crisis to generate crisis-like employment slumps. In fact, the financial crisis appears to have had relatively little impact on Canada (that is, relative to the U.S., and relative to Canada in 1990).

One thing that might be of interest (or concern) for Americans is the length of Canada's employment slump. The E/P ratio essentially flat lined for about 5 or 6 years; and did not attain its pre-recession peak of 62% until well into the next decade.

Let me normalize real per capita GDP and the E/P ratio each to 100 in 1990:1. Here is what Canada's output and employment history looks like for the 1990s:

Now, that's what I call a jobless recovery!

It's interesting to look at other measures of labor market activity too. The next graph shows the participation rates (labor force divided by adult population):

Part rates are similar until 1990, and then exhibit almost a mirror image. Note that the U.S. participation rate shows some evidence of secular decline since reaching its peak. The next graph plots unemployment rates (unemployment divided by labor force):

The large gap in cross-country unemployment rates that emerged in the early 1980s and persisted for two decades elicited a fair amount of hand-wringing and a collective gnashing-of-teeth in Canada. To see what people were talking about, have a look here.

The main point I want to convey here for Americans is that the prospect of a prolonged jobless recovery, with persistently high unemployment rates, is not outside the realm of possibility. Such an episode has occurred in the recent past and, moreover, it occurred in an economy that is more similar to the U.S. than perhaps any other (in particular, Canada is not Japan).

This does not, of course, mean that a jobless recovery is inevitable. But I do think it might be worth exploring what parallels (if any) exist between these two episodes, and to see what might be learned from it. Will keep you posted, but in the meantime, feel free to share your thoughts.

Interpreting the Beveridge Curve

The Beveridge curve (BC) refers to the relationship between job vacancies and unemployment. There are really two types of BCs: one empirical, and one theoretical. The empirical BC is simply a scatterplot of vacancy and unemployment data. Think of data as the entrails of a gutted animal. The theoretical BC is an interpretation of those entrails, as divined by an economic haruspex.

The empirical BC is usually negatively sloped. Except for when it isn't. (You know how it is.)

The theoretical BC is a very intuitive creature. If some measure of general business conditions improve, especially in terms of economic outlook, businesses will generally want to expand their investments. And this includes investment in the form of replenishments to their labor force. If the labor market is subject to search frictions, the hiring process will take time. But an increase in job openings will generally make it easier for unemployed workers to find a job, so we would expect unemployment to decline as job vacancies rise.

Sometimes, however, the BC appears to "shift" its position (e.g., if the BC looks like a shotgun blast). These apparent shifts are sometimes interpreted to be the consequence of shocks that somehow lead to increased search frictions (let me label these "structural" shocks). In his fine Nobel prize lecture, Christopher Pissarides gave the example of Brittain 1975-84:

Usually though, the BC has a sharper negative slope. This was certainly the case in the United States; at least, until recently. Here is a plot of the U.S. BC using JOLTS data. Both job openings and unemployment are divided by a measure of population (16+ civilian). The dots represent the empirical BC and the solid line represents a theoretical BC.

A fairly conventional interpretation of the pattern above is that the U.S. experienced a cyclically-induced increase in unemployment; at least, approximately up until the recession was formally declared ended. These are the blue dots (lying close to that BC line I am forcing into your brain). Since then, something screwy appears to have happened in the labor market. There is evidence of increased recruiting activity, but no evidence of declining unemployment (the red dots).

Is this evidence of some greater difficulty in matching unemployed workers to available jobs? Did the recent recession leave us with some "structural" problems? If so, can we identify precisely what these "structural" problems are, and what--if anything--might be done about it? These are just some of the questions people are asking theses days.

Unfortunately, I'm not presently able to answer these questions. What I offer, instead, is some speculation on another question that has been floating in my mind lately. In particular, is the pattern of the U.S. BC plotted necessarily inconsistent with the notion that "structural" shocks have afflicted the labor market throughout the recent recession?

It was Steve Williamson's blog post here that got me thinking about this. Underlying much of the modern theory of search in the labor market is the Phelps/Pissarides aggregate matching technology:

[1] h_t = x_tM(v_t,u_t)

where h denotes hires, v denotes job openings (vacancies), and u denotes unemployment. For quantitative applications, M(.) is usually specified to be Cobb-Douglas; e.g., M(v,u) = v^0.5u^0.5. The x parameter corresponds to the TFP parameter in a standard aggregate production function. Following Steve, I use the JOLTS data to compute the matching function "Solow residual:"

[2] log(x_t) = log(h_t) - 0.5log(v_t) - 0.5log(u_t)

And here is what I get:

The red dots depict TFP from December 2007 (the official start of the recession) onward to October 2010.

According to the plot above, events beginning with the recession have reduced matching function efficiency by about 20%. That's a big drop. But what does it mean? It's important not to get too carried away with this result. In particular, we have all the usual measurement problems to contend with when constructing TFP measures. For example, much or perhaps even most of the decline in measured TFP may be the consequence of (unmeasured) reductions in search intensity.

On the other hand, there does not appear to be any good reason to simply dismiss the result as evidence of increased search frictions. We just lived through an episode that tore apart many ongoing relationships. Picking up the pieces and putting them back together again (possibly in new and more productive ways--re: Schumpeter's creative destruction) may be a bit more difficult this time around. Ultimately, I think we will need to examine the microdata to assess the "disruptiveness" of the recession. Perhaps a study along the lines of Rogerson and Loungani (JME 1989)--who look at PSID data--might shed some light on the matter.

But until then, if we take the measured TFP data seriously (and, again, I emphasize the caveats), might this warrant reinterpreting the U.S. BC in the following way?

The red dots represent the empirical BC since the beginning of the recession (Dec 2007); the time when the estimated matching function TFP appears to weaken.

It is interesting, I think, to examine this interpretation in the light of a simple labor market search model. In an earlier post, I argued that a negatively sloped BC is not inconsistent with a sequence of shocks that deteriorate matching efficiency; see here. Let me show you what I mean, via a simple example (that restricts attention to steady-states).

There is a cyclical variable, labeled y. This denotes the output produced by a job-worker pair. I assume a "fair share" bargaining rule that divides this output into wage and profit components. A firm's flow profit is given by the share ξy. The present value of this profit flow is denoted J(y). This value is procyclical; i.e., it will increase when the cyclical variable y increases.

If a firm wants to open a job vacancy, it must bear a cost κ. It is successful in finding an unemployed worker with probability xq(θ); where θ = v/u is the "labor market tightness" variable, and where q(.)=M(.)/v. If the new hire starts work next period, the expected present value of posting a vacancy is xq(θ)βJ(y). The following zero-profit condition determines the equilibrium labor market tightness:

[3] xq(θ)βJ(y) = κ

Condition [3] determines θ(y,x). It is easy to show that θ is increasing in the "cyclical" variable y and the "structural" variable x.

Finally, there is a stock-flow equation that determines the equilibrium unemployment rate: u = σ / (σ + xp(θ)); where σ is an exogenous match separation parameter (job destruction rate).

I parameterize this simple model and compute the equilibrium vacancy-unemployment combinations under two scenarios (GAUSS code available on request). First, I vary the "cyclical" variable y 15% above and below its mean value, holding x fixed. Then, I hold y fixed at its mean value and vary the "structural" variable x 15% above and below its mean. And here is what I get:

What is interesting here is that a permanent decrease in the match efficiency parameter x leads to a permanent decline in job creation and permanent increase in unemployment (of course, I am not suggesting that these "structural" shocks are in any way permanent in reality). I think it was Abraham and Katz (JPE 1986) who led many (including myself) to believe that structural changes should lead to a positively-sloped BC. Of course, they did  not have an explicit model. According to this simple model, they appear to be wrong. We may at least conclude that they are not necessarily correct.

In short, one reason why job openings may have declined is because it is generally more difficult for firms to find the right worker. Indeed, given how circumstances may have changed since the recession, firms may not--as of yet--even know what type of skill set constitutes the best hiring investment. Until this uncertainty in the match-making process sorts itself out, it may make sense to recruit less intensively.

Okun's Law Rules the FOMC

Zzzzz...oh...what's that? The FOMC say's what?

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.

(Full statement available here.)

Stop the presses! New headline: Central bank warns recovery too slow to curb unemployment (Financial Times, Dec. 14, 2010).

Oh no! Well, we'd better get that growth going then. What's everyone waiting for? Increase G! Increase M! Increase...increase.....Zzzzzz.

Sorry, but I stayed out way past my regular bedtime last night. And for some strange reason, I find myself mulling over this curious phrase: "...though at a rate that has been insufficient to bring down unemployment." Why did the FOMC include it in their statement? What does it mean? And where does it come from?

Let me start with the last question first. It comes from the late Arthur Okun, who discovered something called Okun's law back in the 1960s. Evidently, Okun's law was widely taught back in the day. These would have been the days when most of the now senior members of the FOMC were impressionable youngsters; see -------->

Alright, so now we know where it comes from. But what does it mean? Obviously, it refers to some sort of ironclad law of economic nature, right?

Uh, well...no, not exactly. When the law breaks down, proponents like to refer to it as a "rule of thumb," instead. To be honest, it's really just a statistical correlation. When economic growth goes up, the unemployment rate goes down. At least, on average this is what happens at business cycle frequencies.

Of course, it's also true that when the unemployment rate goes up, economic growth slows down. To put things another way, output tends to go up when more people are working. I know it's quite the shocker, but many economists believe this to be true. This is why they pay us the big bucks.

But why am I confusing you in this manner? Let's see what that great purveyor of purloined propositions (PPP) has to say about the subject: Growth and Unemployment.

What you see is that unemployment tends to fall when growth is high, rise when it’s low or negative. You also see that growth has to be fairly fast — more than 2 percent — just to keep the unemployment rate from rising. Why? Well, productivity is rising, so that you can produce any given level of output with fewer workers; so output has to rise to keep employment from falling.

(That darned productivity growth--scourge of the labor market.)

Alright, so what is PPP trying to say here, especially in that last sentence? As far as arithmetic goes, it's obviously correct (the language is sloppy, but let's cut him some slack). But arithmetic is not theory. He is trying to explain the empirical correlation of Okun's law. And explanation requires theory. Where is the theory?

To see what I mean here, let me alter the last sentence in the quote like this:

Well, productivity is rising, so that you can produce any given level of output with fewer workers; so employment has to rise if output is to rise at a more rapid pace. 

As far as arithmetic goes, this statement is also correct. But the sentence appears to convey a different message, doesn't it?

Evidently, there's more to Okun's law--the way it is commonly expressed--than a simple correlation. It seems to be sort of a "theory" too (I use the term loosely here). The theory is to be found in the assumption that the direction of causality runs one way only, and that it runs from output to employment, rather than the other way around. Output growth causes--nay, output growth is needed--to bring unemployment down. I guess the idea that more employment might cause more output--reversing the causality--seems less obvious. 

The way Okun's law is commonly expressed naturally leads to more sympathy for "demand side" policies, like increasing G or M, to stimulate employment. I am not saying that this shouldn't be done. What I'm saying is that the arithmetic supplied by PPP is not what supports such a policy. My use of the arithmetic, for example, might instead be used to support "supply side" policies, like a cut in the payroll tax. It would be equally wrong to abuse arithmetic in this manner.

Anyway, I think it is time to bring my morning rant to a close. But I still haven't answered the question of why that silly phrase was included in the FOMC statement. Would anything of any substance have been lost if the statement had not included it? It's not as if QE2 can only be justified if one believes in Okun's law (PPP version). I guess it's difficult to rid oneself of some youthful impressions.