Tag Archive for 'DeLong'

Double-yolk eggs, clustering and the financial crisis

Published on 3 February 2010 in Economics, Epistemology, Finance and USA. Tags: , , , , , . 0 Comments

I happened to be listening when Radio 4’s “Today Show” had a little debate about the probability of getting a pack of six double-yolk eggs.  Tim Harford, who they called to help them sort it out, relates the story here.

So there are two thinking styles here. One is to solve the probability problem as posed. The other is to apply some common sense to figure out whether the probability problem makes any sense. We need both. Common sense can be misleading, but so can precise-sounding misspecifications of real world problems.

There are lessons here for the credit crunch. When the quants calculate that Goldman Sachs had seen 25 standard deviation events, several days in a row, we must conclude not that Goldman Sachs was unlucky, but that the models weren’t accurate depictions of reality.

One listener later solved the two-yolk problem. Apparently workers in egg-packing plants sort out twin-yolk eggs for themselves. If there are too many, they pack the leftovers into cartons. In other words, twin-yolk eggs cluster together. No wonder so many Today listeners have experienced bountiful cartons.

Mortgage backed securities experienced clustered losses in much the same unexpected way. If only more bankers had pondered the fable of the eggs.

The link Tim gives in the middle of my quote is to this piece, also by Tim, at the FT.  Here’s the bit that Tim is referring to (emphasis at the end is mine):

What really screws up a forecast is a “structural break”, which means that some underlying parameter has changed in a way that wasn’t anticipated in the forecaster’s model.

These breaks happen with alarming frequency, but the real problem is that conventional forecasting approaches do not recognise them even after they have happened. [Snip some examples]

In all these cases, the forecasts were wrong because they had an inbuilt view of the “equilibrium” … In each case, the equilibrium changed to something new, and in each case, the forecasters wrongly predicted a return to business as usual, again and again. The lesson is that a forecasting technique that cannot deal with structural breaks is a forecasting technique that can misfire almost indefinitely.

Hendry’s ultimate goal is to forecast structural breaks. That is almost impossible: it requires a parallel model (or models) of external forces – anything from a technological breakthrough to a legislative change to a war.

Some of these structural breaks will never be predictable, although Hendry believes forecasters can and should do more to try to anticipate them.

But even if structural breaks cannot be predicted, that is no excuse for nihilism. Hendry’s methodology has already produced something worth having: the ability to spot structural breaks as they are happening. Even if Hendry cannot predict when the world will change, his computer-automated techniques can quickly spot the change after the fact.

That might sound pointless.

In fact, given that traditional economic forecasts miss structural breaks all the time, it is both difficult to achieve and useful.

Talking to Hendry, I was reminded of one of the most famous laments to be heard when the credit crisis broke in the summer. “We were seeing things that were 25-standard deviation moves, several days in a row,” said Goldman Sachs’ chief financial officer. One day should have been enough to realise that the world had changed.

That’s pretty hard-core.  Imagine if under your maintained hypothesis, what just happened was a 25-standard deviation event.  That’s a “holy fuck” moment.  David Viniar, the GS CFO, then suggests that they occurred for several days in a row.  A variety of people (for example, Brad DeLong, Felix Salmon and Chris Dillow) have pointed out that a 25-standard deviation event is so staggeringly unlikely that the universe isn’t old enough for us to seriously believe that one has ever occurred.  It is therefore absurd to propose that even a single such event occurred.   The idea that several of them happened in the space of a few days is beyond imagining.

Which is why Tim Harford pointed out that even after the first day where, according to their models, it appeared as though a 25-standard deviation event had just occurred, it should have been obvious to anyone with the slightest understanding of probability and statistics that they were staring at a structural break.

In particular, as we now know, asset returns have thicker tails than previously thought and, possibly more importantly, the correlation of asset returns varies with the magnitude of that return.  For exceptionally bad outcomes, asset returns are significantly correlated.

On interest rates

Published on 23 November 2009 in Economics, Finance and USA. Tags: , , , , , . 0 Comments

In what Tyler Cowen calls “Critically important stuff and two of the best recent economics blog posts, in some time,” Paul Krugman and Brad DeLong have got some interesting thoughts on US interest rates.  First Krugman:

On the face of it, there’s no reason to be worried about interest rates on US debt. Despite large deficits, the Federal government is able to borrow cheaply, at rates that are up from the early post-Lehman period … but well below the pre-crisis levels:

DESCRIPTION

Underlying these low rates is, in turn, the fact that overall borrowing by the nonfinancial sector hasn’t risen: the surge in government borrowing has in fact, less than offset a plunge in private borrowing.

So what’s the problem?

Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade; this could, they believe, drive rates way up, even though this possibility doesn’t seem to be priced in by the market.

What’s wrong with this picture?

First of all, what would things look like if the debt situation were perfectly OK? The answer, it seems to me, is that it would look just like what we’re seeing.

Bear in mind that the whole problem right now is that the private sector is hurting, it’s spooked, and it’s looking for safety. So it’s piling into “cash”, which really means short-term debt. (Treasury bill rates briefly went negative yesterday). Meanwhile, the public sector is sustaining demand with deficit spending, financed by long-term debt. So someone has to be bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue; call it a carry trade if you like, but it’s a normal and necessary thing.

Now, you could and should be worried if this thing looked like a great bubble — if long-term rates looked unreasonably low given the fundamentals. But do they? Long rates fluctuated between 4.5 and 5 percent in the mid-2000s, when the economy was driven by an unsustainable housing boom. Now we face the prospect of a prolonged period of near-zero short-term rates — I don’t see any reason for the Fed funds rate to rise for at least a year, and probably two — which should mean substantially lower long rates even if you expect yields eventually to rise back to 2005 levels. And if we’re facing a Japanese-type lost decade, which seems all too possible, long rates are in fact still unreasonably high.

Still, what about the possibility of a squeeze, in which rising rates for whatever reason produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? Well, we’ve seen enough of that sort of thing not to dismiss the possibility. But if it does happen, it’s a financial system problem — not a deficit problem. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized.

And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. Whatever you do, don’t undermine recovery by calling off jobs creation.

The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch. And again, it’s not clear that it even is an issue. What the worriers seem to regard as a danger sign — that supposedly awful carry trade — is exactly what you would expect to see even if fiscal policy were on a perfectly sustainable trajectory.

Then DeLong:

I am not sure Paul is correct when he says that the possible underlying problem is merely “a technical matter of maturity mismatch.” The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickles in front of the steamroller. And to the extent that the prices at which businesses can borrow are set by a market that keys off the Treasury market, an unwinding of this “carry trade”–if it really exists–could produce bizarre outcomes.

Bear in mind that this whole story requires that the demand curve slope the wrong way for a while–that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock…

For reference, here are the time paths of interest rates for a variety of term lengths and risk profiles (all taken from FRED):

interest_rates_1monthinterest_rates_3monthsinterest_rates_30years

To my own mind, I’m somewhat inclined to agree with Krugman.  While I do believe that the carry trade is occurring, I suspect that it’s effects are mostly elsewhere, or at least that the carry trade is not being played particularly heavily in long-dated US government debt relative to other asset markets.

Notice that the AAA and BAA 30-year corporate rates are basically back to pre-crisis levels and that the premium they pay over 30-year government debt is also back to typical levels.  If the long-dated rates are being pushed down to pre-crisis levels solely by increased supply thanks to the carry trade, then we would surely expect the quantity of credit to also be at pre-crisis levels.  But new credit issuance is down relative to the pre-crisis period.  Since the price is largely unchanged, that means that both demand and supply of credit have shrunk – the supply from fear in the financial market pushing money to the short end of the curve and the demand from the fact that there’s been a recession.

Understanding John Yoo and the Bush presidency

Published on 26 September 2009 in Justice/Law and USA. Tags: , , , , , . 0 Comments

Brad DeLong is continuing to maintain his stand against John Yoo.  To my mind, there is one clear way that John Yoo’s torture memos can be reconciled with his earlier writing on Clinton: He believes in the absolute primacy of the United States above all other nations.

Taking that as a postulate, placing US troops under foreign command becomes axiomatically unacceptable and was hence labelled unconstitutional [1], but allowing US agents to torture foreigners is acceptable, albeit unpleasant, because the victims are not American.

In practice, this becomes the application to the international stage of Richard Nixon’s famous 1977 quote, “when the President does it that means that it is not illegal.” Indeed, Condolezza Rice argued this exact point earlier this year (2009):

by definition, if it was authorized by the president, it did not violate our obligations under the Convention Against Torture.

This is simply the logical application (to the arena of military torture) of the belief that America should ignore all international agreements that constrain it in any way because to do otherwise would impugn the sovereignty of the greatest and purest nation in the history of mankind. You really have to admire their mental fortitude in failing to acknowledge the reductio ad absurdum that the Bush torture doctrine represented for that belief.

[1] To almost all Americans (including lawyers), the word “unconstitutional,” especially when applied in a political setting (and when is it not?), essentially means “against my ideology.”

In which I respectfully disagree with Paul Krugman

Published on 25 August 2009 in Academia, Economics, Labour and USA. Tags: , , , , , , , . 0 Comments

Paul Krugman [Ideas, Princeton, Unofficial archive] has recently started using the phrase “jobless recovery” to describe what appears to be the start of the economic recovery in the United States [10 Feb, 21 Aug, 22 Aug, 24 Aug].  The phrase is not new.  It was first used to describe the recovery following the 1990/1991 recession and then used extensively in describing the recovery from the 2001 recession.  In it’s simplest form, it is a description of an economic recovery that is not accompanied by strong jobs growth.  Following the 2001 recession, in particular, people kept losing jobs long after the economy as a whole had reached bottom and even when employment did bottom out, it was very slow to come back up again.  Professor Krugman (correctly) points out that this is a feature of both post-1990 recessions, while prior to that recessions and their subsequent recoveries were much more “V-shaped”.  He worries that it will also describe the recovery from the current recession.

While Professor Krugman’s characterisations of recent recessions are broadly correct, I am still inclined to disagree with him in predicting what will occur in the current recovery.  This is despite Brad DeLong’s excellent advice:

  1. Remember that Paul Krugman is right.
  2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.

This will be quite a long post, so settle in.  It’s quite graph-heavy, though, so it shouldn’t be too hard to read. :-)

Professor Krugman used his 24 August post on his blog to illustrate his point.  I’m going to quote most of it in full, if for no other reason than because his diagrams are awesome:

First, here’s the standard business cycle picture:

DESCRIPTION

Real GDP wobbles up and down, but has an overall upward trend. “Potential output” is what the economy would produce at “full employment”, which is the maximum level consistent with stable inflation. Potential output trends steadily up. The “output gap” — the difference between actual GDP and potential — is what mainly determines the unemployment rate.

Basically, a recession is a period of falling GDP, an expansion a period of rising GDP (yes, there’s some flex in the rules, but that’s more or less what it amounts to.) But what does that say about jobs?

Traditionally, recessions were V-shaped, like this:

DESCRIPTION

So the end of the recession was also the point at which the output gap started falling rapidly, and therefore the point at which the unemployment rate began declining. Here’s the 1981-2 recession and aftermath:

DESCRIPTION

Since 1990, however, growth coming out of a slump has tended to be slow at first, insufficient to prevent a widening output gap and rising unemployment. Here’s a schematic picture:

DESCRIPTION

And here’s the aftermath of the 2001 recession:

DESCRIPTION

Notice that this is NOT just saying that unemployment is a lagging indicator. In 2001-2003 the job market continued to get worse for a year and a half after GDP turned up. The bad times could easily last longer this time.

Before I begin, I have a minor quibble about Prof. Krugman’s definition of “potential output.”  I think of potential output as what would occur with full employment and no structural frictions, while I would call full employment with structural frictions the “natural level of output.”  To me, potential output is a theoretical concept that will never be realised while natural output is the central bank’s target for actual GDP.  See this excellent post by Menzie Chinn.  This doesn’t really matter for my purposes, though.

In everything that follows, I use total hours worked per capita as my variable since that most closely represents the employment situation witnessed by the average household.  I only have data for the last seven US recessions (going back to 1964).  You can get the spreadsheet with all of my data here: US_Employment [Excel].  For all images below, you can click on them to get a bigger version.

The first real point I want to make is that it is entirely normal for employment to start falling before the official start and to continue falling after the official end of recessions.  Although Prof. Krugman is correct to point out that it continued for longer following the 1990/91 and 2001 recessions, in five of the last six recessions (not counting the current one) employment continued to fall after the NBER-determined trough.  As you can see in the following, it is also the case that six times out of seven, employment started falling before the NBER-determined peak, too.

Hours per capita fell before and after recessions

Prof. Krugman is also correct to point out that the recovery in employment following the 1990/91 and 2001 recessions was quite slow, but it is important to appreciate that this followed a remarkably slow decline during the downturn.  The following graph centres each recession around it’s actual trough in hours worked per capita and shows changes relative to those troughs:

Hours per capita relative to and centred around trough

The recoveries following the 1990/91 and 2001 recessions were indeed the slowest of the last six, but they were also the slowest coming down in the first place.  Notice that in comparison, the current downturn has been particularly rapid.

We can go further:  the speed with which hours per capita fell during the downturn is an excellent predictor of how rapidly they rise during the recovery.  Here is a scatter plot that takes points in time chosen symmetrically about each trough (e.g. 3 months before and 3 months after) to compare how far hours per capita fell over that time coming down and how far it had climbed on the way back up:

ComparingRecessions_20090605_Symmetry_Scatter_All

Notice that for five of the last six recoveries, there is quite a tight line describing the speed of recovery as a direct linear function of the speed of the initial decline.  The recovery following the 1981/82 recession was unusually rapid relative to the speed of it’s initial decline.  Remember (go back up and look) that Prof. Krugman used the 1981/82 recession and subsequent recovery to illustrate the classic “V-shaped” recession.  It turns out to have been an unfortunate choice since that recovery was abnormally rapid even for pre-1990 downturns.

Excluding the 1981/82 recession on the basis that it’s recovery seems to have been driven by a separate process, we get quite a good fit for a simple linear regression:

ComparingRecessions_20090605_Symmetry_Scatter_Excl_81-82

Now, I’m the first to admit that this is a very rough-and-ready analysis.  In particular, I’ve not allowed for any autoregressive component to employment growth during the recovery.  Nevertheless, it is quite strongly suggestive.

Given the speed of the decline that we have seen in the current recession, this points us towards quite a rapid recovery in hours worked per capita (although note that the above suggests that all recoveries are slower than the preceding declines – if they were equal, the fitted line would be at 45% (the coefficient would be one)).

US government debt

Published on 14 August 2009 in Economics, Finance, Politics and USA. Tags: , , , , , , . 0 Comments

Greg Mankiw [Harvard] recently quoted a snippet without comment from this opinion piece by Kenneth Rogoff [Harvard]:

Within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three.

Reading this sentence frustrated me, because the “will have to” implies that these are the only choices when they are not.  Cutting government spending is the obvious option that Professor Rogoff left off the list, but perhaps the best option, implicitly rejected by the use of the word “sharply“, is that governments stabilise their annual deficits in nominal terms and then let the real growth of the economy reduce the relative size of the total debt over time.  Finally, there is an implied opposition to any inflation, when a small and stable rate of price inflation is entirely desirable even when a country has no debt at all.

Heck, we can even have annual deficits increase every year, so long as the nominal rate of growth plus the accrual of interest due is less than the nominal growth rate (real + inflation) of the economy as a whole and you’ll still see the debt-to-GDP ratio falling over time.

Via Minzie Chinn [U. of Wisconsin], I see that the IMF has a new paper looking at the growth rates of potential output, and the likely path of government debt in the aftermath of the credit crisis.  Using the the historical correlation between the primary surplus, debt, and output gap, they ran some stochastic simulations of how the debt-to-GDP ratio for America is likely to develop over the next 10 years.  Here’s the upshot (from page 37 of the paper):

IMF_US_debt_profile

Here is their text:

Combining the estimated historical primary surplus reaction function with stochastic forecasts of real GDP growth and real interest rates—and allowing for empirically realistic shocks to the primary surplus—imply a much more favorable median projection but slightly larger risks around the baseline. If the federal government on average adjusts the primary surplus as it has done in the past—implying a stronger improvement in the primary balance than under the baseline projections—the probability that debt would exceed 67 percent of GDP by year 2019 would be around 40 percent (Figure 4). Notably, with 80 percent probability, debt would be lower than the level it would reach under staff’s baseline by 2019. [Emphasis added]

So I am not really worried about debt levels for America.  To be frank, neither is the the market, either, despite what you might have heard.  How do I know this?  Because the market, while clearly not perfectly rational, is rational enough to be forward-looking and if they thought that US government debt was a serious problem, they wouldn’t really want to buy any more of that debt today.  But the US has been selling a lot of new bonds (i.e. borrowing a lot of money) lately and the prices of government bonds haven’t really fallen, so the interest rates on them haven’t really gone up.  Here is Brad DeLong [Berkeley]:

[A] sharp increase in Treasury borrowings is supposed to carry a sharp increase in interest rates along with it to crowd out other forms of interest sensitive spending, [but it] hasn’t happened. Hasn’t happened at all:

Treasury marketable debt borrowing by quarterTreasury yield curve

It is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion–an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp…

I don’t want to bag on Professor Rogoff. The majority of his piece is great: it’s a discussion of fundamental imbalances that need to be dealt with. You should read it. It’s just that I’m a bit more sanguine about US government debt than he appears to be.

US February Employment and Recession vs. Depression

Published on 13 March 2009 in Economics and USA. Tags: , , , , , , , , , , . 2 Comments

The preliminary employment data for February in the USA has been out for a little while now and I thought it worthwhile to update the graphs I did after January’s figures.

As I explained when producing the January graphs, I believe that it’s more representative to look at Weekly Hours Worked Per Capita than at just the number of people with jobs so as to more fully take into account part-time work, the entry of women into the labour force and the effects of discouraged workers.  Graphs that only look at total employment (for example: 1, 2) paint a distorted picture.

The Year-over-Year percentage changes in the number of employed workers, the weekly hours per capita and the weekly hours per workforce member continue to worsen.  The current recession is still not quite as bad as that in 1981/82 by this measure, but it’s so close as to make no difference.

Year-over-year changes in employment and hours worked

Just looking at year-over-year figures is a little deceptive, though, as it’s not just how far below the 0%-change line you fall that matters, but also how long you spend below it.  Notice, for example, that while the 2001 recession never saw catastrophically rapid falls in employment, it continued to decline for a remarkably long time.

That’s why it’s useful to compare recessions in terms of their cumulative declines from peak:

Comparing US recessions relative to actual peaks in weekly hours worked per capitaA few points to note:

  • The figures are relative to the actual peak in weekly hours worked per capita, not to the official (NBER-determined) peak in economic activity.
  • I have shown the official recession durations (solid arrows) and the actual periods of declining weekly hours worked per capita (dotted lines) at the top.
  • The 1980 and 2001 recessions were odd in that weekly hours worked per capita never fully recovered before the next recession started.

The fact that the current recession isn’t yet quite as bad as the 1981/82 recession is a little clearer here.  The 1973-75 recession stands out as being worse than the current one and the 2001 recession was clearly the worst of all.

There’s also some question over the US is actually in a depression rather than just a recession.  The short answer is no, or at least not yet.  There is no official definition of a depression, but a cumulative decline of 10% in real GDP is often bandied around as a good rule of thumb.  Here are two diagrams that illustrate just how much worse things would need to be before the US was really in a depression …

First, from The Liscio Report, we have an estimated unemployment rate time-series that includes the Great Depression:

Historic Unemployment Rates in the USA

Second, from Calculated Risk, we have a time-series of cumulative declines in real gdp since World War II:

Cumulative declines in real GDP (USA)

Remember that we’d need to fall to -10% to hit the common definition of a depression.

Changing Relative Prices

Published on 22 February 2009 in Economics. Tags: , . 0 Comments

From Brad DeLong, this tickled my fancy:

In the email inbox:

In Agatha Christie’s autobiography, she mentioned how she never thought she would ever be wealthy enough to own a car – nor so poor that she wouldn’t have servants…

How to value toxic assets (part 3)

Published on 21 January 2009 in Economics and Finance. Tags: , , , , , . 0 Comments

Continuing on from my previous thoughts (1, 2, 3, 4) …

In the world of accounting, the relevant phrase here is “fair value.”  In the United States (which presently uses a different set of accounting requirements to the rest of the world, although that is changing), assets are classified as being in one of three levels (I’m largely reproducing the Wikipedia article here):

Level one assets are those traded in liquid markets with quoted prices.  Fair value (in a mark-to-market sense) is taken to be the current price.

Level two and level three assets are not traded in liquid markets with quoted prices, so their fair values need to be estimated via a statistical model.

Level two assets are those whose fair value is able to be estimated by looking at publicly-available market information.  As a contrived example, maybe there is currently no market for a particular AA-rated tranche of CDOs, but there are recent prices for the corresponding AAA-rated and A-rated tranches, so the AA-rated stuff should be valued somewhere in between those two.

Level three assets are those whose fair value can only be estimated by appealing to information that is not publicly observable.

These are listed in the U.S. Financial Accounting Standards Board (FASB) Statement 157.  In October of last year, the FASB issued some clarification/guidance on valuing derivatives like CDOs when the market for them had dried up.

Brad DeLong, in early December last year, was given a list of reasons from Steve Ross why we might not want to always mark-to-market (i.e. assume that the fair value is the currently available market price):

  • If you believe in organizational capital–in goodwill–in the value of the enterprise’s skills, knowledge, and relationships as a source of future cash flows–than marking it to market as if that organizational capital had no value is the wrong thing to do.
    • Especially as times in which asset values are disturbed and impaired are likely to be times when the value of that organizational capital is highest.
  • If you believe in mean reversion in risk-adjusted asset values, mark-to-market accounting is the wrong thing to do.
  • If you believe that transaction prices differ from risk-adjusted asset values–perhaps because transaction prices are of particular assets that are or are feared to be adversely selected and hence are not representative of the asset class–than mark-to-market accounting is the wrong thing to do.
  • If you believe that changes in risk-adjusted asset values are unpredictable, but also believe:
    • in time-varying required expected returns do to changing risk premia;
    • that an entity’s own cost of capital does not necessarily move one-for-one with the market’s time-varying risk premia;
    • then mark-to-market accounting is the wrong thing to do.

Other posts in this series:  1, 2, [3], 4, 5, 6.

Negative interest rates on US government debt and Brad DeLong (Updated)

Published on 10 December 2008 in Economics, Finance and USA. Tags: , , , , , , , . 0 Comments

The interest rates on US government debt has turned negative (again) as a result of the enormous flight to perceived safety.  I guess they’ll be able to fund their gargantuan bailouts more easily, at least.

Brad DeLong has written a short and much celebrated essay (available on Cato and his own site) on the financial crisis and (consequently) why investors currently love government debt and hate everything else.  I’ll add my voice to those suggesting that you read the whole thing.  Here is the crux of it:

[T]he wealth of global capital fluctuates … for five reasons:

  1. Savings and Investment: Savings that are transformed into investment add to the productive physical — and organizational, and technological, and intellectual — capital stock of the world. This is the first and in the long run the most important source of fluctuations — in this case, growth — in global capital wealth.
  2. News: Good and bad news about resource constraints, technological opportunities, and political arrangements raise or lower expectations of the cash that is going to flow to those with property and contract rights to the fruits of capital in the future. Such news drives changes in expectations that are a second source of fluctuations in global capital wealth.
  3. Default Discount: Not all the deeds and contracts will turn out to be worth what they promise or indeed even the paper that they are written on. Fluctuations in the degree to which future payments will fall short of present commitments are a third source of fluctuations in global capital wealth.
  4. Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer — to varying degrees at different times — the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are yet a fourth source of fluctuations in global capital wealth.
  5. Risk Discount: Even holding constant the expected value and the date at which the cash will arrive, people prefer certainty to uncertainty. A risky cash flow with both upside and downside is worth less than a certain cash flow by an amount that depends on global risk tolerance. Fluctuations in global risk tolerance are the fifth and final source of fluctuations in global capital wealth.

In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values.

Some people have criticised Brad for his characterisation of the liquidity discount, suggesting that he has confused it with the (pure) rate of time preference.  I don’t think he is confused.  Firstly because he’s a genuine expert in the field and if he’s confused,  we’re in big trouble; and secondly because the two concepts are interlinked.

The liquidity discount is that an inability to readily buy or sell an asset – typically evidenced by low trading volumes and a large bid/ask spread – reduces it’s value.

The pure rate of time preference is a measure of impatience.  $1 today is preferred over $1 tomorrow even if there is no inflation. [Update: see below]

The two are linked because if you want to sell assets in an illiquid market, you can either sell them at a huge discount immediately or sell them gradually over time.  The liquidity discount is (presumably) therefore a monotonically increasing function of the pure rate of time preference for a given level of liquidity.

Minor update:

A more correct illustration of the pure rate of time preference would be to say:

Suppose that you could get a guaranteed (i.e. risk-free) annual rate of return of 4% and there is no inflation.  A positive pure rate of time preference says that $1 today is preferred over $1.04 in a year’s time.

More on the shift from Republican to Democrat

Published on 6 November 2008 in Politics and USA. Tags: , , , , , , . 3 Comments

Brad Delong observes that there is a clear regional exception to the idea of a broad shift in the vote from the Republicans to the Democrats (the original scatterplot comes from Andrew Gelman):

Paul Krugman takes it a bit further, emphasising this beauty of a map (I’m not sure of the source.  Probably the NY Times?):

The shifts to the Republicans in Arizona and Alaska and to the Democrats in Illinois and Delaware are clearly down to the candidates coming from those states.  I’m a little surprised at the strength of the Republican shift in southern Louisiana.  One might have thought that with the memory of Hurricane Katrina they would have moved blue.  Perhaps the administration’s management of Hurricane Gustav was seen as successful?  The Oklahoma-Arkansas-Tennessee shift is presumably McCain’s “real America.”  I’d love to see a demographic breakdown of the vote in those states.

Almost immediate update:

dbt on Brad Delong’s blog points out the obvious about Louisiana:

Don’t lump Louisiana into that. The changes there are demographic, not electoral.

Which of course must be the explanation. Southern Louisiana didn’t turn red because of the success of the handling of Gustav; it turned red because of the failure to handle Katrina – vast numbers of black Americans were forced out and haven’t come back.